Issue 6, 2013. December-January



Ia Vardishvili, Giorgi Kelbakiani, and Yaroslava V. Babych

After a period of negative growth following the 2008 war and the global economic crisis, the Georgian economy recovered in 2010. For ten consecutive quarters the country's economy grew at an average rate of nearly 7%. This rapid growth spurt lasted until the 4th quarter of 2012. Almost immediately after the official change of political power following the 2012 parliamentary elections, the quarterly growth rate of real GDP posted a dramatic drop - from 7.5% (Q3, 2012) to 2.8% (Q4, 2012). The subsequent three quarters of 2013 showed lackluster 2.4%, 1.5% and 1.3% rates of economic growth, respectively. This sharp decline in growth rates has since become the major underlying theme for political bickering between the rival parties.

Political considerations aside, which economic factors can explain the rapid slowdown in the growth rate of GDP? This article analyzes the economic rationale behind the downturn in the GDP growth rate and discusses the measures undertaken by the government to deal with the worsened macroeconomic environment.

Gross Domestic Product by Categories

The Final Consumption Expenditure category (which includes household and general government finalexpenditure on goods and services, and has the largest share in GDP) was one of the main contributors to the GDP growth rate in 2011. (A 1% increase in this category increases the overall growth rate by approximately 0.9%).

After the elections of 2012, the Final Consumption Expenditure was affected by two principal factors: first, the sharp decline in consumer confidence due to political and policy uncertainty, and secondly, by a pullback of government spending. Hence, the contribution of this category to the overall growth rate declined from 15.3% (Q1,2011) to 1.8% (Q1,2013). Moreover, the Final Consumption Expenditure declined in Q2 of 2013 (relative to the same period in 2012), pulling the overall y/y GDP growth rate downward by 1.5%.

Another income expenditure component responsible for the decline in the GDP growth rate is Gross Capital Formation. This category includes investment expenditure by both private and government entities. Starting from 2011, this category of expenditure had a significant positive effect on economic growth, while in the 1st and 2nd quarters of 2013 its growth contribution dropped to 1.7% and -1.5% respectively. This is mainly due to the sharp decline in the growth of public and private investments following the October 2012 elections. The reasons for such a sharp investment drop after the elections are fairly straightforward: policy uncertainty and the prolonged and ineffective process of political cohabitation have impeded private-sector investments in Georgia.In addition, the new government, which had made criticism of "wasteful capital projects" part of its election campaign agenda,sharply reduced capital budget spending after the elections. The contraction was mainly reflected in a significant slowdown of the construction sector. An interesting question would be whether the drop in this category was mainly due to a drop in private or public investment spending. Unfortunately, the existing data do not separate the two categories of capital expenditure.

It is worth noting that, unlike in previous years, an improvement in the external sector contributed positively to economic growthin 2013. According to a recent release by the GeoStat, the external trade sector in the first nine months of 2013 has seen an increase in exports (14% annual growth), while imports declined by 4%. The slowdown in imports is consistent with the general weakening of aggregate demand conditions observed throughout the year. As a result, the trade balance improved significantly and added 5.5% and 8.2% to nominal GDP growth in the 1st and 2nd quarters of 2013, respectively.

To conclude, the decrease in Final Consumption Expenditure and Gross Capital Formation were the two main driving forces behind the decrease in GDP growth rates, while positive developments in the external sector have played a crucial role in supporting real economic growth. If we suppose that the decreases in Final Consumption Expenditure and Gross Capital Formation were mainly due to the reduced consumer/investor confidence stemming from the policy uncertainty of the post-election period, then we might expect some progress in GDP growth after thepolitical transition has been fully realized.

Gross domestic product by Sectors

The previous government was blamed for excessive spending on construction just before the 2012 elections. This argument seems to be supported by the growth dynamics of the construction sector.The growth rates in thissector dramatically increased one year prior to the parliamentary elections and immediately dropped after the elections, thereby affectingoverall growth rates.

A proper cross-sectional analysis, however, requires consideration of the "weight" of each sector in overall GDP. This would allow us to see how much each sector contributed to overall economic growth, and how each sector's dynamics affected the growth slowdown.

Our analysis looks at at the aggregate measures of the first two quarters of 2013 and the corresponding period from the previous year (Q1 2012 - Q2 2012).

As one can see, considering the share (weight) of the construction sector in total GDP (less than 5%), its high growth rates were contributing 2 percentage points, on average to the 7.5% average GDP growth during first two quarters of 2012. This means that the growth in the construction sector constituted 26.7% of total GDP growth, the second highest contribution after the 2.5 percentage point contribution (33.3% of total GDP growth) coming from the manufacturing sector. Since the manufacturing sector did not show any unusual growth patterns before the elections, it would be hard to argue that the 2012 growth was mainly driven by the "political business cycle" effect.

Yet, in the first two quarters of 2013, the construction sector had the most significant negative impact (0.9 percentage points) on the average total growth rate. While the average slowdown in growth rate during the first two quarters of 2013 was 5.6%, 2.9 percentage points (i.e. 43.5% of the total drop) came from the drop in the construction sector.

While the fall in the construction sector did play a significant role, developments in other sectors were important as well. Another drop is especially evident in the manufacturing sector, which was, and still is, the main contributor to Georgian economic growth.

As mentioned before, manufacturing was contributing 2.5 percentage points on average to the total GDP growth of the first half of 2012, while for the same period in 2013, it contributed only 0.8 percentage points. The contributions from the wholesale and retail trade sector also showed a significant decrease (from 1.2% to 0.7%).The transportation sector slowed down as well, contributing negatively (-0.2%) in 2013 after a solid positive (1.2%) contribution in 2012.

Fiscal and Monetary Policy

The effectiveness of the fiscal and monetary policy response to the growth slowdown is subject to debate.

The Georgian government's fiscal policy remained quite conservative in spite of the economic slowdown. Government expenditure in the first nine months of 2013 declined by 3.3% as compared withthe same period of 2012. Most importantly, expenditures on the purchase of goods and services were slashed by 34.5%, whereas compensation to employees and social expenditure increased by 15.5% and 18.4%, respectively.

Cash receipts from operating activities (revenues) decreased by 3.4% over the same nine-month period, mainly due to a drop in the tax revenues and other receipts categories.

From the macroeconomic perspective, the decline in government expenditure surely impedes GDP growth by decreasing aggregate demand in the economy. On the other hand, decreasing some of the non-productive expenditures could help increase the effectiveness of government income and thus aid economic growth over the long run. Overall, a balanced approach to government expenditure is needed in order to both smooth out the output fluctuations, and ensure sustainable growth in the future.

On the monetary policy front, the National Bank of Georgia (NBG) has pursued expansionary monetary policy to combat deflation and stimulate the economy as a whole. From June to August 2013, the NBG monetary policy rate decreased by 0.25 percentage points to reach a historical minimum of 3.75 percent. Yet, the policy had little impact on prices and interest rates, mainly due to the high dollarization rates of credit and deposits.

In September 2013, the real effective exchange rate continued to fall (depreciate) by 3.2% y/y, while the nominal exchange rate increased (appreciated) 1.5% over the same period in September 2012. This means that inflation is higher in Georgia's major partner countries, and that Georgian goods have thus become cheaper relative to foreign alternatives, which further stimulates exports and decreases imports.

Future Trends:

The most recent out European Bank for Reconstruction and Development (EBRD) research paper "Economic Forecasts and Other Regional Economic Prospects Data" highlights the fact that, besides the domestic instability and political uncertainty, the whole region of Eastern Europe and Caucasus (EEC) was affected by an unfavorable global macroeconomic environment. The EBRD expects that real economic growth in Georgia will accelerate in 2014 as political and policy uncertainty subsides after the presidential election. In addition, one might hope that further improvements in the Georgian-Russian commercial relationship will also hasten economic growth.

ISET-PI Forecast:

GDP forecast:

ISET-PI has updated its forecasts for Georgia's real GDP growth rates using the September 2013 releases of predictor indices. The updated growth forecast for the 4th quarter of 2013 was revised downward from 5.2% to 4.5%, though it still stands much higher than the growth rates from previous quarters.The forecast for the yearly growth rate currently stands at 2.4%. This projection is in line with the 2.5% annual growth forecast that the IMF announced for Georgia in their most recent October 2013 report.

Consumer Confidence Index:

The most recent data on the Consumer Confidence Index (CCI) are quite encouraging. The aggregate demand weakness appears to have eased after September. After two months of continuous decline in consumer confidence (with the historical minimum being reached in August 2013), the index increased by 5 points, settling at the -7.9 point mark in September. Consumer confidence continued to climb in October 2013 as well. Overall, the CCI gained 2.9 points over the September 2013 figures, to reach the -5 point mark in total.

While some of the improvements in CCI may be related to seasonal factors (such as "rtveli," the traditional grape harvest), the pickup in consumer sentiment is welcome news for the economy. According to the ISET Consumer Confidence Index (CCI), the monthly change in consumer sentiment was mainly due to a sharp improvement in peoples' expectations about the future, while the annual gains in CCI are mainly associated with a rise in the Present Situation Index.