Document of

The World Bank

FOR OmCI USIE ONLY

Repoct Ne. P-6538-GE

REPORT AND RECONMENDATION

OF THE

PRESIDENT OF THE

INTERNATIONAL DEVELOPMENT ASSOCIATION

TO THE

EXECUTIVE DIRECTORS

ON A PROPOSED REHABILITATION CREDIT

IN AN AMIOUNT OF SDR 51.0 MILLION

TO

THE REPUBLIC OF GEORGIA

MARCH 7, 1995

FILE COPY

This document has a restricted distribution and may be used by recipients only in the performance oftheir official duties. Its contents may not otherwise be disclosed without World Bank authorization.

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GEORGIA - REHABILITATION CREDIT

Currency Equivalents

Currency unit = Coupons

US$1.00 = 1,300,000 Coupons (February 14, 1995)

Weights and Measures

Metric System

Abbreviations and Acronyms

cIS Commonwealth of Independent StatesEU European UnionESW Economic and Sector WorkFSU Former Soviet UnionGDP Gross Domestic ProductGNP Gross National ProductIBC Institutional Building CreditIBRD International Bank for Reconstruction and DevelopmentICB International Competitive BiddingIDA International Development AssociationIFC International Finance CorporationIMF International Monetary FundMIGA Multilateral Investment Guarantee AgencyMOF Ministry of FinanceMPP Mass Privatization ProgramNBG National Bank of GeorgiaNMP Net Material ProductPIU Project Implementation UnitSDR Special Drawing RightsSOE Statement of ExpendituresSPM Ministry of State Property ManagementSTF Systemic Transformation FacilityTICEX Tbilisi Interbank Currency Exchange

Government Fiscal Year

January 1 - December 31

FOR OFFICIAL USE ONLY

REPUBLIC OF GEORGIA - REHABILITATION CREDIT

CREDIT AND PROGRANI SUlMlMARY

Borrower: Republic of Georgia

Amount: SDR 51 million (US$75 million equivalent)

Terms: Standard IDA terms (thirty-five years to maturity, including ten years graceperiod)

Objectivesand Description: The main objective of the proposed credit is to support the Government's

economic reform program aimed at restoring macroeconomic stability and atpromoting the resumption of growth and improvement in living standards. Thereform program comprises three sets of policies: (a) those aimed at reducingand redefining the role of the public sector in the economy; (b) those thatfoster the development and increased efficiency of markets; and (c) those thatmaintain a minimum social safety net through improved targeting of benefits.Among the key reforms are price and trade liberalization; phasing out of thestate order system; restructuring of the Government sector; privatization andprivate sector development; and improved targeting of social benefits.

The other objectives of the credit are to: (i) provide budgetary support tomaintain the level of basic public expenditures, in particular for wages and thesocial safety net; (ii) provide foreign exchange for the purchase of criticalimports; (iii) improve the functioning of the foreign exchange market; and(iv) provide a framework for financial assistance from other donor agencies.

Poverty Category: Poverty focused. The proposed credit would support: (i) public sectorreforms that reallocate public expenditures to ensure access to basic health andeducation services by the poor; and (ii) increases in cash transfers to thepoorest groups (pensioners, children, unemployed, refugees and low-paidgovernment sector employees) by redirecting resources saved through theelimination of generalized subsidies and improved targeting. Further reformsaim at further targeting of benefits and restructuring of the pension system togenerate additional resources for protecting the poorest. Allowances have beenmade in the fiscal program to strengthen the social protection system.

Benefits: Implementation of the proposed reforms will help to restore macroeconomicstability and to reverse the decline in economic activity, thus promotingemployment in the private sector and improved living standards. Thisobjective will also be served through the increased availability of foreignexchange for obtaining critical imports.

Risks: The proposed credit faces four main risks. The first risk relates to possibleslippage in implementation of reforms resulting from lack of continuouspolitical support or from social tensions due to difficult living conditions

This document has a restricted distribution and may be used by recipients only in the performance of theirofricial duties. Its contents may not otherwise be disclosed without World Bank authorization.

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following the sharp price realignment. The lack of adequate and timelyexternal assistance of the magnitude required could also lead to growing socialtensions, by forcing a stronger domestic adjustment that would be sociallyhard to sustain. This risk will be mitigated by the Bank's financial supportand by its efforts to mobilize external donor support and humanitarian aid.The second risk is that Georgia may be unable to reach agreements with itsmain creditors, Russia and Turkmenistan, leading to further disruption inenergy supplies. This risk is being addressed by policies aimed at achievingfull cost recovery in the energy sector, by the Government's commitment toavoid accumulating new arrears, and by bilateral negotiations underway toregularize previous arrears. Weak implementation capacity could also delayimplementation and output recovery; this risk would be addressed throughcontinuous technical support, in particular through the Institutional BuildingCredit. Finally, there is the risk that civil conflicts could resurface.However, it is expected that negotiations underway will lead to a lastingresolution of these conflicts, as well as to the return of refugees to Abkhazia.

Rate of Return: Not applicable

Appraisal Report: Not applicable

EstimatedDisbursement: The proceeds of the proposed credit would be disbursed in one tranche upon

effectiveness. US$15 million (20 percent of the credit) could provideretroactive financing for eligible imports procured in the four monthspreceding the date of loan signing.

Map: IBRD No. 25287.

This report is based on a main mission which visited Georgia in October 1995, comprising MichelleRiboud (senior country economist and mission leader), Prabhat Garg (EC4C2), Judy O'Connor(EC4DR), Stuart Bell (PSD), Heidi Mattila (CFS), John Nash (IECIT), Marcelo Bueno (EC4PE),Michael Fuchs (EMTPS), Gary Burtless and Andre-Paul Weber (consultants). Basil Kavalsky is theCountry Department Director and Wafik Grais is the Division Chief responsible for Georgia in theEurope and Central Asia Region. Documents were reviewed by Carlos Silva and Alberto Valdes.Nadia Pushkina, Rosario Hablero and Una Raymond provided secretarial support.

REPORT AND RECOMMENDATION OF THE PRESIDENTOF THE INTERNATIONAL DEVELOPMENT ASSOCIATION

TO THE EXECUTIVE DIRECTORSON A PROPOSED REHABILITATION CREDIT

TO THE REPUBLIC OF GEORGIA

TABLE OF CONTENTS

PART I. COUNTRY POLICIES AND WORLD BANK ASSISTANCE STRATEGY ... ..... 1I. Recent Economic Developments .1

A. Background .1B. Recent Economic Trends. 2C. Status of Structural Reforms. 5

II. The Government's Economic Reform Program.. 6A. Overview. 6B. The Stabilization Program. 7

(i) Fiscal Policy 7. 7(ii) Monetary Policy. 8(iii) Public Sector Wages and Social Security Payments. 8

C. The Structural Reform Program. 8(i) Reducing and Redefining the Role of the Public Sector. 9(ii) Promoting the Development of Markets and Increasing their

Efficiency .14(iii) Ensuring a Minimum Level of Social Protection .19

III. Macroeconomic Prospects and External Financing Requirements . .22A. Inflation and Output .22B. The Fiscal Outlook .23C. External Sector .24D. External Debt and Financing Requirements .24

PART II. THE BANK GROUP'S ASSISTANCE STRATEGY ......... ............ 27I. Background and Objectives .................................. 27II. A Period of Conflict and Nation-Building ......................... 27III. A New Relationship .......... ............................ 28IV. The Lending Program ......... ............................ 29V. Implications for World Bank Exposure ........................... 31IV. Economic and Sector Work Program ............................ 32VII. MIGA and IFC Activities ................................... 33

PART III. THE PROPOSED CREDIT ................. ................... 33I. Background and Rationale for World Bank Involvement ................ 33II. Program to be Supported ................................... 33Ill. Project Implementation .................................... 35IV. Procurement . .......................................... 36V. Disbursement . .......................................... 37VI. Reporting, Accounting, and Auditing ............................ 38VI. Environmental Safety .......... ........................... 38VIII. Agreements Reached .......... ............................ 38IX. Benefits and Risks ........... ............................ 38

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PART IV. RECOMMENDATION .................................... 39

ANNEX 1 Key Economic IndicatorsANNEX 2 Rehabilitation Credit - Timetable of Key EventsANNEX 3 Letter of Development PolicyANNEX 4 Policy Matrix

MAP

REPORT AND RECOMMENDATION OF THE PRESIDENTOF THE INTERNATIONAL DEVELOPMENT ASSOCIATION

TO THE EXECUTIVE DIRECTORSON A PROPOSED REHABILITATION CREDIT

TO THE REPUBLIC OF GEORGIA

1. I submit for your approval the following report and recommendation on a proposed credit to theRepublic of Georgia for SDR 51 million (the equivalent of US$75 million) to provide support for theGovermnent's economic reform program. The credit would be on standard IDA terms with a maturityof 35 years including a grace period of 10 years.

2. Georgia joined the IBRD in August 1992, MIGA in December 1992, and IDA in August 1993.It has not yet completed the membership process with IFC. The first Country Economic Memorandumentitled "Georgia, from Crisis to Recovery: A Blueprint for Reforms" (Report No. 11275-GE) wasdistributed to the Board in May 1993. An updated version of that report was made available to thegeneral public in October 1993.

PART I. COUNTRY POLICIES AND WORLD BANK ASSISTANCE STRATEGY

I. Recent Economic Developments

A. Background

3. Georgia was among the first Republics of the former Soviet Union (FSU) to declareindependence, which occurred on April 9, 1991. It has a population of 5.4 million people in ageographical area of 70,000 square kilometers, bounded by the Black Sea, Russia, Azerbaijan, Armenia,and Turkey. At the time of its independence, Georgia appeared to be a relatively well-off republic withfairly good growth potential. Its sources of strength were its educated labor force', its long tradition ofentrepreneurship, the existence of a significant underground economy, and non-negligible private sectoractivity in agriculture. Furthermore, the country's location made it a primary transit conduit for goodsshipped elsewhere in the Caucasus. Industry accounted for 37 percent of the net material product (NMP),on average during 1989-91, and agriculture 33 percent. Agriculture was relatively more important inGeorgia than in other FSU economies. In 1990, 96 percent of the country's exports were to other FSUrepublics, and imports from that region constituted 72 percent of its imports.

1/ The proportion of the Georgian population (aged 15 or more) with higher education was 17.5% in1989, the highest proportion among FSU countries. This compares with 13.0% in Russia, 13.5% inthe Baltics, and 12.5% for the Soviet Union overall.

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4. Since independence, Georgia has suffered from intense civil conflict. Throughout 1992 and 1993,Government forces fought against supporters of former President Gamsakhurdia. During the sameperiod, fighting over Abkhazia also continued. The conflict has resulted in a large influx of refugees(about 270,000) from Abkhazia to other parts of Georgia, worsening the economic plight of the country.Toward the end of 1993, the intensity of armed conflict abated and the Government achieved greaterpolitical control. A cease-fire is now in effect, and an agreement involving Russia and the United Nationshas been signed to work out a peaceful resolution of the conflict. Georgia joined the Commonwealth ofIndependent States (CIS) and Russian peacekeeping forces are now in Abkhazia to work out the returnof refugees to the province and to reopen the route to Russia.

B. Recent Economic Trends

5. In recent years, the Georgian economy has been greatly affected by the disruption in paymentsand trade within the FSU, by large terms of trade shocks, and by output declines in Russia and elsewherein the region. A self-imposed trade embargo following the declaration of independence, an earthquakein 1991 and most important of all, two years of civil conflicts, have imposed substantial additionaleconomic and social costs. These factors, aggravated by the effects of increasingly loose financialpolicies, have resulted in the sharp economic decline and worsening of living conditions currentlyobserved in Georgia.

6. Production has been declining since 1989; the contraction has, however, been particularly sharpsince 1991. It is estimated that between 1989 and 1991, net material output (NMP) fell by a cumulativetotal of 30 percent. Further annual declines of over 40 percent and 32 percent are estimated for 1992and 1993, respectively. For the whole period, the cumulative decline is about 75 percent, one of thesharpest declines observed among FSU countries. Available data for the first months of 1994 indicatefurther output contraction, although probably of lesser magnitude. As a result, GNP per capita, estimatedat US$563 for 1993, is one of the lowest among FSU countries.

7. The contraction of output since 1991 has affected all sectors. Except for construction where thecontraction was strongest, the industrial, agricultural and service sectors declined each by about 65percent between 1991 and 1993. In 1993, economic activity in construction practically came to a stopwhile agricultural production fell by 42 percent, and industrial production by 21 percent. Only in theservice sector was the decline relatively small in 1993, indicating that structural changes were alreadytaking place in the economy. Official data do not, however, provide a complete picture of the economicsituation. The informal economy - a long-standing feature of the Georgian economy - seems to havedeveloped considerably, especially in the trade sector, but its activities remain largely unmccorded in thenational accounts. The magnitude of economic decline may thus be overestimated. Still, indirectindicators such as energy consumption suggest that, even if the informal sector has developed rapidly,the overall decline in the economy has been substantial and most likely exceeds 50 percent for the wholeperiod 1990-1993.

8. As a result of the sharp decline in output, the total number of people employed (about 2.7 millionin 1990) has declined by almost 30 percent since 1990. Although private sector employment grew by58 percent (and now represents 20 percent of total employment), its increase was not large enough to

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compensate for the decline in the state sector2. Open unemployment, estimated at about 0.1 percentof the labor force at the beginning of 1992, rose to 8.4 percent by December 1993. In addition, hiddenunemployment is significant: in 1993, one-fourth of state enterprises reported production stoppages.

9. External trade, largely with the states of the FSU, used to play a big role in the Georgianeconomy. Total external trade (average of imports and exports) amounted to almost 43 percent of GDPin 1988-90, with inter-republican trade accounting for as much as 37 percent. Georgia relied heavily onimports of energy from other republics, notably Russia (for electricity and crude oil) and Turkmenistan(natural gas). Imported energy amounted to about 80 percent of total energy supply in 1990. Wheat,sugar, and some heavy machinery were the other major imports. Exports included citrus, tea, tobacco,wine, and mineral water. By far the biggest trading partner was Russia.

10. In 1991 and 1992, trade with the other FSU republics and the rest of the world collapsed. Thiswas due to several factors, which include the self-imposed embargo on trade with other republicsfollowing the declaration of independence, the general breakdown of trade channels in the FSU, thedisruption of transport routes due to the fighting in Abkhazia and Ossetia, the disruption of productionfrom input shortages, and the disintegration of the state order system. Available evidence suggests thatthe volume of imports may have fallen by more than half from 1991 to 1992. Although the importanceof oil and gas increased greatly to over 44 percent of total imports, energy shortages became acute,sharply affecting industry, agriculture and transportation.

11. There are indications3 that trade recovered somewhat in 1993 and 1994, with some re-orientationtowards non-FSU countries and increased private sector participation. However, the -olume of netenergy imports was further reduced as Georgia had to face an increase of more than 148 oercent in theunit cost of natural gas. Foreign exchange shortages, difficulties regarding payments arrangements anduncertainties about currency values have led to increasing reliance on bilateral agreements and bartertrade. Approximately half of Georgia's trade is organized around these bilateral treaties. The tradebalance, which registered a small deficit in 1991, deteriorated thereafter. This reflected both the collapseof exports and the deterioration in the terms of trade. The deficit amounted to about US$243 million in1993, and an estimated US$334 in 1994. Increasingly, Georgia has accumulated arrears related to itsenergy imports. The total stock of arrears is estimated to have reached about US$370 million by the endof 1994. Most of these arrears are owed to Turkmenistan and Russia.

12. Until 1991, inflation was low in Georgia. Since then, however, inflation has surged. Pricesrose, on average, by 80 percent in 1991 and by more than 900 percent in 1992. During the second halfof 1993, the inflationary process accelerated sharply following the introduction of the new currency. Bythe end of 1993, the annual rate of inflation had reached 8,400 percent and was ten-times that of Russia.Inflation during the first months of 1994, with a monthly rate of about 60 percent, showed no sign ofdeceleration. While, in the early period, the surge in prices largely reflected price liberalization, the

2/ Private sector employment (like production) is most likely underestimated. The discrepancies observedbetween figures on job losses in the state sector (over 700,000 jobs since 1990) and on unemployment(about 180,000 at the end of 1993) suggest that employment may be growing rapidly in theunderground economy. Some out-migration and reduction in the labor force may also have takenplace.

3/ Statistical deficiencies prevent an accurate estimate of the increase.

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recent acceleration can be directly associated with deterioration in the fiscal position of the governmentand domestic credit expansion.

13. Georgia's fiscal performance weakened considerably after 1992. The primary budget deficit rosefrom 3.7 percent of GDP in 1991 to about 31 percent in 1992 and 26 percent in 19934. While the wholedeficit was financed through money creation in 1992, 80 percent of the 1993 deficit was financed throughexternal loans and grants (e.g., loans from Turkmenistan for energy imports, loans from the EU andgrants from the US for food). This change reflects the Government's growing difficulties in collectingrevenues through inflationary finance, and its increased reliance on humanitarian aid for food, medicines,and support to refugees, as well as on external financing.

14. The deterioration of the fiscal stance resulted largely from shortfalls in revenues aused by thesteep drop in production, the impact of inflation, and worsening tax collection. Reverue collection(excluding grants), which was around 30 percent of GDP in 1991, fell to 11 percent in 1992 andcollapsed to about 3 percent in 1993. Available data for 1994 indicate a further drop in tax collectionand an estimated deficit of about 32 percent of GDP for the first half of the year. On the expenditureside, the composition of government expenditures changed significantly: wages, expenditures on socialprograms, and capital expenditures have been drastically reduced. Subsidies (explicit and implicit) - themost significant being for electricity, gas, and bread - accounted for 70 percent of government spendingduring the first half of 1994.

15. In common with other countries belonging to the ruble zone, Georgia has experienced severeshortages of ruble banknotes. The Georgian coupon was introduced in April 1993 (at a conversion rateof 1 coupon per ruble) and it was proclaimed the sole legal tender in August 1993. As a result of anexpansionary monetary policy and of the rapid inflation that followed, the exchange rate of the coupondepreciated steadily vis-a-vis the Russian ruble from 5.5:1 in August 1993 to 1,030:1 by August 1994;and vis-a-vis the US dollar from 5,600:1 to 2,400,000:1. Implementation of the first stabilizationmeasures in September 1994 halted the depreciation of the coupon and reversed trends: as of February,the exchange rate was 1,300,000 coupons per US dollar. Price developments during the second half of1993 have also led to substantial currency substitution. Both rubles and dollars are extensively used asunits of account, payment for transactions, and stores of value. This has reduced the demand fordomestic currency to a bare minimum, making the inflationary effects of deficit financing via moneycreation even greater.

16. With the continuous deterioration of the economic situation over the last five years, the livingstandards of the majority of the population have declined sharply, especially since the end of 1991.Unemployment, almost negligible at the beginning of 1992, reached 8.4 percent of the labor force byDecember 1993 (see para. 8). The drop in early 1994 in the number of persons registered "with thestatus of unemployed" was mainly due to the rapid decline in the value of unemployment benefits ratherthan to an improvement in the employment situation. Real wages, which remained practically constantin 1991, declined by about 90 percent over the course of the last two years. Families now spend onaverage about 80 percent of their reported income on food and must rely to a large extent on informalsector activities, sales of personal effects and assets, or remittances from abroad to cover their basic

4/ The 1993 deficit is estimated taking into account grants and implicit subsidies financed by externalloans.

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expenditures. In addition, rationing of electricity, lack of heating during the winter, and cuts in publictransportation are imposing considerable hardship on the population.

17. The Government's capacity to finance social programs and guarantee an adequate safety net hasalso declined sharply. Expenditures on health and education declined from 11 percent of GDP to 2percent in 1993, and there is already evidence that both maternal and infant mortality are increasing.Expenditures on pensions and family allowances do not exceed 1 percent of GDP, although pensionersrepresent one-fifth of the population. The number of persons receiving unemployment benefits is smalland declining, although unemployment is rising. Cash and in-kind assistance is provided to the 270,000refugees from Abkhazia, and is mostly financed with humanitarian aid provided by foreign donors.

C. Status of Structural Reforms

18. In spite of the many difficulties, Georgia has already made progress over the past few years inimplementing structural reforms aimed at reducing the role of the Government in the economy and atcreating a market environment. In contrast with many other FSU countries which chose the oppositepath, Georgia made progress on structural reforms but lagged behind on macroeconomic stabilization.The areas in which progress has been achieved include domestic pricing, international trade, exchangerate policy, and private sector development.

19. Domestic Pricing. Until the beginning of 1992, all prices were regulated although there wereparallel or bazaar markets for many goods. As a first step, prices for a large number of commoditieswere liberalized in February 1992. A second round of liberalization was implemented in July 1992.Barriers to participation in commodity markets and restrictions on trade among citizens were removedduring the same year. Consequently, prices that remained under government control as of mid- 1 994 werethose of bread, medicines, municipal services, energy products (coal, gas and electricity), publictransportation, and communications.

20. International Trade and Foreign Exchange Regime. Although significant export restrictionsand an export tax of 8 percent (scheduled to be eliminated) still prevail, Georgia has adopted an openimport regime since 1992. There are no restrictions on imports from any part of the world. Only a 2percent uniform customs duty applies to imports from outside the CIS. This duty is scheduled to beraised to 12 percent under the stabilization program (see para. 30). Regarding the foreign exchangeregime, the Georgian authorities have been committed since 1992 to a unified, market-determinedexchange rate, which is set in weekly foreign exchange auctions run by the National Bank of Georgia(NBG).

21. Privatization. Before the breakup of the Soviet Union, Georgia was ahead of other FSUrepublics in the area of privatization. Ninety-five percent of rural housing was already private and, asearly as 1987, privatization of small residential houses was made possible. In the agriculture sector,although only 6.5 percent of cultivated land was private, almost one-third of labor (about 8 percent oftotal employment in the country) was working on private plots. In addition, the informal economyalready provided opportunities for private sector activities (see para. 3).

22. Since the country's independence, a basic legal and institutional framework for privatization hasbeen developed. A first and main law on privatization of state-owned enterprises was passed in August1991. It established the overall institutional framework and the basic principles of privatization, includingthe assets that could be privatized as well as methods and procedures. It also defined the eligible buyers

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and certain rights and privileges for employees. This law anticipated the preparation of a privatizationprogram adopted in 1992, which contained a list of state enterprises that would be either subject to orexcluded from privatization. As the main law on privatization is generally empowering, it was followedby other secondary laws, decrees, and regulations, covering auctions and competitive sale, valuation ofassets for privatization, and the transformation of enterprises into joint-stock companies. In 1993, lawsand decrees regarding a voucher program and investment funds were enacted.

23. To enhance administrative efficiency and simplicity, the tripartite institutional structure envisagedin the 1991 law (comprising the Ministry of State Property Management (SPM), State Property Fundsand a Privatization Commission) was modified by an August 1992 decree. The Ministry of SPM nowassumes overall responsibility for managing state-owned property in Georgia, developing privatizationstrategies, reviewing enterprise privatization plans, and carrying out privatization through its 66 regionaloffices5 .

24. Up to now, privatization of small-scale enterprises has progressed fairly rapidly: by October1994, 1,657 small-scale enterprises (out of 6,481 identified for sale) were privatized, including tradingoutlets, gas stations, food processing plants, construction sites, printing shops and tourist agencies. Inaddition, 270 previously leased enterprises have been privatized. Privatization of medium and largeenterprises has been slower: only 8 have been privatized to date. However, over recent months, thereis evidence that the corporatization of medium and large-scale enterprises, an intermediate step in theprivatization process, is making rapid progress (see paras. 38-41).

25. After a period of interruption, privatization of housing was renewed in 1992 and is now nearlycomplete. Transfer of housing to present tenants, has been made practically free of charge, save for atitling fee and the equivalent of a two years' lease. Once the titles are transferred, owners are free to sellor otherwise further transfer the housing. Land reform started in early 1992, with privatization of about740,000 ha (about 25 percent of cultivated land) as the original target. About 650,000 ha have alreadybeen allocated to private farmers, and rural and urban households. Official statistics also indicate thatabout 50 percent of the labor force in the agriculture sector works on private plots, up from 30 percentin 1989. Over 75 percent of vegetables, fruit and meat is now provided by the private sector.

II. The Governmnent's Economic Reform Program

A. Overview

26. Throughout 1992 and 1993, the civil conflicts and the breakdown of law and order have delayedthe consolidation of the Georgian nation, led to deep macro-economic imbalances and interfered with theimplementation of structural reforms. With progress achieved toward political stability and restorationof law and order, the Government has, since the beginning of 1994, focused its attention on rebuildingits economy and expressed its commitment to restore macroeconomic stability and foster the resumptionof growth. To that end, a comprehensive program of macroeconomic stabilization and structural reformswas designed with the assistance of the IMF and the World Bank. To demonstrate its commitment toreversing recent economic trends and to accelerating the transition toward a market economy, the

5/ SPM has responsibility over the whole country except in Tbilisi, Kutaisi, and Batumi wheremunicipalities implement the privatization program.

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Government has over the last few months, taken a series of decisive and courageous measures. Theseinclude a sharp reduction in subsidies for bread and transportation, the adjustment of energy prices to costrecovery levels, the tightening of monetary and credit policies, and several decrees to speed upprivatization. On December 15, 1994, the Board of Directors of the IMF approved a first purchase ofSDR 27.75 million (approximately US$39 million) under the System Transformation Facility (STF).

27. The Government's economic reform prograrn aims at restoring stable macroeconomic conditionsand at promoting output recovery. It focuses on four interconnected and mutually reinforcing elements.First, macroeconomic stabilization will be achieved through a drastic fiscal adjustment and tightmonetary policies. Second, reforms of the public sector will be undertaken to reduce and redefine therole of the Government in the economy. The aim is to ensure the sustainability of the stabilizationprogram, the strengthening of the institutions of public management, and a growing reliance on privatesector activity through an acceleration of the privatization process. It is also to reallocate scarce publicresources toward basic social services. Third, the development and a more efflcient functioning ofmarkets will be fostered by finalizing the liberalization of domestic prices as well as of the foreignexchange and trade regimes; by promoting competition and creating a favorable environment for privatesector development; and by strengthening the financial sector. Finally, a minimum social safety net,compatible with the limited available resources, will be maintained by ensuring a minimum level of cashtransfers to the poorest groups of the population.

B. The Stabilization Program

28. The Governrnent has recognized that the monetary and fiscal policies implemented in recent years,which relied on inflationary finance, domestic dissaving, foreign aid, and external borrowing areunsustainable, and that a stable macroeconomic environment is essential to restore favorable prospectsfor economic growth. To bring about rapid stabilization, leading to a reduction of the monthly inflationrate from about 60 percent during the first half of 1994 to low single-digit levels by the end of 1995, theGovernment is committed to undertaking a drastic fiscal adjustment, and to maintaining tight fiscal andmonetary policies thereafter.

(i) Fiscal Policy

29. The overall fiscal deficit of the general government is targeted to decline from 26 percent of GDPin 1993 to about 9 percent in 1994, and to be limited to no more than 6-7 percent in 1995. For 1994and 1995, the main elements of the fiscal adjustment are the complete elimination of remaininggeneralized subsidies and an increase in budgetary revenues from the sale of donated imports of flour andwheat at the coupon equivalent of world market prices. As of September 1, 1994, domestic prices forgas and electricity were increased to cover costs (import or production and distribution costs), and willthereafter be readjusted every month (see para. 54). Subsidies for bread and transportation weresubstantially reduced and will be phased out by mid-1995. Provision of all subsidies and transfers toenterprises, including interest subsidies, were eliminated.

30. To facilitate tight control of expenditures and further strengthen the fiscal position of theGovermnent, the stabilization program, in addition to quarterly targets for Central Bank borrowing by

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the General Government6 includes: (i) centralization of all budget accounts of the RepublicanGovernmnent at the National Bank of Georgia (NBG); (ii) prohibition of bank borrowing by localgovernments; (iii) preparation for the introduction of a Treasury; and (iv) adoption of revenue-enhancingmeasures: increases from 14 to 20 percent in the VAT rate, from 2 to 12 percent for import customduties; from 10 to 15 percent for the gasoline excise tax. In addition, there will be increases in thepresumptive tax on kiosks, introduction of a 10 percent VAT on flour and bread products; reduced VATexemptions; readjustment of income tax brackets; and increases in penalties for non-compliance with taxobligations. The latter measures have been approved by Parliament in November and declared effectiveas of December 1, 1994. In addition, the Government will, with the assistance of the World Bank (underthe Institutional Building Credit, IBC) and the IMF, strengthen customs and tax administration to enforcecompliance and timely tax collection.

(ii) Monetary Policy

31. In the area of monetary and credit policies, the reform program relies on the control of domesticcredit expansion and more efficient allocation of credit. Changes in bank credit to general governmentand in net domestic assets of the NBG will be guided by inflation and international reserves targets. Tosterilize part of the massive monetization of the fiscal deficit in the third quarter of 1994, the NBGtightened enforcement of reserve requirements, including imposing penalties for non-compliance. Inaddition, reserve requirements on foreign currency deposits were raised to the same level as domesticcurrency deposits (20 percent). Directed credits to selected sectors at highly subsidized rates andautomatic access by state commercial banks to NBG overdraft facilities have been eliminated. To preventthe clogging up of the payments system, they will be replaced by a short-term credit facility to bedeveloped with the assistance of the IMF. The Government also removed restrictions imposed on theconvertibility of coupon deposits into cash that had led to the emergence of a separate market for noncashcoupons and impaired the functioning of the banking system. When policies are in place to ensuresustained price stability, a national currency, the lari, will be introduced.

(iii) Public Sector Wages and Social Security Payments

32. To compensate partially for the increase in prices, in September 1994 the Government increasedthe wages of employees in the budgetary sector, tilting the wage structure in favor of the lowest paid.It also provided additional cash payments for pensioners and other beneficiaries of the social securitysystem. Because of the fragile fiscal situation, further increases in public sector wages and social benefitswill be limited to rates equivalent to the target inflation rate during the first two quarters of 1995; possibleincreases in real wages as well as readjustments of the wage scale and of the social benefit structure, willonly be considered during the second half of 1995. No limit on wage growth will be imposed inenterprises and non-budgetary organizations.

C. The Structural Reform Program

33. The structural reform program of the Government has three main components. The firstcomponent aims at reducing and redefining the role of the public sector through an acceleration of theprivatization process, the imposition of hard-budget constraints on e. terprises and the restructuring of the

6/ The General Government includes republican (central) and local budgets, as well as extrabudgetaryfunds

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government sector, including a focus on basic social services. The second component comprises policiesgoverning price regulation, competition, trade and finance, that will foster the development of marketsand their increased efficiency. The third component aims at maintaining a minimum safety net throughincreased targeting of benefits, thus ensuring a minimum level of cash transfers to the poor. TheGovernment believes that this overall set of policies is necessary to ensure the sustainability of thestabilization program, facilitate a rapid transformation of the Georgian economy and create a favorableenvironment for resumption of growth, without which sustained poverty reduction cannot be achieved.

(i) Reducing and Redefrning the Role of the Public Sector

34. The urgent need to create an environment that facilitates a quick output recovery and to restoremacroeconomic stability requires strengthening the institutions of public management while reducing andredefining the role of the Government in the economy. Tax reform, strengthening customs and taxadministration, and enforcing compliance are ways to increase the capacity of the Government to collectrevenues and administer resources. The Government introduced new tax laws in 1992 and at thebeginning of 1994, and is currently receiving technical assistance to strengthen both its tax and custornsadministration (see para. 30). These measures, in addition to the reforms adopted in November 1994 (seepara. 30), should help to reverse current trends in tax collection. Stabilization itself should alsocontribute to that objective by reducing the negative effect of inflation on real tax revenues.

35. Even with substantial progress in raising revenues, the current level of government resources isso low that public-sector institutions must be thoroughly reorganized in order to narrow the budget deficitand ensure the sustainability of macroeconomic stability. Moreover, the restructuring of manyGovernment activities and the divestiture of state assets is desirable, even in an environment where thepublic deficit would remain moderate, in order to foster the development of private sector activity. ManyGovernment activities can be more efficiently performed by the private sector under a proper regulatoryframework.

36. To address these issues and reduce the scope for public interventions in the economy, theGovernment is committed to a deep reform of the public sector consisting of:

- the rapid transfer of ownership rights to the private sector.- the imposition of hard budget constraints on remaining state-owned enterprises.- the radical restructuring of the Government sector.

37. Transfer of Ownership Rights to the Private Sector. Although Georgia has made substantialprogress in transferring small-scale enterprises to private owners, the need for the Government to reducefurther the range of its interventions, maintaining only a regulatory role for the remaining ones, and toimpose hard-budget constraints on enterprises calls for acceleration of the privatization program.

38. Privatization of State-Owned Enterprises. Until the spring of 1994, small-scale enterprises(defined as enterprises with book value less than Rbl 30 million7 as of January 1993) were privatizedthrough auctions and tenders, while medium and large-scale enterprises (those with book value over Rbl30 million) were subject to mass privatization, or to tenders for selected cases (case-by-case privatization).As an intermediate step towards privatization, all medium- and large-scale enterprises are being

7/ About US$50,000.

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transformed into joint-stock companies. Once corporatized, enterprises are governed by a transitorybody, the privatization board, and are no longer under the control of line ministries.

39. Since May 1994, in an effort to accelerate the pace of the program, and in particular to break theresistance of collectives, a new feature was introduced through a decree of the Head of State (decree 178dated May 1994), which gives employees the right to purchase 100 percent of the shares of small-scaleenterprises and 51 percent of the shares in medium- and large-scale enterprises identified for sale. Thesedirect sales ("insider" privatization) are similar to those adopted in Russia, and are now a hallmark ofthe Government's program. Under this scheme, 100 percent of the shares of small-scale enterprises arefirst offered to "companionships" (partnerships), formed by at least 50 percent of enterprise employees.The partnership must submit an application to the SPM. Employees receive 5 percent of shares for free;payment for the remaining 95 percent can be in vouchers (35-50 percent) and local currency (45-60percent). If the employees do not purchase the enterprise, it is sold at auction or through competitivetender. For medium and large-scale enterprises which have been transformed into joint-stock companies,employees are eligible to purchase up to 51 percent of enterprise equity: 30 percent can be paid for byvouchers, and the remainder is available at a discount8. In addition, employees receive 5 percent ofshares for free bringing their shareholding to 56 percent. There are no restrictions on the subsequentresale of shares by employees. The decree does not apply to enterprises in the mining and militarysectors which will remain under state ownership in the near term and to enterprises subject to case-by-case privatization for which the proportion of shares available to employees will be below 51 percent.Valuations for all enterprises are based upon book value. However, given the payment arrangementsdiscussed above, insiders enjoy substantial discounts.

40. As of October 1994, small-scale privatization was fairly advanced (see para. 24): 1,657 small-scale enterprises had been privatized (25 percent of the 6,481 small enterprises so far identified for sale).Of these, approximately 46 percent has been privatized through competitive tenders, 43 percent throughauctions and 11 percent through direct sales. Privatization of small enterprises is pursued according tofixed targets: between mid-October 1994 and February 1, 1995, 847 additional enterprises have beenprivatized, thus reaching 40 percent of the target (6,481 enterprises). The Government intends tocomplete privatization of these enterprises by the end of 1995. To reach that objective, an Octoberdecree streamlined the administrative process and imposed a two month deadline for completingprivatization through direct sales following notification by SPM. To further accelerate the process, theGovernment adopted additional measures. First, minimum bid prices were eliminated at the second roundof auctions for enterprises not sold at the first auction attempt. Second, enterprises not sold at a secondauction will be liquidated and their assets auctioned piecemeal with no minimum bid prices. Third, toprovide incentives to local authorities to meet privatization targets, a policy is implemented allowing thosemunicipalities that have achieved the SPM-imposed targets for small-scale privatization to retain apercentage of privatization proceeds derived from the sale of enterprises within each municipality.Fourth, the Government eliminated pre-conditions on post-privatization activities for all small enterprises.

41. Privatization of medium and large-scale enterprises had proceeded more slowly. As ofOctober 1994, out of the 1,007 medium and large enterprises designated for privatization (which coversvirtually all enterprises but a small number in the mining and military sectors), 335 had been transformedinto joint-stock companies and only 8 privatized. The process was hampered by the relatively weakposition of the Ministry of SPM vis-a-vis the line ministries, cumbersome and lengthy procedures for

8/ 'Part of the remainder can be paid in coupons on terms and part can be obtained without charge.

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enterprise corporatization, and by lack of support for the program, especially from enterprise managersand collectives. The Government has recognized that these factors have delayed the privatization processand has taken corrective measures. The May decree extending the rights of employees to acquire 51percent of shares through a direct, non-competitive sale has addressed the latter problem (see para. 39).The other constraints have been addressed by strengthening the SPM's position, requiring line ministrycooperation, and streamlining the corporatization process. In consequence, the corporatization processhas accelerated over recent months. Between July and October 1994, 247 enterprises were transformedinto joint-stock companies, and since October, 407 additional ones were corporatized. Thus, as ofFebruary 1, 1995, about 73 percent of medium and large-scale enterprises have been transformed intojoint-stock companies. The government intends to complete the corporatization of all remaining medium-and large-scale enterprises by July 1, 1995.

42. Thirty-five percent of the shares of medium- and large-scale enterprises which have beentransformed into joint-stock companies are currently reserved for voucher auctions (mass privatizationprogram) which the Government intends to implement in several waves over 1995, and to complete bymid-1996. The voucher-based mass privatization program (MPP) is being supported by technicalassistance under the World Bank Institutional Building Credit (IBC). Three pilot auctions are expectedto take place in May and June 1995. Several necessary preparatory tasks have already been completedat the beginning of 1995. The list of eligible recipients of privatization vouchers has been completed;guidelines have been issued to complete the legal framework for the MPP, including the rules fordistribution of vouchers, auctions and bidding procedures; and the large enterprises to be sold at the firsttwo regional and at the first national voucher auctions have been identified. The Government intendsto distribute by May 1995, the preparation packages for the enterprises to be included in the first threeMPP voucher auctions. The MPP will be supported by a comprehensive public relations campaign,publicizing the program objectives, procedures for participants to obtain vouchers, as well as proceduresfor the conversion of vouchers to shares in enterprises and investment funds.

43. The Government is aware that management/employee buy-outs will leave many large enterpriseslacking in the capital and skills required to restructure and tum around potentially viable enterprises.Because such enterprises are expected to be a primary source of supply response to the adjustmentprogram, the Government has adopted a case-by-case track for privatizing a select group of such firms.In this case, employees will be eligible to purchase a minority stake in these enterprises, but the majoritywill be reserved for core investors. To that end, the Government has developed and adopted criteria forselecting enterprises to be privatized through international tenders. It has also identified 15 largeenterprises for this program and intends to complete privatization of these enterprises by mid-1996.

44. Privatization of Land. Land reform started in early 1992; at that time, almost 200,000 ha (6.5percent of cultivated land) were in the hands of private farmers; by mid-1994, another 450,000 ha hadbeen allocated to farmers, and to rural and urban households with the maximum size of land holdings forarable areas and perennial crops set at 1.25 ha. Private land now represents about 38 percent of arableland, 51 percent of land for tree-crops, 20 percent of hay fields, and 5 percent of pasture; in total, about20 percent of cultivated land. Distribution of land has taken place in all regions, although somewhatmore extensively in the west than in the east.

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45. Although the privatization of land has already had positive effects on the economy in terms ofoutput and farmers' incomes9 , the lack of official documentation supporting land holdings and the lackof legislation specifying disposition rights, has prevented private farmers from selling or buying land totake advantage of increased profitability associated with larger farm size. These problems have alsoprevented farmers from renting out land as they fear being unable to take the land back after theprescribed time. The Government is aware of these shortcomings, and has initiated with assistance ofthe World Bank the preparation of a land law defining the legal framework for transactions related to landincluding sale, lease and inheritance, and giving landowners unrestricted rights to enter into suchtransactions. It intends to submit the draft law to Parliament for discussion no later than July 1995. TheGovernment has also set a target of distributing a further 130,000 ha. (excluding Abkhazia) andprivatizing the remaining state and collective farms. By mid-1995, the Government will define theprinciples according to which the distribution of remaining agricultural land will be completed. It willalso define targets for privatization of state and collective farms. Implementation of the land privatizationprogram will be completed by February 1996.

46. Privatization of Housing. Most housing units in rural areas and some urban dwellings werealready privately owned before the country's independence (see para. 25). Legislation on privatizationof dwellings was approved in 1991 and by now, privatization of apartments in urban areas is nearlycomplete. Owners are free to sell or rent their housing. What is still lacking is the definition ofownership rights for communal spaces and facilities and a legal framework allowing for the privatizationof buildings. The Government intends to enact the necessary legislation by mid-1995.

47. Imposition of Hard Budget Constraints on State-Owned Enterprises. Since the process ofprivatizing state-owned enterprises will take time, and some activities will remain under state ownershipin the medium term, imposing a hard budget constraint on state enterprises and improving their autonomyand accountability is crucial for their adjustment as well as for stabilization. These policies will also fosterprivate sector development by preventing unfair competition by state enterprises facing softer constraints,and by revealing profitability to prospective investors. In addition to the imposition of financial disciplinethrough the elimination of subsidies and a market-based system of credit allocation, the Government willalso take measures to signal that the state will not bail out non-viable activities. As a first step in thatdirection, the Government is preparing, with technical assistance from Germany, a draft law onbankruptcy which will be submitted to Parliament by April 1, 1995. Thereafter, the enterprise sector willbe exposed to the provisions of the law. The Government has also identified and made public the list ofthe 25 largest loss-making state-owned industrial and agricultural enterprises and, through a resolutionof the Cabinet of Ministers, has ordered the preparation of detailed action plans for these enterprises,including partial and complete privatization, partial or complete declaration of bankruptcy, breaking upof monopolies, and divestment of social assets. Preparation of these action plans will be undertaken withtechnical assistance financed under a Japanese grant and completed by September 1995. Duringpreparation and implementation of these action plans thereafter, these enterprises will not benefit fromloans from the NBG or from any of the state banks, nor will they benefit from any publicly guaranteedloan from the private banking sector.

48. In addition to the hard budget constraints imposed through fiscal discipline, the Governmentintends to promote increased efficiency of operations in state-owned enterprises through the introduction

9/ More than 75 % of the production of vegetables, fruit and meat is already provided by the privatesector.

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of management contracts. These contracts, which include hiring of senior management on a contractualbasis, incentive schemes, explicit profit or loss reduction targets. and other performance targets, will beintroduced on a pilot basis by the end of 1995 in three enterprises in the mining and military sectorswhich are not subject to privatization in the medium-term. Based on an evaluation of this pilot project,the Government expects to extend the experiment and to institute mechanisms to enhance incentives andmanagerial accountability in other enterprises in the sector.

49. Restructuring the Government Sector. The Government is aware that the fiscal adjustment willin the short run have a major impact on living standards and, in particular, on the real wages of publicemployees who already have to rely on additional jobs or other sources of income to cover their basicneeds'". Although the budgetary savings resulting from the subsidy cuts made possible some wageadjustment in September, the low level of revenues will not allow major wage increases in the near futureunless the number of employees in the budgetary sector is sharply reduced. At the same time, it isessential that the Government strengthen its capacity to provide basic public services. To that end, theGovernment intends to define a set of critical public functions and to identify the civil servants andpublic-sector employees needed to perform these functions efficiently. Functions that can be performedby the private sector will be privatized; functions that no longer correspond to the role of a Governmentin a market economy will be eliminated. The urgent need for such reforms is made evident by thenumerous practices - though illegal - which have already led to the implicit privatization of manyGovernment activities. Public bus drivers collect and keep fares from passengers; school administratorscollect tuition from some of their students; and nurses and doctors in hospitals and polyclinics providemedical services for fees. De facto user fees have already been introduced for a large number of publicservices. Regularizing and rationalizing them can greatly improve efficiency.

50. Time will be needed before these reforms can be implemented and the public sector restructured.However, the Government recognizes that the fragility of the fiscal stance requires their implementationas soon as possible. To carry out the first stage of this reform program, the State Commission on theStructure of State Organizations has been established under the chairmanship of the Prime Minister. Itstask was to prepare a plan to restructure the Government's ministries and departments to better reflecttheir role in a market economy and to oversee a reduction of at least 25 percent in the number of staffemployed by the budgetary sector, currently estimated at about 630,000. The reorganization plan willnot be accomplished with across-the board downsizing, but will instead follow a detailed examination ofthe new responsibilities of each office. Some offices may be expanded; many will be reduced in size;and some will be eliminated altogether because their roles are duplicated or are no longer consistent withthe reduced Government's role in the economy. Two alterniative plans have been submitted toParliament in December 1994 and will be discussed in early 1995. The reduction in staff requirementswill be implemented by the end of the first quarter of 1995.

51. In addition to reform of the top levels of public administration, the Government is also committedto introducing reforms to restructure social services, such as health and education, which have sufferedfrom drastic cuts in public expenditures. Because the Ministries of Education and Health have historicallybeen two of the largest civil service employers, and because both provide essential public services, theirreform is particularly important from the point of view of reducing obligations on the state budget and

10/ Wages of public employees are substantially below those of other workers. The average monthlysalary of an employee in the budgetary sector was equal to 3.5 million coupons in September 1994.This is equivalent to about twice the monthly bread ration.

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improving efficiency in resource allocation. The objective of the reforms is, in particular, to concentratethe limited available public resources on a basic set of services and to ensure access to these services bythe poorest segments of the population.

52. The Ministry of Health has already developed a comprehensive reform plan. A proposal definingthe basic policy lines has been approved by the Cabinet of Ministers, and a decree by the Head of Statewas issued in December 1994 to enact these reforms. The reform guarantees free access to health carein hospitals and polyclinics for a core set of medical services. All other services will be provided on afee-for-service basis. In this way, hospitals and polyclinics will receive income to pay salaries, defraycapital depreciationi, and purchase new equipment and facilities. Some hospitals and polyclinics will beprivatized; all will become self-managing and independent of day-to-day direction from the Ministry ofHealth. Hospital and polyclinic fees will finance the salaries of the health care providers who will beremoved from budgetary sector payrolls. The reform will be implemented, starting in January 1995, overa period of two years. The reform plan will also include regulations and a financing mechanism to ensureprovision of basic health services to all Georgians and especially to those who do not have enough incomeor assets to pay for these services without help. The Ministrv of Health will retain an important role inaccrediting hospitals and licensing doctors and senior health professionals. A plan for accreditation willbe adopted by mid-1995.

53. Preparation of reform in the education sector is less advanced than in the health sector. TheMinistry of Education, however, is developing a comprehensive program to reforn the organization andfinancing of Georgian kindergartens, primary and secondary schools, and post-secondary educationalinstitutions. Under the reform program, basic education during the 9 years of compulsory schooling(from age 7 to 15) will continue to be financed out of the state budget to ensure access by low-icomehouseholds. Enriched education in grades 1 through 9 as well as schooling in kindergartens and post-secondary institutions will be funded out of fees paid by students or their parents. Some secondary andpost-secondary students will qualify for state scholarships, which will be allocated depending on scholasticperformance or the results of competitive examinations. This scheme is being introduced during thisacademic year, on an experimental basis in two moderate-sized cities. Based on an evaluation, a proposalfor reform at a national level will be prepared and discussed by the Georgian Government by the end of1995.

(ii) Promoting the Development of Markets and Increasing their Efficiency

54. Promoting Competition and Private Sector development. Government intervention in the areaof pricing was already substantially reduced in 1992. Most retail and wholesale prices were liberalizedat that time. Currently, medicines are subject to a 25 percent markup over production or import cost,and the prices of rationed bread, municipal services, energy products (gas and electricity), publictransportation and communications are still fixed by the Government (see para. 19). Maintaining theseprices at constant nominal levels at times of accelerating inflation and relying heavily on imports for someof them (energy and wheat), led to increasingly significant subsidies and huge distortions in resourceallocation. In an effort to remove these distortions and strengthen the budget, the Government decidedto readjust all prices to achieve full cost recovery. As of September 1, 1995, domestic prices for gas andelectricity were increased to reflect full import and distribution costs and will be readjusted each monthto maintain full cost recovery. Price adjustments have been huge, especially for consumers: the priceof electricity rose 600 times, that of gas for cooking, 13,000 times, and that of gas for heating about 5times. For enterprises, the price of gas was raised about 5-fold, and that of electricity more than 10times. On September 17, the price of bread was increased from 700 to 200,000 coupons per kilogram;

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a further increase to 280,000 coupons took place on December 25. Subsidies for transportation werereduced in September through a 50-fold increase in subway fares, and will be eliminated by mid-1995.Bread price will be fully liberalized by mid-1995 (see para. 56). Regulated prices therefore will onlyremain for public transportation, energy and municipal services while restructuring of the sectors takesplace (see para. 55). For all of them, the Government is committed to achieving and maintaining fullcost recovery.

55. Although the recently adopted price realignment for electricity eliminates cross-subsidizationbetween types of energy and will have a favorable fiscal impact (provided efforts are intensified towardcollection of bills"), it is only based on average cost. The structure of electricity prices needs to be basedon long-run marginal cost to increase the efficiency and reliability of energy supply, provide propersignals for energy demand, and generate the sources of funds necessary for investment in the sector. TheGovernment is currently preparing a restructuring plan of the power industry, and intends to start itsimplementation by end-1995, corporatizing the generating and distribution companies, and introducingan efficient price structure. In addition, the Government is committed to opening the power generationsub-sector to private investment in order to address supply constraints and to promote competition in thesupply and pricing of energy. Concurrent with these measures, the Government will develop acomprehensive regulatory framework for power generation and distribution.

56. The elimination of the bread subsidy needs to be accompanied by a reorganization and a break-upof the Bread Corporation which has a monopoly over wheat procurement and a quasi-monopoly overbread production. To introduce competition in the market for bread products, the Government intends,in parallel with the liberalization of bread prices and the elimination of rationing, to adopt by mid-1995a restructuring/privatization plan leading to the break-up of the Bread Corporation into independentmilling, baking, and retail units and their subsequent privatization. The Government will completeprivatization of the Bread Corporation according to this plan by the end of 1995. It is expected that thesemeasures will have a positive impact on the domestic production of wheat, and will contribute in themedium term to a reduction in the need for wheat imports.

57. The Government recognizes that the private sector will be the primary source of job creation andgrowth in the economy, and is an important source of competition for remaining state-owned enterprises.Through rapid stabilization, the acceleration of the privatization program, and completion of priceliberalization, the Government is going a long way toward creating a favorable environment for privatesector activity. The Government's strategy also includes the reduction of barriers to entry for newbusinesses and the completion of the legal and institutional framework necessary for private sector activityand competition. To that end, the Government has adopted fairly simple registration procedures for newbusiness, and local authorities clear new applications over a relatively short period of time. Constraintson private sector access to commercial real estate have been addressed through long-term leasingarrangements. A law on entrepreneurship completing the legal framework for private business wasapproved by the Parliament in November 1994. In addition, a law on investment, granting equaltreatment to foreign and domestic investors was submitted to Parliament in September and is underdiscussion. Foreign investors will also be specifically targeted in the marketing of large, strategicenterprises to be sold through international tenders. Finally, an anti-monopoly law designed to facilitatethe break-up of monopolies and to control the abuse of dominant market positions and restrictive trade

11/ Improved collection will be critical to meet the fiscal objectives. As part of the fiscal program agreedwith the IMF, the Government has agreed on targets for collection of bills.

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practices, is under preparation and will be submitted to Parliament by mid-1995. Upon Parliamentaryapproval, an anti-monopoly commission will be created.

58. Also consistent with the Government's policy of liberalization, most restrictions on domestic tradehave been eliminated. All fixed margins on wholesale and retail trade were abolished in 1992 except forthose on medicines (see para. 54). Trade-related infrastructure - such as wholesale storage bases andtrucking enterprises - is either privatized or in the process of privatization. The main remaining factorhindering the development of markets is the obligation imposed on many enterprises to deliver part oftheir production domestically under the state order system. These quotas are used for various purposes,including compensation for input suppliers, direct distribution by municipalities, and building of stateemergency reserves. Although the amount of goods purchased under state orders has declinedsignificantly over the last few years, and has been increasingly directed towards meeting the needs ofinternational trade (see para. 65), the system still represents an important source of taxation on domesticproducers. As part of the program to dismantle the state order system, the Government has taken a firststep by eliminating in February 1995, the quotas directed toward domestic uses and intends to developa market-based system of procurement using bids and tenders.

59. Liberalization of factor markets is also essential for promoting rapid increases in productivity.The Georgian labor market appears to be characterized by a high degree of labor mobility. Since 1990,employment in the state sector has decreased by 30 percent and private sector employment is reportedto have increased by 58 percent. Taking into account the largely unrecorded expansion of the informalsector, labor flows toward the private sector must even be larger. It is essential to accompany the on-going reallocation of labor with an appropriate wage policy. To that end, the Government will notimpose wage regulations that would create the wrong set of incentives. No wage controls will be imposedon the private sector. Wages and other forms of compensation will also be freely negotiated"2 betweenemployers and employees in state-owned enterprises as part of the strategy to impose similar marketconditions on enterprises that remain under state ownership.

60. Fostering Export Growth. For an economy like Georgia's, with a small domestic market andfew energy resources, international trade will be a key factor for economic recovery. Developing asmoothly functioning foreign exchange market and eliminating implicit and explicit taxes on exports arethus two critical elements in the Government's economic program.

61. Foreign Exchange Regime. Although the Government took significant steps toward developinga market for foreign exchange characterized by a unified rate determined in an interbank market, thesystem still had until recently a number of limitations which constrained its effectiveness. One problemwas the requirement that exporters surrender 32 percent of their foreign exchange receipts in return forcoupons. Until very recently, most of this was used to fund the foreign exchange needs of thegovernment through a mechanism that resulted in a large implicit tax on exports. Although, in principle,exporters were supposed to be reimbursed at the market rate, an implicit tax arose for several reasons:(i) payment to exporters was made in non-cash coupons, but at the exchange rate set in the auctions forcash coupons, while the exchange rate for non-cash in the unofficial market was twice as high; (ii) onlyten percentage points of the 32 percent went to the NBG and then directly to the auction, whilereimbursement of the remaining funds allocated to the Ministry of Finance and local governments was

12/ Only a minimum wage regulation applies; however, the level of the minimum wage is so low thatpractically no worker in the formal economy, is reported to be paid at that level.

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generally delayed for periods ranging from several weeks to two months; thus, when inflation and theopportunity cost of funds were high, the funds lost considerable value; and (iii) restrictions on theconvertibility of non-cash coupons limited their value to exporters.

62. An additional problem was that the practice of allocating only a small fraction of the foreignexchange to the NBG limited the development of a free exchange market, as the rest of the foreignexchange was essentially used the same way as under central planning. A final problem was thatregulations limiting participation in the auction and imposing restrictions on bidding obstructed thedevelopment of a smoothly functioning market.

63. To address these issues, the Governrment began at the end of September 1994 to channel thetotality of the surrendered foreign exchange to the NBG (instead of direct allocation to the state and localcurrency funds), thus ensuring that exporters are reimbursed rapidly at the auction rate. This, along withthe abolition at the same time of the distinction between cash and noncash coupons (see para. 72), hasgone a long way toward minimizing the adverse effect of the surrender requirement. The NBG has alsoincreased the frequency of foreign exchange auctions, which now take place twice a week.

64. These important advances notwithstanding, several legal obstacles still obstruct the developmentof a fluid market in foreign exchange and create difficulties for exporters. These include the remainingdistinction between cash and noncash in foreign currencies; restrictions on the purposes for whichexporters can withdraw foreign exchange from their accounts; and the exclusion of all bidders exceptbanks from bidding in the auction. At the end of 1994, the NBG removed remaining restrictions on theexchange of foreign currency cash and non-cash balances. It also intends in the near future to expandparticipation in the auction to foreign exchange bureaus. Exporters to the ruble area are no longer subjectto the surrender requirement. By the end of 1995, the surrender requirement will be eliminated.

65. International Trade. In contrast to the import regime, which is relatively free (uniform customsduty, and virtually no non-tariff barriers), quantitative restrictions on exports are still pervasive andconstitute significant impediments to trade. They take the form of export prohibitions and licenses, andare mostly linked to Georgia's bilateral trade agreements and to the state order system. The exportcontrols are used to ensure that the state is able to secure supplies of certain goods at low real pricesunder the state order system. These goods are used to meet the obligations of the trade agreements. Untilvery recently, they were also used for domestic distribution for various purposes (see para. 58). At theend of 1994, 27 categories of goods were still subject to export licenses and 12, to export prohibitions.These restrictions tax producers, especially exporters, and obstruct the development of export channelsby the enterprises themselves. In addition, exports to non-FSU countries have been subject to an 8percent tax on foreign exchange earnings.

66. Because of the interlinkages among sectors, the state order system has created a tremendousburden of inter-enterprise debt, which has strongly contributed to the breakdown of production inGeorgia. Because of this breakdown and the resistance of producers, only a small fraction of thedeliveries required under the state order system are actually being made. Elimination of the system wouldimprove producers' incentives and lead to greater capacity utilization.

67. The government is aware of the shortcomings of the present system and is committed to itsdismantling. It is, however, keenly aware of how serious would be the consequences of any disruptionin energy supplies, most of which are imported under barter agreements. Thus, it has adopted a phasedapproach. As of December 1, 1994, the 8 percent tax on foreign exchange earnings was abolished. In

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February 1995, the Government eliminated all quotas under the state order system that are not necessaryto ensure deliveries of the specific goods required for export in the barter agreements for energy supplies,thus reducing the number of products under quotas from 27 to 7. For the seven products that remainunder the state order system, the Government will minimize the adverse effects on producers by ensuringthat the prices paid will be equivalent to border prices, converted to local currency at the rate of exchangeprevailing on the date of payment. The Government also intends to phase out completely the quotasystem over a period of about one year.

68. The Government has also started reducing the number of goods under export licensing (from 27to 19) and intends to eliminate gradually remaining requirements and prohibitions, except for thoserequired by agreements giving limited preferential market access to Georgian exports (e.g. the Multi-Fiber Agreement), or those used for reasons of environmental protection, health or arms trade control.This gradual elimination will take place over a period of about one year. During that period of time,export controls will affect mainly the goods used in barter agreements and a few basic food items. Toindicate its commitment toward full trade liberalization, the Government issued in February 1995, adecree specifying the precise timetable for the complete phase out of the remaining state orders and thegradual elimination of export licensing requirements and prohibitions.

69. Strengthening the financial sector. The Government recognizes that financial sector reformsare critical for increasing domestic financial savings and for ensuring that credit is allocated to the mostefficient users. Until very recently, credit allocation continued to be directed by the state. Almost allof the credit expansion came through the main specialized state banks (the Agro Bank, the IndustrialBank, and the Housing Bank), either through directed credits to particular sectors at highly subsidizedrates or through access to overdraft facilities at zero nominal interest rates. The rest of the banking sectorwas largely reduced to financing inventory purchases for short-term trading at very high interest rates.The recent decision to eliminate directed credits to state enterprises and the automatic access of statebanks to overdraft facilities, as well as the commitment not to interfere with the credit decisions of banks,are important steps toward promoting a more efficient allocation of credit and greater financial savings.

70. In addition to these measures, a wide range of structural and institution-building reforms in thefinancial sector are also essential for the effective operation of a market economy.

71. The Government recognizes that establishing the legal framework for the banking sector is anecessary condition for an efficient and competitive financial sector. While the current banking lawcontains the basic provision for central banking, bank supervision, and regulatory enforcement, it stillincludes a number of provisions that limit the independence of the NBG, and at the same time lacks otherprovisions necessary for effective monetary policy and credit management. To that end, a new draft NBGlaw has been prepared with the technical assistance of the IMF, and submitted to Parliament in December1994. The proposed new legislation will substantially strengthen the autonomy of the NBG to carry outmonetary policy, limit the financing of the Government, promote and maintain price stability, and fosterthe liquidity, solvency, and proper functioning of the financial system.

72. Although the process of financial intermediation has been improved by the decision to permitdeposits in foreign currency and to let banks freely set interest rates on deposits, the functioning of thefinancial sector was seriously impaired by the legal dichotomy between "cash" and "non-cash" circuits.The separation between these circuits, although not complete, was accomplished via restrictions on theuse of accounts, in both domestic and foreign currency. Cash withdrawals were permitted only forlimited purposes and involved significant transaction costs. The transfer of funds to other accounts was

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also restricted. These restrictions discouraged households and enterprises from holding deposits in thebanking system, and strongly limited the capacity of the financial sector to mobilize financial resources.Another result was that the market-determined exchange rate for non-cash coupons was twice as high asthat for cash coupons (see para. 61). The Government has recognized that these restrictions which weredesigned to limit the demand for foreign currency were counterproductive and accelerated financialdisintermediation. The Government eliminated the cash-noncash distinction for coupons, in September1994, and for foreign currencies, in December. By mid-1995, it also intends to develop appropriatelegislation for facilitating the use of checks as means of payments.

73. The Government recognizes that the main financial institutions in Georgia are in perilous financialcondition and are poorly equipped to attend the needs of an emerging private sector. It also recognizesthat, as hard budget constraints are imposed on state-owned enterprises, the state banks will have to facean increasing number of unpaid loans. Thus, in addition to the corporatization of the five state bankswhich has already started, a major restructuring program may be required. To that end, the Governmentis undertaking a major diagnostic review of these banks in order to develop a comprehensiveunderstanding of the operational, management, and financial problems besetting them. The review shouldprovide a basis for developing strategies for institutional strengthening consistent with the Government'splan for privatizing and downsizing the state banks, and is being undertaken with technical assistancefinanced under the IBC. Based on the results of the diagnostic studies, which are expected to becompleted by mid-1995, a privatization action plan will be developed and implemented.

74. As regards the situation of the 220 private banks which have been created in recent years, theNBG has identified about one-quarter that warrants closing. On-site bank examination and supervisionis totally lacking, and off-site surveillance is almost non-existent. To halt the proliferation of new banksin the sector, a moratorium on the licensing of new banks was imposed in May 1994 and the minimumlevel of capital was raised from 200 million to 500 million coupons. In October, licenses were withdrawnfrom 42 commercial banks; foreign exchange licenses were also withdrawn from 28 banks. TheGovernment is aware that these measures are still insufficient. With technical assistance from the IMFand the Central Bank of the Netherlands (under the IBC), the NBG intends to strengthen its supervisionfunction. As part of this strategy, the NBG has revised prudential supervisory standards and issued newregulations in February 1995.

(iii) Ensuring a Minimum Level of Social Protection

75. Georgia's system of social protection is still, to a large extent, identical to the system thatprevailed in the Soviet Union. The only recent changes have been the introduction of an unemploymentbenefit scheme and the implementation of special assistance programs for about 90,000 families,considered to be particularly vulnerable, and for about 270,000 refugees from Abkhazia. In recent years,and in parallel with the sharp decline in living standards of the population, the system has facedincreasing difficulties. The reduction in employment, the decline in real wages, and the Government'sinability to collect social security contributions from the informal economy have together produced acollapse in the revenues of the social security and unemployment funds. Maintaining expenditures of thefunds in line with revenues has led to benefit levels that are far too low to sustain a minimal standard ofliving. At the beginning of 1994, monthly pensions and unemployment benefits could only be used topurchase a small number of subsidized items; virtually no products offered for sale in private marketswere accessible to those without other sources of income. The main form of social protection thusconsisted of generalized subsidies for bread, energy, and municipal services. A similar situation appliedto the approximately 630,000 workers paid out of the state budget, whose wages were not much higher

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than pensions. Additional jobs, other sources of income, and strong family ties became in Georgia themain source of social safety net.

76. The Government is thus facing several pressing problems in the short run. First, the currentsystem of social protection provides inadequate cash aid to vulnerable groups but has no capacity to raisesignificant revenues to increase benefits. Second, the removal of subsidies for bread, energy, andtransportation eliminates the most important remaining form of social protection and imposes a sharpreduction in the real incomes of the population, hurting most those who cannot protect themselves.Third, the expected reduction in public employment may lead to a further increase in unemployment.

77. The Government is aware of these issues as well as of the impossibility, given existing financialconstraints, of offering an adequate assistance program. It is, however, highly concerned about thehardship already imposed on the population, and convinced that attempting to maintain a minimum levelof social protection is crucial for the success of its economic reform program. Hence it is determinedto use the limited resources available as efficiently as possible. The overall strategy is to use some ofthe resources saved by eliminating generalized subsidies to strengthen the current system of socialprotection, and to target benefits more effectively.

78. Pension System Reform. By the spring of 1994, increasing financial constraints and periodicadjustments in pensions in response to inflation had largely eliminated differences in monthly pensionsbetween highly paid and poorly paid pensioners. Almost all linkages between past social securitycontributions and current benefits had vanished, transforming pension contributions into a pure tax onlabor. However, the staff of the social security offices were obliged to manually perform burdensomeand time-intensive calculations of individual pensions, even though the resulting differences in pensionshad no significance on standards of living. In September 1994, in order to reduce the administrativeburden and the need for staff, the Government transformed the pension system into a simple socialassistance program providing a flat-rate benefit to all pensioners. At the same time, it eliminatedentitlement to special pension supplements. The system could not afford to grant favorable treatment toimportant groups of pensioners, and, moreover, there was no economic reason to impose the costs ofthese extra benefits on enterprises and workers in the less favored sectors.

79. Also in September, to provide partial compensation for the elimination of subsidies, pensionswere raised to 2.5 million coupons per month, about 18 times their nominal level in July 1994. Childallowances and unemployment benefits were also increased. Fiscal constraints prevented the Governmentfrom raising benefits as much as it raised bread, electricity, and natural gas prices. At the same time,the Government eliminated benefits to pensioners who continued to work -- roughly 16 percent of the1.14 million people who collected pensions in January 1994. It also eliminated childbirth and deathbenefits. In the very short-run, this only saved a modest amount of resources since real benefits remainedvery low. However, by limiting the number of people eligible to collect benefits the Government wasable to provide a somewhat larger adjustment for those who remained eligible.

80. Targeted Social Assistance. The Government already has considerable experience in grantingassistance to the neediest groups in the population. In addition to refugees from Abkhazia, severalvulnerable groups (about 90,000 families) have been identified, including pensioners who live alone,single mothers, and families with many children. Except for groups that are easy to identify, such aspensioners living alone, the system relies mainly on self-targeting as a way of identifying individuals andfamilies who need assistance. Refugees are provided with two kinds of help, cash and in-kind assistance.In-kind assistance is offered in the form of housing to roughly a third of the 270,000 refugees. It is

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provided as food and medicine to selected refugees as well as to lone pensioners, single mothiers, andneedy families with many children. Cash allowances are provided to all refugees who do not hold aformal sector job or receive a pension. In September 1994, as subsidies were eliminated, cashallowances were increased to 833,000 coupons per month for refugees living in government-providedlodgings, and to 2.5 million coupons per month for refugees living outside of special refugee lodgings.When resources are too limited to meet the demand for in-kind aid, targeted families are rotated on andoff the list of those actually receiving assistance, reducing the frequency with which the aid is granted.

81. Medium-Term Reforms. The measures listed above, adopted in September 1994, representsignificant steps toward strengthening the social safety net. The level of benefits is, however, stillextremely low and remains inadequate for people without other sources of support. In the very short run,given the very limited financial resources, increasing the level of benefits to a more significant level couldonly be achieved by sharply reducing still further the number of beneficiaries. Given the difficulties ofobtaining reliable information on household incomes, and thus of identifying the most needy, theGovernment considers that further targeting could leave some fraction of the population totallyunprotected, and would create unsustainable social costs in the context of the current difficult economicsituation. It also considers that further reforms of the social protection system could not be implementedwithout a parallel readjustment of public sector wages which are currently hardly higher than the levelof pensions. The Government is, however, aware that the present set of reforms fails to address medium-term issues and that a comprehensive reform of the social protection system is needed.

82. Over the medium term, there is still room for improved targeting. The most costly form of cashtransfers (besides pensions) is the child allowance program, part of which is financed out of thecontributory pension system. Children age 16 and younger receive monthly cash allowances equal to 45percent of the official minimum wage -- or 450,000 coupons per month in October 1994 -- if they residein urban areas. The child allowance in rural areas is 30 percent of the minimum wage, or 300,000coupons a month. The Government is aware that child allowances are not targeted to the needy andintends to improve methods to identify those families with children that need more support.

83. As economic recovery proceeds, the contribution rate to the public pension system (37 percentof payroll for state and private enterprises and 26 percent of payroll for budgetary organizations) willneed to be gradually reduced to maintain the public pension at a low level while allowing for theintroduction of a second-tier system linking contributions to benefits. In the very short run, theestablishment of privately-funded pension schemes is premature, because these would requiremacroeconomic stability and a secure financial sector. The Government is, however, aware that therecent collapse in the value of public pension benefits has damaged the credibility of public social securityas a source of dependable retirement income. It is also aware that the system is unsustainable. As ofJanuary 1994, only 1.9 million Georgians were officially employed in the civil service, in stateenterprises, in cooperatives, and in registered private-sector enterprises (and many of these workers wereon short hours). In that month, 1.14 million Georgians collected pensions -- roughly 3 pensioners forevery 5 active workers. The ratio of pensioners to social security contributors is probably even higherthan those figures suggest. By October 1994 the number of pensioners had dropped 16 percent, toapproximately 0.96 million, after pensions to working pensioners were eliminated. But the number ofGeorgians contributing to the pension system was estimated to be just 1.2 million active workers,suggesting that there were 4 people collecting pensions for every 5 workers contributing to the pensionsystem. As a first step towards increased sustainability, the Government will need to consider raisingthe retirement age. However, most workers employed in the informal economy do not contribute to thepension system, and many workers in the formal sector who receive wage supplements paid in rubles,

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dollars, or in-kind benefits do not pay contributions on their non-coupon compensation. Hence, theintroduction of a private, defined-contribution pension scheme in the medium term may well be the onlycredible retirement savings vehicle. If prudently regulated and supervised, such a system would mobilizelong-term savings and provide improved income security to retirees. It would also contribute to thedevelopment of a modern and efficient long-term capital market. To prepare the way for these medium-term changes, the Government intends to start developing a regulatory framework to encourage workers,enterprises, and financial institutions to establish privately-funded pension schemes.

84. These reforms go beyond the horizon of the present Rehabilitation Credit. Initiating theirpreparation is however urgent. While there is little room for choice now, by mid-1995, when the fiscalsituation is expected to improve, decisions will have to be taken regarding both the level of wages in thepublic sector and the level of benefits. To that end, in February 1995, a commission headed by theMinister of Labor and Social Security has been appointed to initiate preparation of a reform plan to becompleted by mid-1995. The reform plan will: (i) address the sustainability of the pension system; (ii)examine possibilities for further targeting of benefits, in particular the identification of vulnerable groups;and (iii) evaluate the budgetary implications of a recomnnended set of actions. This program of actionswould be implemented thereafter.

.II. Macroeconomic Prospects and External Financing Requirements

85. Implementation of the reform program described in Section II should stem the decline ofproduction and set the stage for the resumption of growth. This section describes the macroeconomicoutcome of this program in the short and medium term. Caution is warranted however, given the highdegree of uncertainty and the poor quality of available data. Nonetheless, some basic elements of anindicative scenario for the period 1995-2003 can be identified. Monthly inflation is expected to fall tolow single-digits by the end of 1995. Real GDP would still register a small decline in 1995, but realgrowth would resume in 1996. Improvement in living standards would occur only gradually, and onlyafter the end of the decade would the level of private consumption recover to that of 1993. Even thismodest recovery requires substantial extemal financing in the coming years.

A. Inflation and Output

86. After a price surge at the start of the program, following the elimination, or sharp reduction ofsubsidies for bread, gas, electricity and transportation, it is expected that the stabilization process will berapid and that the monthly rate of inflation will drop to low single-digits by the end of 1995. Oversubsequent years, provided that fiscal discipline is maintained, the Georgian and world monthly rates ofinflation could converge.

87. There is little scope for growth of output and consumption in the very short run. Real GDP isestimated to have fallen by about 29 percent in 1994, reflecting the decline that has already occurred inthe first half of the year and the continuation of inappropriate policies until September. In 1995, evenwith satisfactory implementation of the program, a further contraction in economic activity - although ofmuch lesser magnitude - can be expected. Even though Georgia is well endowed with human capital, thenecessary reallocation of resources to more valuable uses, both within and between sectors will be agradual process, in particular in industry. In addition, the stabilization program entails a reduction ofpublic expenditures and in the number of public employees, the elimination of subsidies, and an increasein taxes, as well as the elimination of directed credits to enterprises. All these factors will also reduce

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private consumption in 1995. Positive real growth is expected to resume in 1996 at an annual rate ofabout 3 percent, led by the agricultural and service sectors and fostered by improved external conditions,in particular those related to Russia (which remains the main trading partner of Georgia) and other FSUcountries. Later, as Georgia begins to trade with the rest of the world, investment and export growthwould support a 6-7 per cent growth rate.

88. A number of factors can play a key role in the resumption of growth. The Georgian economyhas already shown its capacity to develop entrepreneurial skills and private sector activities. The growinginformal sector and the emerging private agricultural sector have been the main source of support for thepopulation during the past four years. The service sector has already started developing, and theagricultural sector is showing some signs of recovery in grain producing areas and regarding livestockpopulation. It is expected that further progress in land reform, price and trade liberalization, andincreased competition will contribute to rapid growth of agricultural production. In addition, both theservice and the agricultural sectors have less need for additional capital inputs than does industry. Theycould thus rapidly become the fastest growing sectors in the economy. The fairly high labor mobility thatcharacterizes the Georgian labor market is expected to facilitate the necessary changes in the structureof production and productivity increases. The expected reduction in the size of the government sectorwill also induce the reallocation of labor needed to respond to new growth opportunities. In the industrialsector, although the imposition of hard-budget constraints and the rapid pace of privatization will facilitateenterprise restructuring, the need to adjust to sharp increases in energy prices will somewhat delay outputrecovery, except in the agro-processing sector which should benefit from trade expansion.

89. Recent years have witnessed a very substantial reduction in the rate of investment in the economy.Private sector investment is just incipient and has been discouraged by macroeconomic instability andpolitical events. The public sector has practically stopped investment expenditures because of shortfallsin revenues and rising deficits. As the economy stabilizes and new opportunities for growth emerge, anupward trend is expected. Investment should rise to 9.5 percent of GDP in 1997, thereafter reachingalmost 15 percent in 2000. Public investment will be mostly directed at rebuilding and expanding thephysical infrastructure needed to support private sector development. Significant private investmentwould only arise as of 1997, after a stable political and economic environment is in place.

90. Financing the growth of investment will require substantial external flows even with resoluteimplementation of reforms. Gross domestic savings are only projected to be positive as of 1998, and willremain in the short and medium term insufficient to support economic recovery. In the short term,external resources will be necessary not only to help rebuild infrastructure and finance other investmentsnecessary for growth, but also to complement the limited supply of consumption goods.

B. The Fiscal Outlook

91. Fiscal policy will be central to reestablishing macroeconomic stability and ensuring sustainabilityof the stabilization process. The bulk of the fiscal adjustment is expected to take place during the lastquarter of 1994 and in 1995. The fall in expenditures, along with increases in tax revenues will help toreduce the deficit from about 32 percent during the first half of 1994 to about 5 percent of GDP in 1995.However, improving the fiscal stance in the medium term still requires strengthening revenue efforts andconsiderable adjustment in the level and composition of expenditures.

92. On the revenue side, it is expected that rapid stabilization by eliminating the negative effect ofinflation, will bring about a quick reversal in real tax revenue trends. The strengthening of tax

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administration will lead to improved compliance and to a gradual increase in revenues. Additionalrevenues would be obtained from the privatization proceeds in early years and from tax reforms andgrants. On the basis of these assumptions, government revenues in terms of GDP would almost doubleand tax revenues quadruple by 1998 relative to their 1994 level; however, given the very low level ofcurrent tax revenues, they would only reach 13.5 percent of GDP by 2003. By that time, the relativeimportance of grants would have decreased substantially.

93. On the expenditure side, projections reflect the removal of subsidies as of September 1994 anda substantial reduction in the consumption of gas and electricity by budgetary organizations. Anotherfactor reducing expenditures is the expected decrease in the number of public employees from 630,000in 1994 to about 500,000 by the end of 1995. However, to strengthen the social protection system,allowances are made for increases in expenditures for the social safety net, wages and higher investmentoutlays needed to rebuild physical infrastructure and to maintain an adequate level of human capitalinvestment. Thereafter, wages and expenditures for the social safety net are expected to grow at a rateslightly superior to GDP growth. Capital expenditures are projected to increase steadily from 1995 on,to rebuild infrastructure. By 2003, capital expenditures would represent about 25 percent of total publicexpenditures. A primary fiscal surplus from 1999 on could be used to service interest on debt.

C. External Sector

94. The financial constraints expected to prevail in 1995, the sharp relative price adjustment, and thecommitment not to accumulate further arrears are expected to prevent any increase in imports during thatyear. Imports would only recover later, responding to the needs for raw materials, equipment, andcapital goods that have been severely lacking in recent years. From 1996 on, imports would grow at anannual rate of about 6 percent, lower than that of exports, contributing to a gradual narrowing of thetrade balance.

95. The sharp increase in energy prices should induce adjustment in energy use. In the very shortrun, one can expect a reduction in residential consumption and in energy-intensive industries. Later, thenew energy prices should promote energy substitution and provide incentives for developing domesticenergy sources. These elements would reduce the demand for energy imports and the currently highshare of energy products in total imports.

96. The recovery of exports is likely to be a key contributor to the resumption of economic growthin Georgia. Exports are expected to be fostered by the removal of restrictions which constitute majorimpediments to their development: export prohibitions and licenses, state order system, explicit exporttaxes, and foreign exchange requirements. As these restrictions are lifted, exports are expected to growin 1996 and 1997 at an annual rate of about 10-11 percent, recovering from their currently depressedlevel, and thereafter, at an average annual rate of about 9 percent. The agricultural sector and the foodprocessing industry are likely to be the main short run beneficiaries from the changes in trade policies,in particular following the expected revival of agricultural output.

97. As a result of the expected fiscal adjustment, the current account deficit is expected to decreasefrom US$492 million in 1994 to about US$422 million in 1995. Higher rates of growth for exports thanfor imports during the whole period will contribute slowly to a steady reduction in the current accountdeficit in terms of GDP, projected at 24 percent in 1995. By 2003, the current account deficit would beequal to about 4.4 percent of GDP.

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D. External Debt and Financing Requirements

98. Although Georgia agreed to the zero option with the Russian Federation and has no responsibilityfor the external debt of the FSU, it has accumulated significant external obligations over the past fewyears, mostly on commercial terms and with short maturities. Excluding arrears, the total stock of debtamounts to US$595 million at the end of 1994. Forty-five percent of this amount is bilateral debt duemostly to Russia and Turkmenistan, and 22 percent is due to the European Union. Including arrears,mostly for gas imports, the total stock of external debt is estimated at about US$975 million at the endof 1994.

99. In 1995, Georgia will need substantial external financial resources to finance a current accountdeficit of US$422 million, US$261 million of amortization payments on existing debt, and US$18 millionfor building up foreign exchange reserves to cover three and a half weeks of imports. In addition, thestock of external arrears will have reached about US$367 million at the beginning of the year. Thisentails a gross financing requirement of about US$1 billion. Based on current information on the lendingprogram of multilateral institutions, and other identified commnitments including grants, the residualfinancing would amount to about US$728 million. The greater part of this requirement is expected tobe filled by either debt relief or restructuring, and refinancing of arrears, which would reduce residualfinancing needs to about US$100 million.

100. During the period 1996-2003, total gross financing requirements are projected at about US$446million annually on average. This amount would be necessary to finance an average annual currentaccount deficit of US$277 million; a modest built-up of reserves of US$36 million, with the reserve coverincreasing from three and a half weeks of imports in 1995 to about 2.3 months on average from 1996on; and US$133 million of amortization payments due. During these years, the bulk of external resourceswould have to come from official sources, initially on concessional terms. A good portion of multilateralassistance would take the form of balance of payments support aimed at financing critical imports andmitigating the decline in living standards. As Georgia gains commercial creditworthiness, financing fromprivate creditors and foreign private investors is expected to become important.

101. Georgia's debt burden is projected to peak in 1998, decreasing thereafter. Total debt in termsof exports is expected to reach 289 percent of exports in 1997, decreasing thereafter to 199 percent in2003. Total debt service burden in terms of exports would decrease from 63 percent in 1995 to about36 percent in 2003. These indicators are significantly higher than those of countries with similar levelsof income. The magnitude of external obligations and financing requirements for the coming yearsstrongly indicates that, in the short run, debt service relief, together with a significant amount of grantsand lending on concessional terms will be crucial in assisting Georgia during the transition.

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Key Macroeconomic Indicators (in Percentage)

1993 1994 1995 1996 1997-98 99-2003Actual Est. - --- ---------------Projected------------------------

Real Growth RatesGDP at Factor Cost -32.1 -28.7 -3.8 3.1 5.5 6.9Exports of G&NFS' -10.6 0.9 11.4 9.7 8.7Imports of G&NFS' 4.2 -0.2 6.6 5.9 6.0Private Consumption -23.2 -15.0 -3.9 0.1 2.2 4.6

(index: 1994=100) 117.1 100.0 96.1 96.2 99.5 114.9

As percent of GDPDomestic Savings -18.9 -35.1 -19.8 -10.2 -0.1 9.4Gross Domestic Investment 6.0 3.5 3.5 6.7 11.3 15.2Resource Balance -24.9 -38.6 -23.3 -16.9 -11.4 -5.8Primary Deficit -26.2 -10.9 4.5 -3.2 -0.5 0.3Fiscal Deficit -26.3 -10.9 4.8 -4.0 -1.4 -0.4Total Debt Outstanding 53.2 92.2 85.1 93.0 98.9 90.1

Total DOD (millions of US$) 648.0 974.9 1380.3 1744.1 2113.0 2670.5

Inflation (Annual Avg) 4085.6 12,620.4 118.6 15.7 6.0 6.0

Sources: Georgian authorities and staff estimnates.' Trade data for 1993 have been revised and are not compatible with 1992. Exports and imports for 1994 are based on preliminary datafrom the IMF.

External Financing (in millions of US Dollars)

1993 1994 1995 1996Actual Estimated ----------Projected---------

Gross Financing Needs 309.5 647.0 700.9 522.9Current Account Deficit 306.2 491.8 422.1 368.2Amortization 3.3 119.2 260.8 119.3Changes in Reserves (+= Increase) 0.0 36.0 18.0 35.4

Assumed Identified Financing 640.6 291.1 300.8 107.2Official Transfers' 131.2 162.0 169.8 34.7Foreign Direct Investment 5.5 0.0 0.0 5.0Medium/Long-term Disbursement2 503.9 129.1 131.0 67.5Short-term Capital Inflows 0.0 0.0 0.0 0.0

Financing Gap -331.1 355.9 400.1 415.7Covered by

Net IMF Purchases 0.0 38.9 38.9 0.0Changes in Arrears 62.0 305.0 -367.0 0.0

Gap-fill Financing3 -393.1 12.0 728.2 415.7

Sources: Georgian authorities and staff estimates.Estimates for 1995 are based on the results of the Consultative Group (CG) meeting held in Paris in November 1994.Estimates for 1995 include disbursement from an EBRD loan and a Turkish loan announced at the November CG meeting.Includes new money and debt rescheduling.

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PART II. THE BANK GROUP'S ASSISTANCE STRATEGY

I. Background and Objectives

102. The objectives of the World Bank's country assistance strategy are to help reverse the economicdecline of the past few years, to assist the transition to a market economy and alleviate the poverty whichhas emerged in Georgia in recent years. With a particular focus on promoting private sector developmentand redefining the role and improving the efficiency of the public sector, the World Bank will supportGeorgia's structural reform programs through lending, economic and sector work (ESW), policy dialogueand an active role in resource mobilization and aid coordination. Through its lending program, the Bankwill support economy-wide and sector-specific reforms that promote economic growth as well asinvestments to rehabilitate and build new capacity in critical infrastructure sectors. The Bank will alsoassist in strengthening public management, developing human resource and institutional capacities andstrengthening the social safety net. The following preliminary country assistance strategy has beendiscussed with the Georgian authorities in general terms.

lI. A Period of Conflict and Nation-Building

103. The assistance strategy reflects the constraints that have hindered a more active role for the Bankuntil recent months. While some constraints have eased, others continue to affect the Bank's ability todevelop and implement lending operations and the composition of the program. The Bank must alsoproceed with the understanding that many of the causes of Georgia's recent problems have not yet beenfully resolved.

104. The primary constraint hindering development of a full assistance program with Georgia was thecivil conflict. When Georgia joined the World Bank in mid-1992, clashes were continuing betweensupporters of the current government and those of the previous president who had been deposed in early1992. In addition, secessionists in Ossetia and in Abkhazia during mid-to-late 1993 fought againstgovernment forces to achieve independence. With the settlement in Ossetia and the defeat of governmentforces in Abkhazia, the civil conflicts are now quiet, and negotiations to find a lasting resolution inAbkhazia are taking place. While the possibility remains that conflict could resurface, governmentofficials are now able to refocus their attention on economic matters.

105. A second important constraint had been a lack of commitment to reform on the part ofgovernment officials responsible for economic policies. This constraint has been relieved over time bythe appointment of an increasing number of higher-level government officials committed to working withthe IMF and the World Bank on the design and implementation of stabilization and structural reformprograms and their ability to achieve agreement on change within the government. A further issue hasbeen the weak institutional and technical capacities within the government, which impinge on programdevelopment and will continue to constrain project implementation as more projects are initiated.Technical assistance and training, through the Institution Building Credit and other donor programs, arehelping to improve this situation, though substantial institutional development and capacity building arestill needed.

106. These constraints prevented the Bank from instituting a comprehensive assistance program duringthe first two years of Georgia's membership in the Bank. Given the security situation through early

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1994, lending in particular was not feasible, nor was the Bank able to devote many resources toidentifying or preparing eventual investment operations. In this situation, the Bank instead focused onbuilding macroeconomic and sector knowledge and providing limited technical assistance through Bankmissions. A Country Economic Memorandum was prepared and introductory missions on transport,agriculture, and the environment took place.

III. A New Relationship

107. After the halt of the civil conflict, during early 1994 the Bank was able to initiate a broaderprogram of lending preparation. The Institution Building Credit which had been negotiated in June 1993was finalized and approved by the Board in July 1994. This credit provides support to the country'sprivatization efforts, financial sector reform, tax and customs administration strengthening, and economicpolicy development. Project implementation in these areas has begun. During the summer of 1994, theBank prepared a Municipal Infrastructure Rehabilitation Credit which addresses the severe deteriorationof municipal infrastructure in Tbilisi and other larger cities. It includes assistance with immediate heatingneeds and energy efficiency improvements in schools and hospitals. This project was approved by theBoard in November 1994 and is already having an impact this winter. In addition to these activities,Georgia is benefiting from the GEF-funded Black Sea Environmental Program which is being jointlyexecuted by the Bank, UNDP, and UNEP. With the aim of addressing environmental problems alongthe Georgian Black Sea coast and in the coastal zone, and in coordination with the MunicipalInfrastructure project, technical assistance and project preparation funds are directed toward wastewatertreatment and solid waste management in Poti and Batumi and the establishment of a national park incoastal wetlands. Furthermore, given the agreement with the IMF on a program of macroeconomicstabilization and the government's commitment to structural reform, the Bank began working with thegovernment in October 1994 on a reform program that could be supported by this Rehabilitation Credit.

108. To gain a more in-depth understanding of the constraints and possibilities of the Georgianeconomy, the Bank has broadened the scope of its ESW studies. To date the most detailed work has beenon agriculture, energy, transport, municipal services, and health, and an Economic Update has beencompleted. In addition, the Bank organized and chaired an initial donor meeting in July 1994 and afollow-up session specifically on urgent energy needs. The Bank also chaired a first Consultative Groupmeeting in November 1994 to mobilize support of stabilization and structural reform from theinternational donor community. At the CG, donors made financial commitments for 1995 representingabout three-fourths of estimated financing needs exclusive of arrears and debt servicing.

109. At the request of the Government of Georgia, and given the build-up of the lending program inthe country, the World Bank is planning to establish a resident mission in Tbilisi. The resident mission,which will be opened during FY96, will have the potential to contribute greatly toward maintaining aneffective working relationship between the government and the World Bank, and will assist theimplementation and supervision of World Bank projects. It will also help to monitor and report onGeorgia's economic and financial situation and developments. A key responsibility of the residentmission will be to assist the government's aid coordination efforts, including assistance with theidentification of external aid and borrowing priorities.

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IV. The Lending Program

110. The World Bank's lending strategy addresses Georgia's primary economic constraints andpromotes policy reform and investments required to resume economic growth and reduce poverty. GivenGeorgia's difficult fiscal situation, much of the program will concentrate on improving the cost-effectiveness of government programs and on redirecting public sector involvement in the economy, withthe aim of providing a favorable environment for private sector development.

111. The economy faces constraints and challenges in a number of areas. The energy and transportsectors represent key constraints. Despite substantial hydropower potential, Georgia is highly dependenton imported fuels, and there is great need for rehabilitation and efficiency improvements in the existingtransmission and thermal and hydropower generation facilities, as well as for policy and institutionalstrengthening. As a transit economy, Georgia and its neighbors, Armenia and Azerbaijan, need aneffective transport and communication infrastructure. However, transport institutions and infrastructureare deteriorating from lack of maintenance and rehabilitation, which has resulted in poor and costlyservices. Environmental degradation in Georgia and the Black Sea may require country-specific as wellas regional solutions. Also key to Georgia's development prospects and to the transition to a marketeconomy will be investment in human capital, capacity-building and institutional development. Follow-through with plans to reform the health sector to improve service delivery to the poor and to privatizethe system where possible would not only reduce obligations on the state budget and improve resourceallocation efficiency, but would also help to strengthen Georgia's social safety net.

112. In FY95, three operations have been included in the lending program: the Institution Building(US$10 million) and Municipal Infrastructure Rehabilitation (US$18 million) Credits, which have alreadybeen approved, and this Rehabilitation Credit (US$75 million). IDA lending during FY95 will thus totalUS$103 million. The size of this allocation reflects the fact that Georgia is experiencing not only theinitial transition costs as elsewhere in the FSU but also additional costs caused by delayed initiation ofreform due to the civil conflict. Allocating this amount of IDA resources in one year reflects thejudgment that IDA now has a unique opportunity to catalyze market-oriented reform in Georgia and thatthis lending could make a difference between the success or failure of reform efforts at this crucial time.Beyond FY95, IDA lending to Georgia would be within the normal IDA allocation.

113. Three scenarios for future World Bank lending are envisaged. Each of the three cases assumesthat there is continued progress toward achieving a lasting resolution of civil conflicts that will allowmore normal trading and other economic relationships to develop. The base and high scenarios arepredicated on satisfactory implementation of the macroeconomic stabilization program. Under the basecase, only IDA lending is being planned, and the economy is assumed to become IBRD creditworthy after1998 when reforms have taken hold and peace in the region has been consolidated. In the high case, thereforms promoting fiscal strengthening, export development and overall supply response would strengthenGeorgia's creditworthiness earlier and would allow IBRD lending to commence in FY97.

114. The base or medium case would be characterized by continued progress in implementing thestructural reforms required to sustain the macroeconomic stabilization effort and to lay a basis forreestablishment of economic growth. While implementation of reform might not be completely evenacross all sectors, key structural reforms, which form a part of the government's economic reformprogram, would be expected. These key actions, or triggers, are:

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* continued progress on small-scale privatization at a pace which would allow the completion ofthe program by end-1995;

* substantial progress toward completion of trade liberalization through elimination of restrictionson exports;

* introduction of the framework governing agricultural land reform, including the establishment offull and unrestricted property rights on agricultural land, and advances in its implementation; and

* adoption of energy sector reforms including progress toward appropriate pricing, andstrengthening of sector management and organization.

115. Under the base case the volume of IDA lending would total approximately US$150-180 millionin five projects. One adjustment operation would be planned to help relieve policy constraints and toprovide fast-disbursing balance of payments support. The operation would be devoted to economy-wideissues such as fiscal reform; strengthening the competitiveness of markets; the next steps in privatization,enterprise reform and demonopolization; and to priority sectoral constraints.

116. Under this scenario, the Bank's investment projects would focus on restoring and improvingpublic infrastructure and services, promoting an environment more conducive to private sectordevelopment, assisting institutional development and achieving a sustainable social safety net. Inparticular, the investment lending program would include projects to support rehabilitation and efficiencyimprovements in the energy and transport sectors, strengthening of health service delivery, provision ofneeded assistance in land reform and the development of competitive production, processing, andmarketing in agriculture. Environmental issues would be addressed through components of specificprojects and through Bank-supported and administered regional initiatives, rather than through discreteenvironmental lending operations. To lay a basis for the investment projects, the Government will needto implement, beyond the overall triggers for this case, the specific policy and institutional changesnecessary for successful execution of particular programs. For example, setting and enforcing appropriatecost recovery policies will be essential in the energy and transport sectors. In the health sector, theGovernment has developed a satisfactory program. Implementation of this program, in particularintroduction of user fees and an adequate definition of priorities for public intervention, will be neededfor lending in this sector.

117. The high case would be characterized by sustained progress in implementing macroeconomicstabilization and success in implementing the structural reform program and resolving structural policyissues. In addition to fulfilling the triggers of the intermediate scenario, the high case would result from:

* corporatization and privatization of medium and large scale enterprises in accordance with targetsagreed under the Rehabilitation Credit;

* enforcement of financial discipline notably through the implementation of bankruptcy and anti-monopoly legislation and of action plans for dealing with the main large, loss-making state-ownedenterprises; and

* improved targeting of assistance programs and reform of the pension system to improvesustainability.

118. Under this scenario, during FY96-98 a blend of IDA and IBRD lending would totalUS$250 million in seven projects (about US$180 million from IDA and about US$70 million from theIBRD); there would be two adjustment operations and five investment projects. One adjustment operationwould address the economy-wide issues as under the base case and a further operation during the periodcould focus on transition of the agricultural sector. One investment project would be added to the lending

31

program relative to the base scenario and would support adjustment in the enterprise sector. The programwould be predicated on the adoption by the Government of the high case triggers and project-specificactions such as the ones noted above, in addition to implementation of restructuring/privatization plansfor the state banks and improvements in banking supervision capacity.

119. The low case would reflect a limited effort on the part of the government to undertake meaningfulstabilization measures and structural reforms. This scenario would be triggered by weak budgetarydiscipline, delayed elimination of administrative controls on trade and the slowing down of theprivatization program. Under this case no policy-based lending would be considered, but someinvestment lending for infrastructure and human resource development would be planned. This lendingwould have the objective of avoiding deterioration of critically-needed infrastructure, maintaining a basiclevel of social protection, and keeping open a dialogue on structural reform matters with the government.In this case, IDA lending would be offered at a level commensurate with the poor performance ratingsthat would result in these circumstances. One project per year could be envisaged, with lending duringFY96-98 totalling about US$60-70 million.

V. Implications for World Bank Exposure

120. For some time to come, Georgia will need substantial external capital inflows to finance its importneeds, build foreign exchange reserves, and meet its debt service obligations. In addition, the burdenof payment on external arrears and on debt servicing due in the coming few years will need to bealleviated as part of the financing package. Given its near-term resource constraints and hence itsdifficulties in servicing harder-term debt, it will be important for Georgia to receive external assistancehaving long grace periods, lengthy maturities and, if possible, concessional interest rates. For thesereasons, under the base case World Bank lending will come from IDA only during the initial period, andIBRD lending will build over time after 1998. Resulting from the medium case noted above, it isestimated that Georgia's outstanding debt, which is estimated to total US$975 million at end-1994(including arrears), will increase to US$2.8 billion by 2003. The IBRD's share in total debt will increasefrom zero at present to 2.3 percent by 2003, which is significantly below the average of countries atGeorgia's income level. The share of debt service owed to the IBRD in total debt service owed to officialcreditors will reach 1.5 percent by 2003, which corresponds to 0.1 percent of total exports by that year.This value is well within the Bank's exposure guidelines. Bank exposure will be monitored closely, andto spread risk, co-financing with other donors will be incorporated into project design.

32

Projected Creditworthiness Indicators - high case lerlding (percentafge)

Low Inconit1993 1994 1995 I99'S 20(3 Coumtries (1992)

Total DOD/GDP 53.2 92.2 85.; 93.0 77.7 46.!

Total DOD/Exports of GNFS 100.6 190.6 264.5 285.0 198.7 212.8IBRD DOD/Exports of GNFS 0.0 0.0 0.0 0.0 5.2 14. EBRD DOD/Total DOD 0.0 0,0 0.0 0.0 2.3 7.8IDA DOD/Exports of GNFS 0.0 0.8 16.9 24.4 28.3 21.5IDA DOD/Total DOD 0.0 0A4 6.4 8.6 14.3 11.9

Debt Service/Exports of GNFS 1.2 31.0 63.2 29.8 36.0 17.4of which: IBRD 0.0 0.0 0.0 0.0 0.1 2.2of which: IDA 0.0 0.0 0.0 0.1 0.1 0.3

IBRD Debt Service/Debt Serviceon public Guaranteed Debt 0.0 0.0 0.0 0.0 1.5 15.8

IDA Debt Service/Debt Serviceon public Guaranteed Debt 0.0 0.0 0.0 0.3 2.1 2.1

World Bank estimates.

IV. Economic and Sector Work Program

121. The World Bank's ESW program with Georgia supports the country assistance strategy's focus

on planning and implementing structural reform to move Georgia to a market-based economy. ESW

provides analytical means for advising the government on appropriate policy and investment strategies,

as well as an intellectual basis for the Bank's policy dialogue. Carefully selected and timed ESW will

also underpin the development of future policy-based and investment lending and will assist aid

coordination.

122. There are four broad areas where ESW is planned for the coming three years: macroeconomic

stability and growth, improving public sector efficiency, private sector development, and poverty

alleviation. In the macro area the Bank will continue to update the status of structural reforms and to

place them in a medium-term framework through the preparation of policy notes. In future years the

Bank will also work with the government and the IMF in the preparation of Policy Framework Papers.

To assist the improvement of public sector efficiency, the Bank is planning to undertake a review of

public expenditures, particularly public investment. This work would take advantage of, and build upon,

the ongoing and planned work in energy, transport, municipal services, health, and environment. In this

review, work would also be planned on public sector labor and employment policies. The intention is

that the review of the public investment program would serve as a basis for a future consultative group

meeting. In the area of private sector development, the Bank is presently undertaking a review of the

agriculture sector and is planning to initiate a broader private sector assessment which will include a focus

on enterprise reform, including privatization, and the financial sector, augmenting the substantial work

and technical assistance carried out in some of these areas under the Institution Building Credit

preparation. Using household survey work financed under the IBC, a poverty assessment will be

undertaken to measure the incidence of poverty, help identify most vulnerable groups and recommend

means of targeting poverty reduction measures.

33

VII. MIGA and IFC Activities

123. Georgia became a member of MIGA in December 1992. To date there have been no investmentguarantees issued.

124. Although Georgian officials have spoken on several occasions with IFC staff about possiblemembership, the government has not yet completed the membership processes. Its assessment has beenthat up-front membership costs would outweigh possible benefits in a climate of political uncertainty andmacroeconomic instability. As economic conditions improve and as the government sees more immediatebenefit, Georgia's interest in IFC membership will also likely grow.

PART III. THE PROPOSED CREDIT

I. Background and Rationale for World Bank Involvement

125. The economy of Georgia is undergoing the transition to a market economy under difficultconditions. In addition to experiencing terms of trade shocks and disruptions in supplies, as well as theeffect of output declines in neighboring countries, Georgia's economy is suffering from the aftermath oftwo years of civil conflicts and political instability. In the short run, economic recovery will operateunder sharp financial constraints (weak fiscal stance and large external obligations). The proposed creditwould support the initial stage of Georgia's transition to a market-based economy and if implementedsuccessfully would serve as the basis for the World Bank's future lending program to Georgia. Theproceeds of the credit would finance critical imports needed to stem the decline in output and wouldcontribute to developing the foreign exchange market. The project funds will be utilized within theoverall budget envelope supported by the Systemic Transformation Facility (STF), and thus the localcounterpart funds generated through the sale of the foreign exchange will provide non-inflationaryfinancing for the Government's public expenditure program. The project should also provide aframework for the provision of financial assistance from other donor agencies.

II. Program to be Supported

126. The Government's program of structural reform to be supported by this Rehabilitation Credit isoutlined in Part I and in the attached Letter of Development Policy (Annex 3). The structural reformprogram described in the Letter complements the macroeconomic stabilization program supported by theSTF which was approved by the IMF Executive Directors on December 15, 1994.

34

127. The following key policy measures were iiiplenienited prior io the submission of the proposedcredit to the Board:

Transfer of Ownership Rights to the Private Sector

Privatization of small-scale enterprises

* Regulations were issued prohibiting the imposition of conditions on post-privatization businessactivities and eliminating minimum bid prices for enterprises not sold after the first auctionattempt.

* About 847 small-scale enterprises were privatized (in addition to the 1,651 enterprises privatizedas of October 12, 1994), reaching 40% of target (6,481 small enterprises).

Privatization of medium and large-scale enterprises

* About 402 medium- and large-scale enterprises were corporatized (in addition to the 335 alreadycorporatized as of October 12, 1994) reaching 73% of target (1,007 medium- and large-scaleenterprises).

* The following preparatory steps for the Mass Privatization Program (MPP) were finalized:(a) completed collection of lists of eligible voucher recipients; (b) issued guidelines for thecompletion of the legal framework for MPP, including rules and regulations regardingdistribution of vouchers, auctions, and bidding procedures; and (c) identified the large enterprisesto be sold at the first three pilot auctions.

* Criteria for the selection of enterprises to be privatized through international tenders weredeveloped and adopted, and 15 enterprises were identified for this program.

Land Reform

* Preparation of a draft law on land reform was initiated: (a) defining the legal framework fortransactions related to land including sale, lease and inheritance; and (b) giving landownersunrestricted rights to enter into such transactions. The government agreed to submit the draft lawto Parliament for discussion no later than July 1995.

Imposition of Hard-Budget Constraints on State-Owned Enterprises

* The 25 largest loss-making state-owned industrial or agricultural enterprises were identified, anda decree ordering the preparation of action plans for these enterprises by September 1995 wasissued.

Restructuring the Government Sector

* A restructuring plan for Government's ministries and departments, including a reduction of atleast 25 % in the number of employees in the budgetary sector to be achieved through

35

rationalization and reorganization rather than through across-the-board downsizing, was submittedto Parliament.

* A decree specifying basic policy lines for a reform of the health sector was issued. The reformnwill define a basic package of services to be publicly financed so as to ensure access by the poor.It will also introduce fee-for-service charges, foresee privatization of some hospitals and clinics,and reduce the number of health care providers paid out of the state budget.

Promoting the Development of Markets and their Increased Efficiency

* All remaining restrictions on converting non-cash into cash money (and vice versa) for foreigncurrency were eliminated.

* All requirements for delivery of goods under the state order system, except for those goods usedto fulfill the existing barter trade agreements for energy resources, were eliminated. Forremaining state orders, it was agreed that the price paid to producers will be equivalent to theborder price, converted to domestic currency at the exchange rate prevailing at date of payment.

3 The number of products under export licensing requirements was reduced. Export controls wereonly maintained to: (i) fulfill the existing barter trade agreements for energy resources;(ii) protect environment and health; (iii) control arms trade; liv) control exports as required bytrade agreements that give market access to limited quantities of Georgian products (e.g. theMulti-Fiber Agreement); or (v) protect temporarily the domestic supply of a small number ofbasic food items.

* A decree was issued establishing a timetable for complete phasing out of the state order system,export licensing and export prohibitions (except for goods related to environmental protection,health, arms control and multilateral trade agreements).

* A draft law for operations of the NBG was submitted to Parliament, and revised prudentialregulations were issued.

Ensuring a Minimum Level of Social Protection

* A commission was appointed to prepare a reform plan of the social protection system which willbuild on the measures taken prior to Board presentation to increase cash transfers to the poorestgroups. The plan to be completed by mid-1995 will form the basis for reforms starting later inthe year.

III. Project Implementation

128. Proceeds of this Credit will be disbursed monthly based upon evidence acceptable to the Bankthat imports of eligible goods have taken place. The Credit funds will be disbursed into a Ministry ofFinance (MOF) foreign exchange account with the NBG specially set up for this purpose. The NBG willwithdraw the foreign exchange as and when needed to meet market demand from both the public and

36

private sectors and will reimburse the MOF at that time with the equivalent local currency at the marketexchange rate.

129. The exchange rate applied to the credit proceeds will be determined by the inter-bank foreigncurrency auction market. This market was established in 1993 by the NBG and a group of commercialbanks; currently about 45 of the registered commercial banks are eligible and participate in the auction.Following the decision to channel the totality of the surrender requirement to the NBG and to includenon-cash sales/purchases, the frequency of auctions has been raised from once to twice a week since mid-September. The volume of transactions going through the inter-bank auction is currently aboutUS$1.1 million per month. The Government expects this volume to expand as its stabilization andstructural reforms strengthen the role of markets forces in allocating foreign exchange.

130. All proceeds of the Rehabilitation Credit will be made available to Georgia upon the credit'seffectiveness. In view of the significant reform actions already undertaken since September 1994 and thesubstantial balance of payments needs of the country, 20% of the credit amount (US$15 million) shallbe made available as retroactive financing and will provide reimbursement for imports procured in thefour months preceding the date of credit signing. Such retroactive financing would allow the Governmentto procure energy and other critical imports essential for survival during the winter months. ConsideringGeorgia's urgent need for import financing, it is expected that the Credit will be disbursed in a very shorttime. The closing date of the credit shall therefore be June 30, 1996.

131. The Deputy Prime Minister responsible for economic reform will oversee, coordinate, andmonitor implementation of the policy reform program. He will be assisted by the ministries concerned,including those of Economy, Finance, Agriculture, State Property Management, Labor and SocialProtection and the NBG.

132. A senior official from the Cabinet of Ministers has been appointed as project manager. Thatofficial will monitor the collection of customs documents and will supervise the preparation of thewithdrawal applications and their submission to the World Bank. The project manager will ensure thatadequate project accounts are maintained and that timely audits are conducted. Relevant staff in thecustoms department have been designated to assist in the preparation of relevant documentation andmonitoring of the project. It has been agreed that the project staff would have access to the procurementand disbursement experts in the project implementation unit (PIU) of the Institutional Building Credit(IBC) for technical advice that may be required. These staff shall also be encouraged to attend WorldBank seminars on disbursement procedures.

IV. Procurement

133. Procurement under the project will follow standard procedures as spelled out in the "Guidelinesfor Procurement under the IBRD Loans and IDA Credits." On the basis of visits with Georgianimporters, it is evident that their procurement practices are evolving toward those of a market economy.As in the case of other FSU countries, enterprises in Georgia traditionally had been supplied for the mostpart through non-competitive arrangements. After the break-up of the FSU and the dislocations causedby the civil conflicts, enterprises have had to seek other sources of supply. While communication withsuppliers is not easy, evidence of business practice indicates that enterprises are concerned with marketcriteria of availability and reliability of supply, price, and quality and that importers have solicitedmultiple sources of supply from multiple countries. Given the stage of Georgia's move to a market

37

economy, the relative size of the country, and the limited experience to date with procurement inGeorgia, the ICB threshold has been set at USS500,000. which is substantially lower than the thresholdof US$5 million recommended in the Operational Manual. Below US$500,000. given evidence thatimporters have begun using acceptable purchasing practices, procurement using normal commercialpractices will be allowed.

134. Government purchases are subject to regulations which require competitive procurement. Decree264 approved by the Cabinet of Ministers in March 1993 specified that government procurement wouldtake place on a competitive basis and set forth procedures for advertisement, bidding, selection andannouncement of winning bidders. As for the enterprise sector, the ICB threshold shall be US$500,000.Below that amount, procurement of Government imports shall take place on the basis of quotationssolicited from suppliers of at least two different countries. To ascertain greater information onprocurement practices in the public and private sectors and to lay out a strategy for its improvement, theBank will prepare a procurement review by end-1995. This review will serve as a basis for determininghow the Bank could assist this effort, for example through use of the Institution Building Credit or apossible Institutional Development Facility grant.

135. In addition to the arrangements noted above, retroactive financing of goods would be allowedprovided procurement has taken place according to these procedures and thresholds and that appropriatesupporting documentation is available. With the prior approval of the Bank, LIB will be allowed forspecialized goods in accordance with the procurement guidelines. Subject to prior approval of the Bank,commonly traded commodities may be procured through organized international commodities marketsor other channels of competitive procurement. Direct purchases made in accordance with Bankprocurement guidelines and with the prior approval of the Bank may also be financed using this Credit.Pre-shipment inspection will not be required under the proposed credit. The low import tariffs for thebulk of imports limits the probability of tax evasion through under-invoicing while the move towardmacroeconomic stabilization will diminish incentives for over-invoicing. In addition, the InstitutionBuilding Credit is providing assistance to the Ministry of Finance and the Customs Department forreviewing and strengthening customs operations.

V. Disbursement

136. The Bank will finance 100 percent of foreign expenditures for directly imported goods. Importseligible for reimbursement will be subject to the World Bank's standard negative list. The minimumcontract value for this Credit shall be US$5,000. The financing will be provided on the basis of(i) statements of expenditure (SOE) prepared in accordance with the Bank's simplified documentationrequirements for adjustment operations (i.e. based on customs certificates) for contracts valued at lessthan US$500,000, and (ii) full documentation for contracts of US$500,000 and above, provided there issupporting documentation acceptable to the Bank that these contracts were awarded on the basis of openand competitive procedures. For some imports into Georgia (e.g., natural gas) which are not subject tocustoms inspection, a certificate of delivery shall be an acceptable alternative to the customsdocumentation requirement. The project manager will prepare the withdrawal applications based on thedocuments provided by the Customs Department, and will keep photocopies of the relevant customs andfull documentation. The original documentation will be retained by the Customs Department for threeyears after the closing of the project, and will be made available to Bank supervision missions and to theauditors, as requested.

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VI. Reporting, Accounting, and Auditing

137. The project manager will maintain all project accounts, which will be audited annually byindependent auditors in accordance with the World Bank's guidelines on auditing and financing reporting.Audit reports will be submitted to the World Bank not later than six months after the close of each fiscalyear, or the date of final disbursement. The project manager will also prepare monthly progress reportsdetailing the status of all procurement transactions, commitments, and disbursement requests. For thepurposes of undertaking the required audits, the government will hire an independent auditing firmacceptable to the World Bank. The foreign cost of hiring of an auditing firm can be financed out of theInstitution Building Credit.

VII. Enviromnental Safety

138. As an adjustment operation, this project has been assigned to Category U (unrated) for thepurposes of Operational Directive 4.01, which does not require an environmental assessment.

VIII. Agreements Reached

139. At negotiations, understandings acceptable to the World Bank were reached on: (a) the attachedLetter of Development Policy, outlining the Government's reform program and the timing ofimplementation; (b) the standard negative list of goods precluded from financing under the proposedcredit; and (c) accounting and auditing arrangements.

IX. Benefits and Risks

140. The potential benefits from the successful implementation of the economic reform program areenormous. With its educated labor force, its long tradition of entrepreneurship, and its already significantprivate sector, Georgia has substantial assets for becoming a fast-growing economy provided a favorableenvironment can be established. Over recent years, its potential has been wasted by inappropriate policiesand civil conflicts which have added to the costs of the transition and imposed considerable hardship tothe population. A successful reform program, adequately supported by external assistance, can lead toa quick reversal of recent trends and improvement of living standards of the population. The proposedcredit would contribute to that reversal by easing the transition to a market economy through a rapiddownsizing of the state-controlled sector and by setting policies that foster increased efficiency in resourceuse. The balance of payments support would finance imports critical to economic activity, and the localcounterpart funds would provide budgetary support to ease the fiscal adjustment and to maintain a basiclevel of public expenditures, in particular for the social safety net. The disbursement mechanism of thecredit will also support development of the foreign exchange market.

141. There are four main risks involved in the program. First, a lack of continuous political consensusand social tensions could lead to a slippage in implementation of reforms. Although the government hastaken a series of decisive and courageous measures over the last few months, and there is a growingnumber of top government officials committed to reform, there is not yet unanimous support for allaspects of the reform program. The impossibility of providing more than a very limited social safety netcould also create social tensions, making it more difficult to implement certain reforms, in particular those

39

related to the enforcement of price increases. To some extent, this risk can be reduced throughinterventions from the international community. By maintaining a substantial amount of humanitarianaid, through technical support and generous financial assistance, it should be possible to lessen the socialcosts of the adjustment and to provide continuous support to the team of reformers within thegovernment. Growth of the informal economy should also help to reduce social tensions.

142. A second substantial risk is that adequate and timely external assistance of the magnitude requiredwill not be forthcoming. The macroeconomic prospects are such that even with timely implementationof reforms and substantial external assistance, Georgia's economy will not start growing again before1996, and will not reach the 1993 levels of per-capita consumption (already depressed relative to 1990)before the end of the century. The failure to achieve a fully funded program, and in particular, to obtainfrom Georgia's creditors restructuring or refinancing of the external debt on concessional terms, wouldforce a much stronger domestic adjustment, imposing substantial additional'social costs on a populationthat has already suffered from considerable hardship. This could threaten public support for reforms andcould increase the risk of political instability. To address this problem, the Bank will not only beprepared to provide solid financial support, but it will also assist Georgia in mobilizing external resourcesthrough the Consultative Group process and other donor coordination efforts.

143. A third risk is delayed implementation due to inadequate capacity within the Govermment and theexecuting agencies. Given the sharp economic decline experienced by the Georgian economy, timelyimplementation and rapid materialization of benefits from the program are essential to its success. Toreduce that risk, continuous effort will be provided by the Bank, through the IBC and by mobilizingextemal technical assistance, to assist the Government in the design and implementation of the muchneeded reforms.

144. Finally, there is the risk that civil conflicts might resurface. Although the conflicts in Ossetiaand Abkhazia are now quiet and negotiations are taking place for a lasting resolution on the latter, thereis still uncertainty regarding the final outcome of these negotiations.

PART IV. RECOMMENDATION

145. I am satisfied that the proposed credit would comply with the Articles of Agreement of the IDAand recommend that the Executive Directors approve it.

Lewis T. PrestonPresident

by Sven Sandstrom

Washington D.C.March 7, 1995

Attachments

Nt 'ILA A

Georgia: Key Macroeconomic Indicators

(in percent unless otherwise stated)

1993 1994 1995 1996 1997 1998 1999 2000 2001 2002 2003

Real Growth Rates

GOP at Factor cost -32.1 -28.7 -3.8 3.1 5.1 5.9 6.6 6.7 7.0 7.1 7.1

Exports of G&NFS 1/ -10.6 0.9 11.4 9.9 9.4 8.8 8.8 8.6 8.7 8.8

Imports of G&NFS 1/ 4.2 -0.2 6.6 5.8 5.9 6.0 5.8 6.0 6.1 6.1

Private Consumption -23.2 -15.0 -3.9 0.1 2.4 2.1 4.5 4.3 4.5 4.6 5.0

INDEX (1994=100) 117.6 100.0 96.1 96.2 98.5 100.5 105.0 109.6 114.5 119.8 125.8

As X of GDP

Domestic Savings -18.9 -35.1 -19.8 -10.2 -2.8 2.5 5.2 7.3 9.8 11.7 13.1

Gross Domestic Investment 6.0 3.5 3.5 6.7 9.5 13.0 14.0 14.5 15.5 16.0 16.0

Resource Balance -24.9 -38.6 -23.3 -16.9 -12.3 -10.5 -8.8 -7.2 -5.7 -4.3 -2.9

Budget Revenues 2/ 9.7 6.6 8.5 10.1 11.8 12.9 12.9 12.8 13.6 13.5 13.5

Budget Expenditures 3/ 35.9 17.4 13.3 14.1 13.7 13.8 13.5 13.4 13.9 13.8 13.7

Primary Deficit -26.2 -10.9 -4.5 -3.2 -1.1 0.0 0.2 0.1 0.4 0.3 0.3

Fiscal Deficit -26.3 -10.9 -4.8 -4.0 -2.0 -0.8 -0.6 -0.6 -0.2 -0.3 -0.2

Trade Balance -19.9 -31.6 -16.9 -12.6 -8.7 -7.6 -6.6 -5.7 -4.9 -4.2 -3.2

Exports 40.8 43.9 28.7 29.1 30.3 31.0 31.4 31.7 31.9 32.3 32.3

Imports 60.8 75.4 45.6 41.8 39.1 38.6 38.0 37.4 36.8 36.5 35.5

Current Account 4/ -14.4 -31.2 -23.9 -17.8 -13.5 -12.0 -10.4 -8.7 -7.2 -5.9 -4.4

Total Debt Outstanding 53.2 92.2 85.1 93.0 98.3 99.4 98.4 97.6 91.5 85.4 77.7

Total DOD (millions of USS) 648 975 1380 1744 2005 2221 2419 2635 2726 2791 2781

Amnual avg. Inflation 4085.6 12620.4 118.6 15.7 6.0 6.0 6.0 6.0 6.0 6.0 6.0

Sources: Georgian authorities and staff estimates.

1/ Trade data for 1993 has been revised and it is not compatible with 1992. Exports and Imports for 1994 are based on

preliminary data from the IMF.

2/ Includes grants.

3/ Includes off-budget subsidies for bread, electricity and gas in 1993 and the first half of 1994.

4/ includes official transfers.

Georgia: Bslance of Payments ANNEX I(millions of USS)

1993 1994 1995 1996 1997 1998 1999 2000 2001 2002 2003

A. Export of Goods and NFS 570.6 487.8 491.8 576.8 652.2 733.7 821.2 919.3 1027.1 1148.7 1263.5

1. Herchandise (FOB) 497.0 464.0 465.0 546.5 618.0 693.5 772.1 856.8 950.4 1054.9 1156.52. Non-Factor Services 73.6 23.8 26.8 30.2 34.2 40.2 49.2 62.5 76.6 93.8 107.1

B. Import of Goods and NFS 873.2 947.5 853.1 893.7 903.1 967.7 1037.7 1112.5 1197.5 1290.1 1365.91. Merchandise (FOB) 739.8 798.0 739.0 783.2 796.5 862.8 934.5 1009.8 1097.2 1192.5 1270.12. Non-Factor Services 133.4 149.5 114.1 110.5 106.6 104.9 103.3 102.8 100.3 97.6 95.8

C. Resource Balance -302.5 -459.7 -361.3 -316.9 -250.8 -234.0 -216.5 -193.2 -170.4 -141.5 -102.3

D. Net Factor Income -3.7 -32.0 -60.8 -51.2 -60.1 -69.9 -74.6 -77.7 -79.6 -85.2 -88.51. Factor Receipts 0.0 0.0 3.2 4.9 8.0 8.5 10.9 15.6 25.0 26.9 29.02. Factor Payments 3.7 32.0 64.0 56.1 68.1 78.4 85.5 93.3 104.6 112.2 117.6

(Interest on Gap) 0.0 0.0 0.5 35.9 52.5 66.5 71.6 75.2 79.9 78.4 74.7(Interest on Arrears) 0.0 0.0 12.2 0.0 0.0 0.0 0.0 0.0 0.0 0.0 0.0

E. Current Account Balance -306.2 -491.8 -422.1 -368.2 -310.9 -304.0 -291.1 -271.0 -250.0 -226.7 -190.9(before official transfers)

1. Official Transfers 131.2 162.0 34.7 34.7 34.7 35.0 35.0 35.0 35.0 35.0 35.02. Current Account Balance -175.0 -329.8 -387.4 -333.5 -276.2 -269.0 -256.1 -236.0 -215.0 -191.7 -155.9(after official transfers)

F. Long Term Capital Inflow 506.1 21.9 733.5 368.8 281.2 251.7 270.4 301.1 9.1 -95.6 -205.01. Foreign Direct Investment 5.5 0.0 0.0 5.0 20.0 30.0 60.0 75.0 85.0 90.0 125.02. Net LT Borrowing 500.6 9.9 -151.8 -51.9 -89.2 94.9 120.0 110.2 -38.5 -92.7 -127.33. Other LT Inflows (net) -0.0 12.0 885.3 415.7 350.4 126.8 90.4 115.9 -37.4 -92.8 -202.7

G. Total Other Items (Net) -331.1 305.0 -367.0 0.0 0.0 50.0 50.0 50.0 60.0 60.0 60.01. Net Short-Term Capital 0.0 0.0 0.0 0.0 0.0 50.0 50.0 50.0 60.0 60.0 60.02. Change in Arrears 62.0 305.0 -367.0 0.0 0.0 0.0 0.0 0.0 0.0 0.0 0.03. Errors & Omissions -393.1 0.0 0.0 0.0 0.0 0.0 0.0 0.0 0.0 0.0 0.0

H. Change in Net Reserves 0.0 2.9 20.9 -35.4 -4.7 -33.4 -65.0 -118.2 -34.2 -36.3 -31.81. Net Credit from IMF 0.0 38.9 38.9 0.0 0.0 -6.5 -13.0 -13.0 -13.0 -13.1 -12.82. Other Reserve Changes 0.0 -36.0 -18.0 -35.4 -4.7 -26.9 -52.0 -105.2 -21.2 -23.2 -18.9

(in months of imports) 0.0 0.5 0.8 1.2 1.3 1.5 2.0 3.0 3.0 3.0 3.0

ANNEX I

Memo items:

Nominal avg. Exchange Rate 13.5 1414.8 1971.3 2037.6 2103.2 2176.1 2250.4 2325.2 2401.8 2484.8 2577.7

(in thousands of coupons)

Real Exchange Rate (1993=100) 100.0 85.0 55.0 50.0 50.0 50.0 50.0 50.0 50.0 50.0 50.0

Source: Georgian authorities and staff estimates.

ANNEX 2

Schedule A

REPUBLIC OF GEORGIA

REHABILITATION CREDIT

Timetable of Key Processing Events

(a) Time taken to prepare: 6 months

(b) Prepared by: Government of Georgia with theassistance of IDA staff

(c) Preparation Mission: October 10-28, 1994

(d) Negotiations: February 15-17, 1995

(e) Planned Board presentation: March 30, 1995

(f) Planned date of effectiveness: March 31, 1995

(g) Expected program completion: June 30, 1996

(h) Appraisal Report Not applicable

6bJb6O)30VTM6 6DIX63OJOb DEPUTY PRIME MINISTER3a6o3a3-a8o66oI06 8A VCn D REPUBLIC OF GEORGIA

6aCaQjGo: (8832) - 99-9757 ph: (8832) -99-9757(8832) - 98-9953 (8832) - 98-99-53

UJOdbo: 495151113060-176 Fax: 495d51/13U060 ext. 176

495151/13086476 495151/13086 ext. 476

(8832) 98-4083 Or (8832) 98-4083

N-____ ,<__,,_ -ebrar 1 L_-- 1995

Dear Mr. President,

The attached letter of Development Policy outlines the Program of Macroeconomic Stabilizationand Structural Reform of the Republic of Georgia. We request the World Bank to support thisprogram with a Rehabilitation Credit of USS75 million.

The program of measures in the Letter is intended to achieve the rapid resumption of economicgrowth within a sustainable macroeconomic framework. If adjustment and corrective measuresare required during the course of the implementation of the program we will, where appropriate,review those measures with the World Bank.

Sincerely yours,

Temur Basilia

Lewis T. PrestonPresidentInternational Bank forReconstruction and Development

Annex 3Page I of 10

GEORGIA

LETTER OF DEVELOPMENT POLICY

1. Over the last few years, the Georgian economy has been negatively affected by the disruption ofeconomic ties within the FSU, large terms of trade shocks and output decline in Russia and elsewhere in theregion, and also by two years of civil conflicts. As a result, Georgia has suffered from a very sharpeconomic contraction, high and rising inflation, and a substantial deterioration in the standard of living of thepopulation. Today, with the restoration of peace and increased political stability, the way is open forattempting to rebuild the economy, and for undertaking the necessary reforms that will bring about asuccessful transition toward a market economy.

2. The Government of Georgia is strongly committed to undertaking this task and to implementing acomprehensive program of macroeconomic stabilization and structural reforms aimed at restoring stablemacroeconomic conditions and at promoting output recovery.

3. The Government's economic reform program focuses on four key elements, which are interconnectedand mutually reinforcing:

- First, macroeconomic stabilization will be achieved through fiscal adjustment and tight monetarypolicies.

- Second, reforms of the public sector will be undertaken to reduce and redefine the role of theGovernment in the economy. The aim is to ensure that the stabilization program is sustainable, theinstitutions of public management are strengthened and that private sector activity expands rapidly throughacceleration of the privatization process.

- Third, the development and increased efficiency of markets will be fostered by finalizing theliberalization of domestic prices, as well as of the foreign exchange and trade regimes; promoting competitionand creating a favorable environment for private sector development; and by strengthening the financialsector.

- Finally, a minimum social safety net, compatible with the limited available resources, will bemaintained to protect those who might suffer most during the adjustment process.

The critical elements of the Government's economic program, including the timetable of key actions, aredescribed below and also summarized in the attached policy matrix.

4. In parallel to the implementation of its economic program, the Government is committed to regularizerelations with its external creditors. Since the country's independence, Georgia has contracted substantialexternal debt and has accumulated arrears, mostly related to its energy imports. The Government is awarethat it now faces debt obligations that far exceed the country's current capacity to pay. To address this issue,

AnnexPage 2 of I

the Government has requested a stand-still on debt service payments and initiated negotiations on arestructuring or refinancing of its debt and arrears. In addition, the Government is committed not to contractany additional short-term debt and not to increase non-concessional medium- and long-term debt by more theiUS23 million between September 1994 and June 1995 without previous consultation with the Bank.

I. Stabilization Program

5. To bring about rapid price stabilization, leading to a reduction of the monthly inflation rate from anaverage of 50-60 percent during the first half of 1994 to low single-digits by the end of 1995, theGovernment is committed to undertaking a drastic fiscal adjustment, and to maintaining tight fiscal andmonetary policies thereafter.

6. The overall fiscal deficit of the general government is targeted to decline from 26 percent of GDP in1993 to about 9 percent in 1994, and to be limited to no more than 6-7 percent in 1995. The main elementof the fiscal adjustment is the complete elimination of remaining generalized subsidies. As of September,1994, domestic prices for gas and electricity were raised to reflect their full cost (import or production anddistribution costs), and will thereafter be readjusted every month. Subsidies for bread and transportation weresubstantially reduced and will be phased out by mid-1995. Subsidies and transfers to enterprises, includinginterest subsidies also ceased. In addition, revenue-enhancing measures were adopted. These include the saleof donated imports of wheat and flour at the coupon equivalent of world market prices, and a package of taxmeasures, the most significant being increased tax rates for VAT, customs duties, and gasoline excise tax allof which became effective on December 1, 1994. To partly compensate for the price increases resultingfrom the removal of subsidies, modest wage increases were provided to the employees of budgetaryorganizations as of mid-September, 1994; cash supplements were also granted to the lowest paid employees.Pensions and other social benefits were also increased. Because of the fragile fiscal situation, furtherincreases in public sector wages and social benefits will be limited to target inflation during the first half of1995; possible increases in real wages and readjustments to the wage scale and to the structure of socialbenefits will only be considered during the second half of 1995.

7. To achieve stabilization objectives, the National Bank of Georgia (NBG) will tighten monetarypolicy. Changes in bank credit to general government and in net domestic assets of the NBG will be guidedby inflation and international reserves targets. To sterilize part of the massive monetization of the fiscaldeficit in the 3rd quarter of 1994, the NBG tightened its enforcement of reserve requirements, includinglevying penalties for non-compliance. In addition, reserve requirements on foreign currency deposits wereraised at the beginning of September 1994, to the same level as domestic currency deposits (20 percent).Directed credits to selected sectors at highly subsidized rates and automatic access by state commercial banksto overdraft facilities, have both been eliminated as of October 1, 1994. To meet the liquidity needs ofbanks, the Government has undertaken to develop a short-term credit facility since the end of 1994.

II. The Structural Reform Program

8. The Government is fully aware that sustained stabilization and output recovery require fundamentalstructural reforms designed to transform the economy into a market economy. Over the past three years,some measures have been taken in the areas of price liberalization, foreign exchange and trade regime

Annex 3Page 3 of 10

reform, and private sector development. However, the scope of these reforms still needs to be extended andbroadened to form a fully comprehensive program. This is the primary focus of the Government's currentprogram.

A. Reducing and Redefining the Role of the State Sector

9. The Government recognizes the need to strengthen the institutions of public management in order tosuccessfully implement the structural reform program. Through reform of the tax system and bystrengthening tax and customs administration, reducing collection lags, and enforcing compliance, theGovernment intends to increase its capacity to collect revenues and administer resources. The stabilizationprogram will also contribute to that objective by reducing the negative effect of inflation on real tax revenues.

10. However, the Government is also aware that even with substantial progress in raising revenues, thecurrent level of revenues is so low that public-sector institutions must be thoroughly reorganized in order tonarrow the budget deficit and ensure the sustainability of the stabilization program. Moreover, it recognizesthat the restructuring of many Government activities and the divestiture of state assets is desirable, even if thebudget deficit remains moderate, in order to foster the development of private sector activity.

11. To address these issues, the Government is committed to a deep reform of the public sector. Thiswill include: (i) rapid transfer of ownership rights to the private sector; (ii) the imposition of a hard-budgetconstraint on remaining state-owned enterprises; and (iii) restructuring of the Government sector.

Transfer of Ownership Rights to the Private Sector

12. The Government recognizes that the need to further reduce the range of its interventions, retainingonly a regulatory role for the remaining ones, and to impose hard-budget constraints to remaining state-ownedenterprises calls for accelerating the privatization program.

13. Privatization of State-Owned Enterprises. The Government is fully committed to accelerating theprogram. With respect to small-scale privatization which is already fairly advanced, the Government intendsto complete the privatization of 6,481 small enterprises under state ownership by the end of 1995.' Towardthis end, the Government has privatized between mid-October and February 1, 1995, 847 small enterprises,which, added to the 1,657 enterprises privatized at an earlier date, already represent 40 percent of the fixedtarget (up from 25 percent in October 1994).

14. To expedite implementation of the program, the Government has adopted a number of measures.First, minimum bid prices have been eliminated at the second round of auctions for all enterprises not sold atthe first auction attempt. Second, all small state-owned enterprises not sold at a second auction will beimmediately liquidated and their assets auctioned piecemeal with no minimum bid prices; no more than onemonth shall pass between a first and second auction attempt. Third, in order to provide an incentive for localauthorities to meet these accelerated targets, the Govermnent adopted and started implementing a policy

I This target may not be fully met in Abkhazia and South Ossetia, but the Government is committed tomaking its best effort to complete the programs in these two regions.

Annex 3Page 4 of 10

allowing all municipalities that have achieved the SPM imposed targets to retain a percentage of privatizationproceeds from the sale of local and republican enterprises within each municipality. Fourth, the Governmenteliminated commercial tenders which imposed conditions on post-privatization business activities, for all smallenterprises (except for those selling rationed goods or owning assets deemed to be of historical significance).

15. With respect to medium-sized and large enterprises, the Government will implement a voucher-based mass privatization prograrn (MPP), supported by a comprehensive public relations campaign publicizingthe program's objectives, procedures for participants to obtain vouchers, and procedures for the conversion ofvouchers to shares in enterprises and investment funds. In order to establish a solid legal foundation for thevoucher program, the Government has issued guidelines to complete the necessary legal framework for theMPP, including the issuance of regulations regarding the distribution of vouchers, auctions, and biddingprocedures.

16. Successive waves of enterprises will be auctioned, both locally and nationally, throughout 1995, andthe MPP will be completed by July 1996. The first wave of the MPP will involve two local pilot voucherauctions, and one national pilot auction, which will be carried out during May and June 1995. In preparationfor the MPP pilot auctions, the Government completed the corporatization of 402 large enterprises, inaddition to the 335 already corporatized as of October 12, 1994. As of February 1, 1995, about 73 percentof medium- and large-scale enterprises have been transformed into joint-stock companies. The Governmenthas also identified the enterprises to be sold in the first three pilot auctions. Thereafter, it will distributeenterprise preparation packages to the enterprises participating in the first three pilot auctions.

17. Identification of voucher recipients is a binding constraint on the voucher distribution process andhence on implementation of voucher auctions. The Government has recognized the critical need to finish thistask in a relatively short period of time and completed in February 1995, the compilation of lists of eligiblevoucher recipients.

18. In order to facilitate the mobilization of financial resources for investment, the Government willintroduce a case-by-case approach to privatizing a select group of large enterprises, targeting the sale of amajority of their shares to foreign or domestic investors with the capital necessary for new investment and theskills and experience required to quickly restructure these enterprises for successful operation in a marketeconomy. Toward this end, the Government has developed and adopted criteria for the selection ofenterprises to be privatized through international tenders, and identified 15 large enterprises for this program.These enterprises will be exempted from Decree 178 dated May 29, 1994. The Government expects tocomplete privatization of these enterprises by mid-1996.

19. Privatization of land. To date, distribution of land has taken place without establishment of a legalframework for land ownership. As a result, land which has been distributed is still legally owned by thestate. To facilitate the restructuring of the agriculture sector, the Government is preparing a draft land lawwith assistance of World Bank staff. The draft will be submitted to and discussed by Parliament no later thanJuly 1995. The draft Land Law will: (a) define the legal framework for transactions related to land,including sale, lease and inheritance; (b) give landowners unrestricted rights to enter into such transactions;and (c) recognize all land previously distributed to Gerogian citizens as their private property. Following theadoption of the land law, the Government will establish land registration procedures and initiate thedistribution of property titles.

Annex 3Page 5 of 10

20. The Government is committed to completing the transitional reforms in agriculture and to foster thecreation of economically viable and efficient production units. By mid-1995. it will prepare a program forland privatization which defines the general principles according to which the remaining agricultural land willbe distributed, and which also sets targets for privatizing remaining state and collective farms.Implementation of the land privatization program will be completed by February 1996.

21. Privatization of Housing. Most housing units in rural areas and urban apartments have beenprivatized and owners are free to sell or rent their housing. However, the legal framework is still incompleteand the Government intends to enact by mid-1995 the legislation necessary to define ownership rights forcommunal spaces and facilities, as well as providing a framework for privatization of buildings.

Enterprise Management and Restructuring

22. Notwithstanding privatization and growth of the private sector, state enterprises will continue to playa significant role in the Georgian economy in the near term. Strengthening their economic performance willbe critical to improvement in the Government's fiscal position, recovery of output, further development ofthe private sector, and to the viability of the banking system.

23. The Government will take measures to enforce financial discipline and will signal that the State willnot bail out uneconomic activities. It will do so by submitting a draft Law on Bankruptcy to Parliament byApril 1, 1995, exposing thereafter the enterprise sector to the provisions of the law. In addition, theGovernment has identified and made public a list of 25 largest loss-making state-owned industrial oragricultural enterprises and, through a resolution of the Cabinet of Ministers, has ordered the preparation ofdetailed action plans for these enterprises, including partial or complete privatization, partial or completedeclaration of bankruptcy, breaking up of monopolies and divestment of social assets. These action plans willbe made public by September 1995 and implemented thereafter. During the whole period of preparation andimplementation of the action plans, the Government is committed to maintain these enterprises isolated fromthe banking system. None of them will benefit from government loans nor from government-guaranteedloans from conmmercial banks.

24. In addition to hard-budget constraints imposed through fiscal discipline, the Government intends topromote increased efficiency of operations in state-owned enterprises through the introduction of managementcontracts. These contracts include hiring of senior management on a contractual basis, incentive schemes,explicit profit or loss reduction target, and other performance measures. They will be introduced on a pilotbasis, by end-1995, in three enterprises of the mining and military sectors which are not subject toprivatization in the medium-term. Based on an evaluation of this pilot project, the Government intends toextend the experiment to other enterprises.

Restructuring of the Government Sector

25. This part of the reform program is designed to reduce the size of the public sector while strengtheningits capacity to perform a limited set of critical public functions. As a first step, the Government is committedto reorganizing and streamlining the public administration in order to reduce staff requirements by at least 25percent. Two alternative reorganization plans have been submitted to Parliament and will be discussed inearly 1995. Reorganization will not be accomplished with across-the-board cutbacks in the staff of eachoffice, but following a detailed examination of the new responsibilities of each office. Some may be

Annex 3Page 6 of 10

expanded: many will be reduced in size, and some will be eliminated altogether, because their roles duplicatethose of another government offices or because their original missions are no longer consistent with thereduced government role in the Georgian economy. The Government intends to implement the reduction instaff requirements by the end of the first quarter of 1995.

26. In addition to reform of the top levels of public administration, the Govermnent is also committed toreform of important public functions which up to now have been managed by government officials andfinanced out of the State budget. Two of the most important of these functions are the provision of healthcare and education. In light of the severe constraints on public revenues, part of these two functions willhave to be financed on a new basis, including fee-for-service charges to users of the services. TheGovernment will retain a central role in regulating the quality of services provided by these institutions,licensing the nurses, doctors, and instructors, financing a basic package of services and ensuring access tohealth and education services for needy patients and students respectively.

27 A detailed proposal for reform of the health sector was approved by the Cabinet of Ministers and aDecree by the Head of State was issued in December 1994 to enact these reforms. The reform will guaranteefree access to health care in hospitals and polyclinics for a basic but limited range of medical services. Allother services will be provided on a fee-for-service basis. Some hospitals and polyclinics will be privatized;all will become self-managing and independent of day-by-day direction from the Ministry of Health. Hospitaland polyclinic fees will finance the salaries of the health care providers who work in these institutions andwho will no longer be paid out of the State budget. Implementation of the reform started in January 1995and is expected to take place over a period of two years.

28. The reform plan will include regulations and a financing mechanism to ensure provision of basichealth services to all Georgians and especially to those who do not have enough income or assets to pay forthese services without help. The Ministry of Health will retain its important role in accrediting hospitals andlicensing the doctors and senior health professionals. A plan for accreditation will be adopted by mid-1995.

29. The Government also expects to introduce a reform of the educational sector which would guaranteefree basic education for the nine years of compulsory schooling, but would change the financing basis andorganizational structure of education for children under age 7 and older than age 15. Under the proposedplan, these very young or older students (or their parents) would be charged fees to cover the costs of theeducational services received. Nursery schools, kindergartens, and educational institutions that offereducation and training after compulsory schooling ends would become self-financing, though scholarshipassistance would be provided out of the State budget to pay for the schooling of some needy and/or talentedstudents. For this academic year, the Government has introduced this scheme on an experimental basis, intwo cities. Based on an evaluation of this experiment, a proposal for reform at the national level will beprepared and discussed by the Government by end-1995.

B. Promoting the Development of Markets and Increasing their Efficiency.

Promoting Competition and Private Sector Development

30. Government intervention in the area of pricing has already been substantially reduced through theliberalization of most retail and wholesale prices in 1992. The Government is aware, however, thatremaining price controls - mainly on bread, gas, electricity, and public transportation - have led to huge

Annex 3Page 7 of 10

distortions in resource allocation and increasing budgetary difficulties. The Government is conmmitted toremove these distortions both to promote efficient resource allocation and to strengthen the budget. As ofSeptember 1, 1994, domestic prices for gas and electricity were increased to reflect full import anddistribution costs and will be readjusted each month to maintain full cost recovery. Effective September 17,the price of bread was increased from 700 to 200,000 coupons per kilogram. It was further increased to280,000 coupons in December 1994 and will be liberalized by mid 1995. Subsidies for transportation havealso been reduced and will be eliminated by mid-1995. Regulated prices therefore remain only for a verylimited number of goods: gas, electricity, transportation, municipal services, and rents (for non-privatizedhousing). For the most important of these goods, the Government is commnitted to maintaining full costrecovery.

31. Although the recently adopted price realignment for gas and electricity eliminates cross-subsidizationbetween types of energy and will have a favorable fiscal impact, it is only based on average cost. TheGovernment is aware that the structure of electricity prices needs to be based on long-run marginal cost inorder to increase the efficiency and reliability of energy supply, provide proper signals for energy demand,and generate the sources of funds necessary for investment in the sector. The Government is currentlypreparing a restructuring plan for the power industry and will start its implementation by the end of 1995,corporatizing the generating and distribution companies and introducing an efficient price structure. Inaddition, the Govermnent is committed to opening the power generation sub-sector to private investment inorder to address supply constraints and to promote competition in the supply and pricing of energy.Concurrent with these measures, the Government will develop a comprehensive regulatory framework forpower generation and distribution.

32. Breaking-up the monopoly of the Bread Corporation is also a top priority for the Government.However, the current need to ration and control prices for this critical staple involves sensitive socialconsiderations in privatizing this enterprise, and the Government wants to move carefully. Therefore, inparallel with liberalization of the price of bread and the elimination of rationing, the Government will, by mid1995, develop and adopt a restructuring/privatization plan for the Bread Corporation which includes measuresto breakup the milling, baking, and retail units so as to introduce competition in the market for breadproducts. The Government will complete privatization of the Bread Corporation according to this plan by theend of 1995.

33. The Government realizes that the private sector will be the primary source of job creation and growththroughout the economy, and is an important source of competition for existing state-owned enterprises. It isaddressing the main obstacles to private sector development by reducing barriers to entry for new businesses,and by completing the legal and institutional framework necessary for private sector activity and competition.To that end, the Government has adopted fairly simple registration procedures, and local authorities now clearnew business applications over a relatively short period of time. A law on entrepreneurship -- which providesa comprehensive legal framework for development of private business -- was approved by the Parliament inNovember 1994. In addition, a law on investment, granting equal treatment to foreign and domestic investorswas submitted to Parliament in September and is being discussed. Foreign investors will also be specificallytargeted in the marketing of large, strategic enterprises to be sold by international tenders. Finally, an anti-monopoly law is under preparation designed to facilitate the breakup of monopolies and to control abuse ofdominant market positions and restrictive trade practices. This draft law will be submitted to Parliament bymid-1995. Upon Parliamentary approval, the Government intends to create an anti-monopoly commission.

Annex 3Page 8 of 10

34. Liberalization of Domestic Trade. Consistent with the Government's general policv of liberalization.and to further promote private sector development, most restrictions on domestic trade have been eliminated.All fixed margins on wholesale and retail trade have been abolished. Trade-related infrastructure -- such aswholesale storage bases and trucking enterprises -- is either already privatized, or in the process ofprivatization. Constraints on private sector access to commercial real estate have been addressed throughlong-term leasing arrangements.

35. The main remaining factor hindering the development of markets was the obligation that manyenterprises faced to deliver part of their production domestically under the state order system. These quotaswere used for various purposes, including compensation to input suppliers, direct distribution bymunicipalities, and building of state emergency reserves. The Government has now eliminated theserequirements as part of the program to dismantle the state order system in favor of a market-based system ofprocurement.

Fostering Export Growth

36. The Governmnent recognizes the imnportance of rapidly integrating Georgia into the world economyand intends to remove impediments that hinder export growth. To improve the functioning of the foreignexchange market, the Government has, as of September 21, 1994, increased the frequency of foreignexchange auctions to twice a week and is channeling the totality of the 32% surrender requirement throughthe NBG with rapid reimbursement at the auction rate. In addition, the restrictions on conversion of non-cashto cash coupons and similar restrictions applied to foreign currency deposits have been eliminated. Thesemeasures have two salutary effects: removing an implicit tax on exports, and contributing to the developmentof exchange market institutions.

37. The Government also intends to continue moving toward an interbank foreign exchange market byextending participation in the auction to foreign exchange bureaus and large importers, and by eliminatingmost restrictions on bidding. By the end of 1995, the surrender requirement for exporters will be eliminated.

38. The Government has also taken action to liberalize foreign trade. There are no restrictions onimports and the import tariff is uniform. Legislation has been approved by Parliament to raise the importtariff rate to 12% (for fiscal reasons) and to eliminate the 8% tax on exports as of December 1, 1994. InFebruary 1995, requirements for delivery of quotas have been removed except for those used to fulfill theterms of the agreements to supply energy resources and a decree has been adopted to establish a timetable forphasing out completely the state order system by the end of the first quarter of 1996. All purchases of goodsby the Government to fulfill the terms of the agreements to supply energy resources will be carried out on thebasis of market prices in foreign currency converted to coupons at the exchange rate prevailing on the date ofpayment.

39. The Government has also started eliminating export prohibitions and licensing requirements, with thefollowing exceptions: first, restrictions are maintained for a few goods for reasons of ecological conservation,health (when feasible, these restrictions will be replaced by taxes) or foreign policy (e.g., arms). Second,licenses are retained for export of specified goods to countries with which Georgia negotiates tradeagreements that give preferential market access for limited quantities of trade in these products. Theselicenses, if any, will be auctioned. Third, export licensing requirements temporarily remain in place for ashort list of goods that are needed to obtain energy resources. Fourth, also temporarily, the Government willmaintain export prohibitions for a small number of goods - mostly basic food items - in order to protect

Annex 3Page 9 of 10

domestic supply. The Government, however. intends to eliminate gradually these licensing requirements andprohibitions over a period of about one year (except those for reasons of ecological conservation, health, armcontrol or limited preferential market access for Georgian products). A decree has been issued in February1995 specifying the corresponding timetable.

Strengthening the Financial Sector

40. Prospects for economic recovery will depend much on the capacity to increase financial savings in theeconomy and to allocate financial resources more efficiently. The Government is, however, aware that thefinancial sector in Georgia suffers from widespread disintermediation and misallocation of credit and that anumber of features of the sector require immediate reform to attend the needs of an emerging private sector.

41. At the end of September 1994, the Government started addressing these issues by eliminating therestrictions on conversion of non-cash to cash coupons which led to a segmentation into a cash and non-cashcircuit and discouraged households and enterprises from holding deposits in the banking system. It alsoeliminated the cash-non-cash distinction for foreign currencies at the end of 1994. Directed credits to stateenterprises have been eliminated, and the state banks' access to refinance credits and overdrafts at the NBGhas been discontinued as of October 1994. To meet the liquidity needs of the banking system, theGovernment has undertaken to develop a short-term interbank credit facility. These measures, in addition tostrengthening the capacity to monitor and administer fiscal and monetary policy, should promote a moreefficient allocation of credit and greater financial savings.

42. The Government also recognizes that establishing an adequate legal and regulatory framework anddeveloping the institutional capaciiy to supervise banks and enforce regulations are necessary conditions foran efficient and competitive financial sector. To that end, the Government has - with the assistance of theIMF - prepared a new law on the National Bank which addresses monetary and credit regulations, NBGinterventions in banking activities, and foreign currency regulations. The law was submitted to Parliament inDecember 1994 and will be discussed in early 1995. The Government also intends to strengthen thesupervision function of the NBG with technical assistance provided by the IMF and the World Bank (underthe IBC). As part of this strategy, the NBG has suspended the general licenses of 42 commercial banks andthe foreign exchange licenses of 28 banks in October 1994. It has undertaken the revision of prudentialstandards and issued new regulations with appropriate phasing for implementation. It also intends to tightenenforcement of these regulations.

43. The Govermment is aware that the main financial institutions in Georgia are in perilous financialcondition. To address the issue of restructuring, possible re-capitalization, and privatization of the stateconmmercial banks, the Government is undertaking a diagnostic review of the five specialized state commercialbanks with technical assistance financed under the World Bank IBC. Based on the review results, expectedby April 1995, the Govermment is committed to define, adopt, and implement an action plan for restructuringand privatizing the five state-owned banks.

C. Ensuring a Minimum Level of Social Protection

44. The Government is highly concemed about the decline in living standards for most Georgians, andabout the additional fall in real incomes that the stabilization program will impose on the population in the

Annex 3Page 10 of 10

short run, particularly through the elimination of subsidies. At the same time, the Government is aware thatthe collapse in revenues of the social security and unemployment funds and the existing financial constraintspreclude the implementation of an adequate program of assistance. It is thus committed to use the limitedresources available as efficiently as possible, and to improve targeting of the social assistance that can befinanced out of the budget.

45. Improving targeting of benefits does however imply drastic reforms in a system of social protection.This system, inherited from the past, covers half of the population. Improved targeting also impliesidentification of the most vulnerable groups, task which is particularly difficult in a country with deficientstatistics and a large informal economy. Aware that denying benefits to large fractions of the populationwithout precise knowledge of their economic situation could entail substantial social costs at times ofeconomic difficulty, the Government has taken a gradual approach.

46. Considering that the pension system could not afford to grant favorable treatment to particularcategories of pensioners, the Governrent eliminated, as of September 1994, special pension supplements andtransformed the pension system into a simple assistance program providing a flat-rate benefit to allpensioners. By doing so, the Government also reduced the administrative burden linked to the calculation ofpensions and the need for staff.

47. To provide compensation for the elimination of subsidies, pensions were raised in September 1994 to2.5 million coupons per month (about 18 times their level in July 1994). Child allowances andunemployment benefits were also raised. However, other benefits - childbirth and death benefits - wereeliminated, and pensions were denied to working pensioners, thus reducing the number of pensioners by 16percent. Through these measures, the Government was able to provide a larger adjustment to thoseremaining eligible. The Government is also comrnitted to implement special cash and in-kind assistanceprograms for the refugees from Abkhazia and the 90,000 families considered as particularly vulnerable.

48. Although the measures described above represent significant steps towards strengthening the socialsafety net, the level of benefits remains extremely low. The Government recognizes that this set of measuresis still insufficient and that a comprehensive reform of the social protection system is needed. Accordingly,in February 1995, an order of the Cabinet of Ministers has been issued to a commission headed by theMinister of labor and Social Security to prepare a reform plan aimed at strengthening the system of socialprotection. This reform plan will: (a) address the sustainability of the pension system; (b) examinepossibilities for further targeting of benefits, in particular the identification of vulnerable groups; (c) evaluatebudgetary implications; and (d) recommend a program of actions. It is the Government's intention tocomplete preparation of the reform plan by mid-1995, and to begin implementation during the second half of1995.

Page I of 12

OBJECTIVES CURRENT STATUS | MEASURES TO BE TAKEN

l | Before Between March 1, 1995l_____________________________ J (as or sept. 1, 1994) March 1, 1995 and March 1, 1996

1. MACROECONOMIC STABILIZATION

To create a stable macroeconomic Inflation showed no sign of Agreement reached with IMF on a Agreement on Stand-by Arrangementenvironment conducive to economic deceleration: monthly rate of inflation stabilization program. First purchase with IMF in April 1995.growth. remaining around 60% during first under STF approved on December 15,

half of 1994. 1594.Reduce the monthly rate of inflation tolow single-digit levels by end-1995.

Introduction of a new stable nationalcurrency, the Lari.

a. Fiscal Policy Weakening of the fiscal stance: sharp Budget deficit for second half of 1994 Budget deficit to be restricted to 6-7%drop in revenue collection to 3% of reduced to 3% of GDP. of GDP through monthly readjustmentsGDP in 1993; budget deficit of 26% of regulated prices, phasing out ofof GDP in 1993 financed through Expenditures reduced through sharp remaining subsidies, tax reforms andmoney creation, external borrowing cuts in subsidies for gas, electricity, strict controls on increases in wages andand grants; budget deficit for the first bread and transportation - subsidies and social benefits.half of 1994 about 32% of GDP on a transfers to enterprises ceased.*cash basis.

Partial compensation for removal ofsubsidies through higher wages inbudgetary sector and increases in socialbenefits as of Sept. 94.

Government spending: sharp reduction Revenues increased through: increasesin real wages, social spending and in VAT rate, import customs duty,capital expenditures: subsidies gasoline excise tax, presumptive tax onaccounting for 70% of expenditures. kiosks, reduction in exemptions from

VAT, increases in penalties for non-compliance, effective on Dec. 1.*

Tighter control of General Govermnentexpenditures through prohibition ofbank borrowing by local Governmentsand centralization of Government bankaccounts at NBG.*

e Prior action for IMF STF.

GEORGIA REHABILITATION CREDIT POLICY MATRIX Annex 4Page 2 of 12

OBJECTIVES CURRENT STATUS MEASURES TO BE TAKEN

Beore Between Marcb 1, 1995(as of Sept. 1, 1994) M , 199 and Mtich 1, 1996

b. Monetary Policy Initial anempts to tighten monetary Consistent with inflation and Development of short-term creditpolicy remained ineffective as state international rcserves targets, increase facility.commercial banks did not comply in net domestic assets and net domesticwith reserve requirements and made credit to General Government Other measures to be defuned in theextensive use of overdraft facilities. restricted. context of the Stand-by Arrangement.

Reserve requirements on foreigncurrency deposits raised to the samelevel as domestic currency deposits(20%)* as of Sept. 1; enforcementtightened.

Automatic access to overdraft facilitiesby state commercial banks eliminatedas of Oct. 1.*

Restriction on conversion of bankcoupon deposits into cash removed asof Sept. 23.*

GEORGIA REHABILITATION CREDIT POLICY MATRIX Annex 4Page 3 of 12

OBJECTIVES CURRENT STATUS MEASURES TO BE TAKEN

l Before Between March 1, 1995(as of Sept, 1, 1994) Marcb 1, 1995 and March 1, 1996

IHn. REFORMS OF THE PUBLIC SECTOR

A. Transfer of ownership rights to the private sector

To accelerate the transfer of ownership Establishment of basic legal andof productive assets from the state to institutional framework through lawsprivate owners. and decrees since 1991: Ministry of

State Property Management (SPM)established; Law on Privatization ofSOEs (1991); Privatization Programapproved by Parliament (1992).

In May 1994, to accelerate the process,new decree introduces direct sales anddiscounts to employees as an additionalprivatization option.

Privatization of small-scale enterprises Decrees and regulations on auctions, October decree streamlined thetenders and valuations of assets (1992). administrative process and

imposed a two month deadline tocomplete privatization followingnotification by SPM.

Regulations issued prohibiting theirnposition of conditions on post-privatization business activitiesand eliminating the minimum bidprices at second round of auctions,for enterprises not sold at firstauction attempt.

847 additional small-scale1,651 small-scale enterprises (out of enterprises privatized since Oct. Complete privatization of all small-scale6,481 identified for sale) privatized by 12, 1994, reaching 40% of target enterprises identified for privatization by end-October 12, 1994, by auctions, (6,481 enterprises). 1995.commercial tenders and direct sales.

GEORGIA REHABILITATION CREDIT POLICY MATRIX Annex 4Page 4 of 12

OBJECTIVES CURRENT STATUS MEASURES TO BE TAKEN

040000000 t; 0 00 000 ;E070000 0 0 0 0 ; E0 ; 0 X t 0titi0 illt 0 BEtSe t Betwveen March 1, 1995____________________________________ (as of Sept. 1, 1994) n d M arch 1, 1996

A. Transfer of ownership rights to the private sector (cont'd)

Privatization of medium and large- Adoption of laws and decrees relative 402 additional large enterprises Corporatize all remaining enterprises by mid-scale enterprises to transformation of SOEs into joint- corporatized since mid-October 1995.

stock companies (1992), valuation of 1994 reaching 73% of targetassets (1992), voucher program and (1,007 enterprises).investment funds (1993).

Finalized following preparatory Implement the Mass Privatization Program:Of the 1007 medium and large steps for the Mass Privatization a. Distribute enterprise preparation packages toenterprises identified for privatization, Program (MPP): the enterprises to be included in the two335 have been corporatized and eight a. Completed collection of lists of regional and the first national pilot auctions byprivatized by October 12, 1994. eligible voucher recipients. May 1, 1995.

b. Issued guidelines for the b. Distribute vouchers to the eligible recipientscompletion of the legal framework and complete the pilot auction by Sept. 1, 1995.for the MPP, including rules and c. Proceed with the voucher program to beregulations regarding distribution completed by July 1996.of vouchers, auction and biddingprocedures.c. Identified the large enterprisesto be sold at the first three pilotauctions. Proceed with the privatization of 15 large

enterprises by international tenders to beDeveloped and adopted criteria for completed by mid-1996.selection of enterprises to beprivatized through internationaltenders, and identified at least 15large enterprises for this program.

Privatization of Housing Law on privatization of dwellings Complete legal framework for privatization ofadopted in 1992. apartment buildings and define ownership rightsPrivatization of housing nearly relative to communal spaces and facilities bycomplete, with the right to buy and sell mid-1995.apartments established and a rentalmarket with no price controls.

Page 5 of 12

OBJECTIVES CURRENT STATUS MEASURES TO BE TAKEN

l Before Between March 1, 1995|_______________________________ j (as of Sept. 1, 1994) March 1, 1995 and March 1, 1996

A. Transfer of ownership rights to the private sector (cont'd)

Privatization of Land About 650,000 ha of land (about 40% Initiated preparation of a draft Submit a draft land law to Parliament forof total arable land and 52% of land land law: discussion no later than July 1995.for tree-crops) have been distributed to a. Creating full unrestrictedprivate farmers, rural and urban property rights on agricultural land Establish a land cadastre.households with maximum holding of including the right to buy, sell,1.25 ha. However, distribution took lease and inherit; Distribute property titles for all land alreadyplace without legal framework for land b. Providing land already in allocated to private farmers.ownership preventing development of a private use to farmers as their ownland market. property. Prepare by mid-1995 a program for land

privatization, which defines the generalNumber of collective and state farms principles according to which the distribution ofreduced from 1,433 to 609 between remaining agricultural land will be completed,1989 and 1994. including targets for privatization of state and

collective farms aiming at creating economicallyviable and efficient production units.

Implement the land privatization program:distribution of remaining agricultural land andprivatization of state and collective farms byFebruary 1, 1996.

B. Imposition of hard-budget constraints to SOEs

To ensure appropriate response to The GOG continued to provide support All subsidies and transfers to Submit to Parliament by April 1, 1995 the draftmarket forces. to SOEs through subsidized credits and enterprises ceased as of Sept. 94.* law on bankruptcy

energy subsidies.Identified and made public the 25 Initiate implementation of the action plan forlargest loss-making state-owned main loss-making enterprises by Sept. 1995.industrial or agriculturalenterprises and initiated Introduce by end-1995, Performance Contractspreparation of an action plan for on pilot basis at three enterprises of the miningthese enterprises which would be and military sectors that are not subject toadopted and made public by privatization in the medium-term. Based onSeptember 1995. evaluation, implement performance evaluation

and incentive schemes for senior management atother SOEs military and mining sectors during1996.

GEORGIA REHABILITATION CREDIT POLICY MATRIX Annex 4Page 6 of 12

OBJECTIVES CURRENT STATUS IMEASURES TO BE TAKEN

BerorI Between March 1, 1995.___________________________ (as of Sept. 1, 1994) March 1, 1995 and arch 1, 199

C. Restructuring of the Government Sector

To strengthen the institutions of public Composition of budget distorted with Subsidies drastically reducedmanagement. high proponion of spepding for through stabilization measures;

subsidies, extremely low level of level of Government revenuesTo narrow budget deficit and ensure salaries in the budgetary sector, however, remain low andsustainability of macroeconomic declining capital expenditures and insufficient to cover publicstability spending on social programs. spending (see la).

To make the public role's About 630,000 employees paid out of Strengthening tax and customs Proceed with tax collection efforts andcommensurate with growing reliance the budget. administration. enforcement of compliance.on private sector activity.

Prepared and submitted to Restructuring Plan to be implemented by end ofParliament Restructuring Plan for 1995. Reduction in staff requirementspublic administration, including a implemented by April 1995.reduction of at least 25% innumber of employees.

Public expenditures on health and Adopted in Dec. 94 a reform plan Proceed with implementation of reforms ofeducation reduced to about 2% of for health sector defining basic health sector.GDP; package of services to be publicly

financed, introducing fee-for-service charges, foreseeingprivatization of some hospital andclinics and reducing number ofhealth care providers paid out ofthe State budget.

Educational reform changingfinancing basis and organizational Based on pilot experiment, adoption andstructure for all but basic level of implementation of reforms of the educationeducation experimented on pilot sector initiated by end-1995.basis in 2 cities.

* Prior action for IMF STF

Page 7 ot 12

OBJECFIVES CURRENT STATUS MEASURES TO BE TAKEN

I i I i X i i;i Before: I Between March 1, 1995________________________________ j (as of Sept.1, 1994) March 1, 199S and March 1, 1996

III. REFORMS ADlMED AT THE DEVELOPMENT OF MARKETS AND THEIR INCREASED EFFICIENCY

A. Promoting Competiton and Private Sector Development

To complete price liberalization. Government intervention in the On Sept. 1, prices for gas and electricity increased to Monthly adjustment in prices to reflectarea of pricing already reflect full import and distribution costs: for any increase in costs. Prices not to be

To set regulated prices so as to achieve substantially reduced. Most retail consumers, price of electricity rose 600 times, of gas reduced until improvements infull cost recovery. and wholesale prices liberalized in for cooking 13,000 times, and gas for heating 5 collection of bills allow for achieving

1992. times. For enterprises, price of gas increased 5 times, full cost recovery.and of electricity 10 times.*

Price controls maintained forbread, municipal services, energy On Sept. 17, price of bread increased from 700 toproducts, public transportation and 200,000 coupons per kg.* Price raised again tocommunications. 280,000 coupons on Dec. 25. Bread price liberalized by mid-1995.

Remaining regulated prices Subway fares raised 50 times on Sept. 17.*m aintained constant in nominalterms at times of acceleratinginflation and reliance on imports Subway fares raised again untilfor energy and wheat led to complete elimination of subsidies bysubstantial subsidies and huge April 1, 1995.distortions in resource allocation.

* Prior Acdon for IMF STF

GEORGIA REHABILITATION CREDIT POLICY MAT&UX Annex 4Page 8 of 12

OBJECTI CURRENT STATUS MEASURES TO BE TAKEN

Before Between March 1, 1995:____________________._________ (as otSept.l, 1994) March 1, 1995 ind March 1, 1996

A. Promoting Competition and Private Sector Development (cont'd) l

To promote domestic competition and Fixed margins on wholesale and Price and trade liberalization measures (see above and Preparation of a restructuring plan forfoster private sector development retail trade abolished, trade-related nib). the power industry; development of a

infrastructure privatized or subject regulatory framework: introduction ofto privatization, constraints on Acceleration of privatization process (see 11). an efficient price structure by end-access to commercial real-estate 1995.addressed through long-term Imposition of hard-budget constraints on SOEs (seeleasing arrangements. 11). Develop and adopt by mid-1995 a

demonopolization/privatization plan ofSubstantial growth of informal Eliminated all quotas under the state order system for the Bread Corporationeconomy. domestic uses and replace by a market-based system

of procurement [see IJIb). Privatization of the Bread CorporalionHowever, growth of private sector by end-1995.still hindered by unstable Law on Entrepreneurship adopted by Parliament inmacroeconomic environment, Nov. 1995 Anti-Monopoly Law submitted toprice distortions, export Parliament by mid-1995restrictions, incomplete legal Law of tnvestment granting equal treatment to foreignframework and functioning of the and domestic investors submitted to Parliament instate order system. Sept. 1994

No wage controls imposed on the private sector.

Wages and other forms of compensation freelyTo foster rapid increases in negotiated between employers and employees in SOEsproductivity through labor mobility Since 1990, employment in the and non-budgetary organizations.

state sector decreased by 30% andprivate sector employment rose by58%, Actual labor flows towardsthe private sector may beunderestimated.

GEORGIA REHABILITATION CREDIT POLICY MATRIX Annex 4Page 9 of 12

OBJECTIVES CURRENT STATUS MEASURES TO BE TAKEN

_________________________ oft00000 Sept.1,;0-: Ma; 0 Before Between March 1, 1995

________________ i :(as of Sept.l, 1994) M ereb e1 e and March 1, 1996

B. Fostering Export Growth

To promote export growth through Open import regime with no Totality of surrender requirement channeled to the Surrender requirement eliminated byelimination of implicit and explicit restrictions and uniform customs NBG to ensure quick reimbursement at auction rate.* end-1995taxes on exports and development of duty (2%), but strong anti-export Frequency of foreign exchange auctions raised tosmoothly functioning foreign exchange bias through: (i) foreign exchange twice a week.market surrender system; (ii) dichotomy Restrictions on convertibility of coupon deposits into

between cash and non-cash; (iii) cash lifted on Sept. 23.*system of state orders andprocurement, export quotas and Eliminated restrictions on converting non-cash to cashlicenses; (iv) export prohibitions; for foreign currencies.and (v) explicit export taxes (8%).

Import tax raised to 12% and 8% export taxEstablishment of a unified market eliminated as of Dec. 1.*determnined exchange rate, set bythe NBG on the basis of weekly Eliminated all quotas under state order system exceptinterbank foreign exchange for those used to fulfill barter trade agreements forauctions, energy resources. For remaining state orders, price

paid to producer equivalent to border prices convertedto local currency at exchange rate prevailing at dateof payment.

Eliminated prohibitions and licensing requirements forexports except (i) to fulfill barter agreement forenergy resources; (ii) to protect ecology; (iii) toconduct foreign policy (arms exports); (iv) to controlexports as required by trade agreements givinglimited access to Georgian products; and (v) toprotect domestic supply of a small number of basicfood items.

* Prior Action for IMP STF

GEORGIA REHABILITATION CREDIT POLICY MATRIX Annex 4Page 10 of 12

OBJECTIVES CURRENT STATUS MEASURES TO BE TAKEN

Before Between March 1, 1995(as of Sept.1, 1994) March 1, 1995 and March 1, 1996

B. Fostering Export Growth (cont'd)

Issued decree establishing timetable for phasing out of Phase out state order system,state order system, export licensing requirements and remaining export licensingprohibitions (except those for reasons of requirements and prohibitionsenvironmental protection, health, arms control, and according to established timetable.for goods subject to international preferentialagreements).

C. Strengthening the Fmancial Sector

To strengthen the capacity of the The financial sector developed Directed credits from NBG and access by State banksbanking system to increase financial rapidly with about 220 private to overdraft facilities eliminated as of Oct. 94 (seesavings and allocate financial resources banks created besides 5 large state lb).*more efficiently banks but credit allocation

continued to be directed by the Establish interbank short-term credit auctions. All Develop short-term credit facility (seestate and provided at highly new credit to be allocated to banks via auctions. lb).subsidized rates.

Restrictions on use of accounts, both in domestic* Improve prudential supervision ofFunctioning of the financial sector and foreign currency eliminated (see lb). banks by the NBG.also impaired by restrictions onuse of accounts, both in domestic Licenses withdrawn from 42 commercial banks.and foreign currency. Foreign exchange licenses withdrawn from 28 other

banks in Oct. 1994.Bank supervision and enforcementof prudential regulations remains Submitted to Parliament draft law for operations ofinadequate to assess the financial the NBG and issued revised prudential regulations.condition of banks and to remedyproblem situations. Moratorium on Diagnostic review of the 5 specialized state Based on results of diagnostic review,licensing of new banks imposed in commercial banks undertaken. develop and initiate implementation ofMay 1994. Minimum level of restructuring/privatization plan bycapital requirement raised. mid-1995.

* Prior Action for IMF STF

Page 11 of 12

OBJECTIVES CURRENT STATUS MEASURES TO BE TAKEN

Before Between March 1, 1995(as of Sept 1, 1994) March 1, 1995 and March 1, 1996

IV. REFORMS OF THE SOCIAL SAFETY NET

To maintain a minimum level of safety System of Social Protection essentially As of Sept. 1994, generalized subsidies Increases in wages of budgetarynet during the adjustment and reform identical to the old system of the Soviet for bread, electricity, gas and sector, pensions and other socialprocess, compatible with extremely Union. Unemployment system transportation drastically reduced (see benefits limited to targeted inflationlimited budgetary resources. introduced recently. la), and partially replaced by cash until mid-1995.

compensations for pensioners,Special assistance programs - in kind unemployed and other beneficiaries ofand in-cash - also introduced recently social protection system, andto provide support to particularly employees of the budgetary sector.*vulnerable groups (about 90,000families and 250,000 refugees from Pensions denied to working pensioners,Abkhazia). These programs are reducing by 16% number ofsupported in part through humanitarian beneficiaries as of Sept. 1994.aid.

Special pension supplements to favoredRevenues of social security and categories of pensioners eliminated.unemployment funds drasticallyreduced over recent years by the sharp Childbirth and death benefits alsoreduction of employment in the state eliminated as of Sept. 1994.sector, decline in real wages, andfailure to tax wages in the informal Complexity of pension systemeconomy. Maintaining benefits in line simplified and administrative burdenwith revenues have led to benefits that reduced by adoption of a simpleare too small to even sustain a assistance program characterized by aminimum standard of living. The main flat-rate benefit set in Sept. 1994 at 2.5form of social protection consisted of million coupons (equal to lowest salaryheavily subsidized bread, energy, in budgetary sector).transportation and municipal services.

Commission appointed to prepare Implementation of comprehensiveReal wages of employees of budgetary reform plan of the social safety net reform to be initiated during secondsector hardly higher than pensions. leading to program of actions, to be half of 1995.

completed by mid-1995.Other forms of social protectionprovided through family ties and theinformal economy.

e Prior action to IMF/STF.

GEORGIA REHABILITATION CREDIT POLICY MATRIX Annex 4Page 12 of 12

OBJECTIVES CURRENT STATUS MEASURES TO BE TAKEN

Before Between March 1, 1995:____________________________ j (as of Sept 1, 1994) March 1, 199S and March 1, 1996

IV. REFORMS OF THE SOCIAL SAFETY NET (cont'd) l

Generous eligibility conditions (inparticular early retirement) and lack oftargeting make the system ineffectiveand unsustainable even in the mediumterm: approximately half of thepopulation are eligible for benefits.

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