Georgia: Will the Theories of Economic Deregulation Face Harsh Reality in Tbilisi?

Georgian President Mikheil Saakashvili insists that a package of constitutional reforms will transform Georgia into a global showcase for the benefits of economic deregulation. However, a sharp recent decline in foreign investment, coupled with a gaping trade deficit, is raising questions about whether Saakashvili's deregulatory push will do more harm than good to the Georgian economy, analysts say.

Georgia has been beset with political difficulties for almost two years, highlighted by the summer war with Russia in 2008. [For background see the Eurasia Insight archive]. But the plethora of turmoil has not seemed to dent Saakashvili's economic confidence. That confidence was on full display in an early October speech to Georgian MPs, during which the president suggested that Georgia could teach the world a thing or two about economic reforms.

"Respected ambassadors are often giving us recommendations on how to manage the economy," Saakashvili said. "We are ready to send some of them our experts, to enable them [the ambassadors' countries] to at least slightly move forward, if they can't catch up to us."

Much of Saakashvili's confidence is rooted in a recent World Bank assessment, which ranked Georgia 11th in the world for ease of doing business. Yet that ranking is based mainly on conditions that existed prior to the onset of the global financial crisis in late 2008. More recent indicators suggest that the president's abundant optimism rests on a shaky foundation.

Foreign direct investment (FDI) has traditionally played a crucial role in the Georgian economy as a balance to the country's large trade deficit. In 2007, FDI made up 19.8 percent of the Gross Domestic Product (or roughly $2 billion); the trade deficit stood at 19.7 percent of GDP (just over $2 billion).

Of late, however, there has been a marked decrease in FDI while the trade deficit has remained relatively stable. In the first half of 2009, foreign investment was down by 80 percent to $226.1 million, according to official data. The trade deficit still made up a significant 16.3 percent of GDP, or about $787.6 million.

Georgia, in other words, is now spending far more in foreign currencies than it is bringing in. Other countries, notably the United States, also suffer from large trade deficits, but their higher rates of investment and larger economic muscle allow them to better withstand the economic pressures generated by trade deficits.

Economist Giorgi Gaganidze a former head of the state export promotion agency, states that a lack of exports augurs poorly for Georgia's future economic competitiveness, regardless of how easy it is to do business in the country. "We do not have a major problem in export markets. We have a problem with export products," Gaganidze said.

Georgian exports are largely limited to unprocessed goods or lightly processed goods, which, according to Gaganidze, bring in very little money -- and jobs -- to the local economy.

The top four exports for the first half of 2009 were ferroalloys (a mixture of iron and manganese), gold (roughly $52.5 million), used cars (roughly $38.2 million) and scrap metal (roughly $32 million). Wine and mineral water, despite a vigorous government promotion campaign, comprised only 2.5 and less than 2.1 percent respectively of Georgia's total 2008 export portfolio. No figures are thus far available for 2009 trade.

To increase the value of its exports, Gaganidze advises that Georgia could "add value" to its products -- turning manganese into batteries, for instance -- but, so far, that has not happened.

Vakhtang Lezhava, chief advisor to Prime Minister Nika Gilauri and one of the architects of the country's economic reforms, attributes Georgia's lack of value-added exports to a long-standing lack of updated "technology, knowledge, skills."

The World Economic Forum's Global Competitiveness Report 2009-2010 claimed that no aspect of the Georgian educational system is "competitive," despite more than five years of reforms.

Once investment enhances the country's skill set, Lezhava argues, exports will follow naturally. "Somebody has to invest to create the sectors, branches, enterprises which are competitive on a global market," Lezhava said. "And then, [at] the next stage, you can look at export."

Bringing in the investment needed to improve that skill set could prove tricky if Saakashvili's Economic Freedom Act is approved, argues Alice Mummery, deputy editor of the London-based Economist Intelligence Unit.

Saakashvili's proposal to make tax increases subject to a referendum "could potentially ? deter foreign investment," Mummery said. "In most countries, the electorate often does not have sufficient information to make informed decisions on the various implications of different tax policies."

Mummery termed the president's proposed ban on new regulatory agencies and additional licenses and permits "a second area of concern."

"Well-managed regulation plays an important role in promoting the private sector, and ensuring that goods and services are used efficiently," she said. "It can also serve as a check on the actions of powerful business groups."

The government's plan also includes a constitutional cap on budget deficits (no more than 3 percent of GDP), state spending (no more than 30 percent of GDP) and debt (no more than 60 percent of GDP). "Questions remain over the ability to implement such a wide-ranging set of proposals effectively," Mummery added.

David Narmania, executive director of the Caucasus Institute for Economic and Social Research, argued that less sensational changes are needed to boost Georgia's production capabilities and investment.

Closer attention needs to be paid to tax administration -- a frequently cited cause of investor headaches -- improving infrastructure and overhauling the rickety judicial system, Narmania said.

But even if those changes are made, and investment and exports soar, the government may or may not be pushing Georgian products in foreign markets. Georgia's export promotion agency, part of the Ministry of Economic Development, will close this month, stated agency head Giorgi Kalandadze. A ministry spokesperson said that the closure is part of the ministry's "reorganization." She could not state which -- if any -- bodies will take over its responsibilities.

Deputy Economic Development Minister Zurab Alavidze cautions that the burden for building up Georgia's export capacities lies ultimately with the private sector, not with the state. "The state cannot oblige somebody to make it," Alavidze said in reference to export-ready products.