Report No. 27264-GE Georgia An Integrated Trade Development Strategy November 5, 2003 Poverty Reduction and Economic Management Unit Europe and Central Asia Region Document of the World Bank CURRENCY AND EQUIVALENTUNITS (ExchangeRate Effective as of November 5,2003) CurrencyUnit =Lari US$1.OO =GEL 2.10690000 WEIGHTS AND MEASURES Metric System FISCAL YEAR January 1 to December 31 ACRONYMS AND ABBREVIATIONS ADR Accord Dangereux Routiers ADP Agricultural Development Project AES The AES Corporation AJC Apple Juice Concentrate ASYCUDA Automated System for Customs Data BEEPS Business Environment and Enterprise Performance Survey BTC Baku-Tbilisi-Ceyhan CCOF California Certified Organic Farmers CDB Cost of Doing Business CEE Central and Eastern Europe CERMA Center for Enterprise Restructuringand Management CIF Cost, Insurance and Freight COMTRADE United Nations Commodity Trade System CIS Commonwealth of Independent States CNC ComputerNumerically Controlled CMR Cargo Manifest Report CMT Cut-Make-and-Trim CODEX Codex Alimentarious Commission COMECON Council for Mutual Economic Cooperation CPI ConsumerPrice Index DSA Debt SustainabilityAnalysis EBRD European Bank for Reconstruction and Development ECA Europe and Central Asia ECAs Export Credit Agencies ECMT European Conference of Ministers of Transport EDPFU' EconomicDevelopment and Poverty Reduction Program EGA Export Guarantee Agency EU European Union EUR Euro FA0 Food and Agriculture Organization FDA Food and Drug Administration FDI Foreign Direct Investment FSC Forestry Stewardship Council FIAS Foreign Investment Advisory Service FOB Free on Board FSU Former Soviet Union .. 11 FTA FreeTrade Agreement GATT GeneralAgreement ofTariffs andTrade GBC GeorgianBusinessConfederation GDP Gross Domestic Product GEL GeorgianLari GEOPRO GeorgianPro-Committeefor Trade andTransport Facilitation GEPA GeorgianExportPromotionAgency GEPLAC Georgian-EuropeanPolicy andLegalAdvice Center GIC GeorgianInvestmentCouncil GHA GeorgiaHardwoodsAssociation GMP GoodManufacturingPractice GNFS Goods andNon-FactorServices GOG Governmentof Georgia GOST GosudarstrennyiStandarty-ex-Soviet Systemof Standards GSP Generalized Systemof Preferences HACCP HazardAnalysis of CriticalControlPoints IDA InternationalDevelopmentAssociation IFC InternationalFinanceCorporation IF1 InternationalFinancialInstitution IMF InternationalMonetary Fund I S 0 InternationalStandardOrganization IT InformationTechnology ITB InternationaleTourismus Borse - L/C Letterof Credit LDCs Less DevelopedCountries LIBOR LondonInterBankOfferingRate LPG LiquefiedPetroleumGas MDF MediumDensityFiberboard MEITT Ministryo fEconomy, Industry, Trade and Tourism MFN Most-FavoredNation MIGA MultilateralInvestmentGuaranteeAgency MoF Ministryo fFinance MOT Ministryo fTransport NBG NationalBank o f Georgia NTA NationalTourismAuthority OECD Organizationfor Economic Cooperation andDevelopment OPIC OverseasPrivateInvestment Corporation PCA Partnershipand CooperationAgreement PER PublicExpenditureReview REER RealEffectiveExchangeRate SAMTREST State IndustryCorporationfor Viticultureand Winemaking SCD StateCustomsDepartment SDTR State Departmentfor TourismandResorts SDS State Departmentof Statistics SGHH Survey o f GeorgianHousehold SGMS Agreement on InternationalRailwayFreightCommunications SMEs Small andMediumEnterprises TACIS Technical Assistance to the Commonwealthof IndependentStates TBT Technical Barriersto Trade TEU Twenty-footEquivalentUnit TIR Transport InternationalRoutier ... 111 TLE Task LevelEfficiency TRACECA Transport Corridor Europe, Caucasus, Central Asia TRIPS Trade-Related IntellectualPropertyRights TS Transit Service TTF Trade andTransport Facilitation UAE UnitedArab Emirates UNCTAD UnitedNations Conferenceon Trade andDevelopment UNDP UnitedNationsDevelopmentProgram USAID United States Agency for InternationalDevelopment voc VAT Value Added Tax Vehicle Operating Cost WTM World TravelMarket WTO World Trade Organization CountryDirector: Donna Dowsett-Coirolo Sector Director: CherylW. Gray Sector Manager: Samuel Otoo iv CONTENTS EXECUTIVE SUMMARY .............................................................................................................. .. vi1 CHAPTER 1. Macroeconomic Setting .............................................................................................. RecentEconomic Developments........................................................................... 1 1 Stabilization and Structural Reforms .............................................................. 1 TheEconomy ................................................................................................... 3 5 InternationalPrice Competitiveness ...................................................................... Poverty............................................................................................................. 6 The BusinessClimate............................................................................................ 8 CHAPTER 2. Trade and Investment Performance ....................................................................... ExternalTrade ..................................................................................................... 11 11 Merchandise Trade........................................................................................ 11 Tradein Services.................................................................................. Foreign Direct Investment (FDI)Flows............................... Private Income and Transfers....................................................................... 16 CHAPTER 3. Trade Policyand Market Access ............................................................................ The Trade Regime................................................................................................ -18 18 Import Regime................................ ......................................................... 18 Export Regime................................................... Terms of MarketAccess .................................... TheInvestmentRegime................ Market Access to Non-CIS Countries................ Free TradeAgreements with CIS Countries.............................. .................... 23 Relationswith the WTO .................................... Georgia'sAccession to the WTO................................................ Trade andInvestmentRelatedInstitutions........................................................... Post-AccessionIssues........................................................... Conclusion........................................................................................................... 26 28 CHAPTER 4. Transport and Trade Facilitationin Georgia ........................................................ InternationalTransportAnalysis.......................................................................... 29 29 Transport Sector......... ............................................................................. 29 Transport Costsfor Tr and Transit through Georgia.......... CurrentandPotentialTransit............................................................................... Explanatory Factorsfor Excess Transport Costs...................... 35 Current Transit... .................................................................. TheFuture of Transit......................................... .............. West-East Transit ............................... ................................... East-West Transit .................................................................. ........36 37 ProposedStrategy andRecommendations........................... Potential Impact of Conflict Resolutions in the Region ........................... ........................... 37 38 InstitutionalDevelopmento fBorderAgencies.................................................... ........ ........... .38 UpgradingTransport Infrastructure..................................................................... Implementation of CustomsReform ............. 38 41 V CHAPTER 5 . FinanceSupport Services ......................................................................................... The Financial System........................................................................................... 42 42 TheBanking Sector........................................................................................ 43 Export Finance..................................................................................................... 47 Conclusion........................................................................................................... Government'sInitiatives to IncreaseAccess to Finance............................... 48 50 CHAPTER 6. Agro-Food Exports Introduction.......................................................................................................... ................................................................................................... 51 51 Wine Industry....................................................................................................... 52 Grape Supply...................................... ................................ 53 Number and Size of Vintners ............................................... 55 Industrial Efficiency ............. 56 57 Hazelnut Sector.................................................................................................... ................................................................. .............................. 59 Industry Efficiency.,........................... Production................................................................................... ........................... Markets.................................... .............................................. ProcessedHorticultural Products......................................................................... TheRole of Government .............................................. 64 CropProduction............................................................................................ 64 Industry Efficiency ....................................................................... Markets........................................................................... ........................... 66 Strategic Orientation for Georgian Agribusiness................................................. TheRole of Government................................................. ........................... 67 68 CHAPTER 7. Light Manufacturing ................................................................................................ Garments Industry................................................................................................ 70 70 Industry Characteristics..................................................... Productivity ................................................. Wood Processing Industry........................................ Other Constraints............................................... Industry Characteristics............ Challenges in Realizing Opport ....................... 75 Access to Inputs and Equipment.......... Productivity and Market Segment. A Strategyfor the WoodIndustry .. GovernmentPolicy: Access to Timber and Developing Strategic Marketing andProdu Raising Eficiency at the Firm Level ........... CHAPTER 8. Mining and Mineral-BasedExports ....................................................................... Industrial Minerals............................................................................................... 84 84 Export Opportunities and Proven Reserves .... ................................ 84 Upstream GovernmentPolicy ......................... 84 Downstream Constraints................................. ........................... Natural Stone: Decorative and Construction....................................................... 86 Access to Raw Material ................................................................................. 87 Technology................................................................................. Marketing and ConnectionswithForeign Investors ................................ 88 vi CHAPTER 9 . Services Exports InformationTechnology ...................................................................................... .................................. ............................. ....................................... 89 89 Labor .......................................................................................... Intellectual Property Rights ................................................. ........................................ ...................................... 91 EngineeringServices ........................................................................................... nd Administration ..................................... 92 Labor ............................................................................................................. 93 ..................................................................... 93 Corruption........................... Technologyand Standards.. ..................................... ........................... 94 Tax Policy andAdministration ...................................................................... 94 CHAPTER 10 . Tourism ................................................................................................................ Tourism to Georgia.............................................................................................. 96 96 97 Barriers Specific to the Tourism Industry............................................................ Cross-cutting Barriers to Export Growth............................................................. Opportunities for Tourism Growth ...................................................................... 97 A Strategy for Tourism Development................................................................ 98 102 TargetMarkets .............................. ..................................... 102 Entrepreneur Support................................................................ National TourismMarketing Authority .......................... Destination Marketing................... .................................................. Attractions .......... Accommodation............ ............................... ...................104 Information .................................................................................................. 105 105 Donor Co.ordination ..................................................... Quality......................................................................................................... .................... 105 CHAPTER 11. Trade and Poverty .................................................................................................. Introduction ....................................................................................................... 106 Poverty in Georgia............................................................................................. 106 Sources o f HouseholdIncome ........................................................................... 106 107 Internal Market Integration................................................................................ Labor Market............................................................................................... 108 110 Institutional Structures to Support Smallholder Agriculture ............................. 112 Corruption................................................................................................... 113 114 Employment................................................................................................. Rural Roads................................................................................................. 115 Conclusion ......................................................................................................... 117 Map IBRD vii Tables Table 1.1 Georgia: SelectedMacroeconomic Indicators............................................................. 2 Table 1.2 Georgia: Share ofthe Shadow Economy..................................................................... 5 Table 1.3 7 11 Georgia: TradeBalance, 1994-2002.......................................................................... GeneralTrade Statistics-Comparisonof Data Sources............................................ Georgia: Key Non-tradable Costs, 1996-2002............................................................ Table 2.1 Table 2.2 12 Table 2.3 13 14 Georgia: Transport and Travel Services.................................................................... Georgia: Major Import Categories............................................................................ Georgia: Major Export Categories............................................................................ Table 2.4 Table 2.5 15 Table 2.6 Georgia: ForeignDirect Investment.......................................................................... 15 Table 2.7 17 Georgia: Taxation ofImports, 1997-2001................................................................. Georgia: 2003 Import Tariff Schedule ...................................................................... Georgia: Private Incomeand Transfers..................................................................... Table 3.1 19 Table 3.2 20 Table 4.1 29 Freight TransportIndicators 1997-2001for Georgia................................................. TransportNetwork inGeorgia 1989-2000................................................................. Table 4.2 30 Table 4.3 Port Tariffs on Dry Cargoes inTracecaand Other Countries.................................... 31 Table 4.4 IndicativeTime and Money Expendituresto Move One Container (TEU) Indicative Logistical Cost for aTEU Containerby Roadfrom Potito Armenia .......32 by RoadRail............................................................................................................... Table 4.5 34 Table 5.1 Georgia: Monetary Indicators.................................................................................... 44 Table 5.2 Georgia: Structure of Lending by Sectors................................................................. 45 Table 5.3 Georgia: Average Interest Rates................................................................................ 46 Table 5.4 Georgia: Profit Margins of Commercial Banks......................................................... 46 Table 5.5 Georgia: Maturity of Bank Loans.............................................................................. 47 Table 6.1 Agro-Foodmeverage Export Trends, 1997to 2001................................................... 52 Table 6.2 GrapeYield Comparison............................................................................................ 55 Table 6.3 ComparativeEfficiency inGeorgianWine Production.............................................. 55 Table 6.4 61 Comparative ProductionCashCosts of Hazelnuts..................................................... HazelnutPriceHistory ............................................................................................... Table 6.5 61 Table 6.6 Task Level Efficiency & Sales per Employee............................................................ 61 Table 6.7 Apply Juice ConcentrateManufacturing Task Level Efficiency GeorgianGarments Exports 1999-2001..................................................................... & Salesper Employee................................................................................................ 65 Table 7.1 70 Table 7.2 Relative Competitivenessof Georgia's GarmentsIndustry ...................................... -72 Table 7.3 Added Value for Wood Products' Exports................................................................. Romaniaand Georgia's Exportsof Wood Products................................................... 74 Table 7.4 74 Table 7.5 Typical Cost of Access to Timber .............................................................................. Structure ofthe Wood Sector ..................................................................................... 75 Table 7.6 76 Table 7.7 Timber Exportsfrom Georgia (FOB, 1999)............................................................... 78 Table 7.8 Productivity inInternationalFurnitureMakingFirms ............................................... 78 Table 7.9 Productivity inGeorgianFirms.................................................................................. 78 Table 7.10 PricesObtainedfor Wooden Products........................................................................ 79 Table 8.1 Stone Productioninthe Soviet Period........................................................................ 86 Table 10.1 Sources of Tourists inGeorgia................................................................................... 96 Table 10.2 Tourism Budgets and Staffing o f EuropeanCountries- 1999................................... 99 Table 11.1 Change inPoverty between 1997and 2000 ............................................................. 107 Table 11.2 Percentof Individuals with Calorie intake below 1,800 kcal/day............................ 107 Table 11.3 Georgia: Wage Employment................................................................................... 110 Table 11.4 Agricultural Area Sownby Agricultural Enterprises(`000 of ha's) ........................ Self-subsistence Rates inRural Georgia.................................................................. 111 Table 11.5 112 viii Table 11.6 Comparisonofthe RoadNetwork Across the CIS7 in 1999.................................... 115 Table 11.7 Nominal Wage Rates and Wage Rates as apercentofPoverty Line by Industry....116 Figures Figure 1.1 Georgia: Index of SectoralGrowth ............................................................................. Georgia: Index of Real GDP andExportsto GDP...................................................... 4 Figure 1.2 4 Figure 1.3 Georgia: Employment by EconomicActivity (1999).................................................. 6 Figure 1.4 Georgia: Index of Real ExchangeRate....................................................................... 7 Figure 1.5 Georgia: Perceptionsof the Business Climate. 2002................................................... 9 Figure 1.6 Share of Annual Sales Reportedfor Tax Purposes. 2002............................................. 9 Figure 1.7 9 Perceptionof Major Obstaclesto Business Growth, 2002......................................... Share o fAnnual Sales Paid in Bribes, 2002................................................................. Figure 1.8 10 Figure 2.1 Georgia: Exports by Country Groups......................................................................... 12 Figure 2.2 Average FDIPer Capita Over 1992-2001............................................................... Georgia: Imports by Country Groups........................................................................ 12 Figure 2.3 16 Figure 2.4 Georgia: PrivateIncome, Transfers, andFDI............................................................ 16 Figure 5.1 Banking Sector Development: Cross Country Comparison inpercentageofGDP (2001) ...................................................................................... 42 Figure 5.2 Number ofBanks inGeorgia, 1993-2002.................................................................. 43 Figure 5.3 Level of Bank Intermediation inGeorgia, 1996-2002................................................ 43 Figure 5.4 The Spreads Chargedby GeorgianCommercial Banks............................................. 46 Figure 6.1 52 Grapes usedinWine & SpiritsProduction inGeorgia, 1990-2002......................... Georgia's Agro/Food Imports and Exports................................................................ Figure 6.2 54 Figure 6.3 RussianWine Import Trends...................................................................................... 57 Figure 6.4 Hazelnut In-ShellProduction Output inGeorgia, 1998-2001.................................... 60 Figure 11.1 Sources of Income for a GeorgianHousehold: 1997-2000..................................... 108 Figure 11.2 108 Employment by Economic Activity, Georgia(1999)............................................... Sources ofIncome Across National Quintiles in 2000............................................. Figure 11.3 Figure 11.4 Poverty Among Rural LandownersandPoor Access to Markets by Regions.........109 111 Boxes Box 1. Key Steps of Reform Programin Georgia.................................................................... 3 Box 4.1 The Official and Unofficial Costs ofImporting to Georgia....................................... 33 Box 4.2 Creation of a Transit ServiceUnit: An Option for Discussion.................................. Trade andTransport Facilitation Programin Southeast Europe ................................ 39 Box 4.3 40 Box 5.1 Georgia: Trade FinancingFacilities .......................................................................... 49 Box 7.1 Cost-SharingTechnology Schemes............................................................................ 82 ix Annexes Annex 1.1 Georgia: Gross DomesticProduct Structure Annex 1.2 Georgia: Index of Gross DomesticProduct, inconstant prices Annex 1.3 Georgia: Employment by EconomicActivity 1980-1999 Annex 1.4 Index of Real ExchangeRate, Foreign CurrencyILari Annex 2.1 Georgia: Major Export Categories Annex 2.2 Georgia: Major Import Categories Annex 2.3 Georgia: GeographicDistribution ofExports Annex 2.4 Georgia: GeographicDistribution of Imports Annex 2.5 Georgia: Exports and Imports by Country Group Annex 2.6 Georgia: Total Services Annex 2.7 Georgia: Incomeand Transfers Annex 3.1 Donor Activities on Trade andPrivate Sector Development inGeorgia Annex 4 Main Ports inGeorgia A. PortofPoti Table 4A.1: StatisticalDatafor the Port of Poti in 1999-2001 Table 4A.2: Turnover of Poti Port 1999-2002 Table 4A.3: Poti Port Transit Distribution B. Port ofBatumi Attachment 4.1. Map ofExisting andProposedPipelines Attachment 4.2. TurkishRailways andPorts Annex 5 Export Credit Agencies 1. Working Capital Facility 2. Export PerformanceInsuranceFacility 3. Credit InsuranceFacility 4. Political Risk InsuranceFacility X Acknowledgements This report was preparedby Rocio Castro (Task Team Leader) based on the findings of a World Bank mission which took place in November 2002. The mission interviewed 65 Georgian firms. The report reflects the contributionsof Tyler Biggs (coordinator of firm-level interviews), GeraldTyler, David Neubert, Sean Browne (Consultants), who elaborated the industry case studies presented in Chapters 6- 10. Contributions were also received from Afsaneh Sedghi (Macro and Trade, Investment Flows), Sergo Vashakmadze (Privatization), Evgeny Polyakov (Trade Policy and Market Access), Ramin Shojai (Financial Support Services), Gerald Ollivier and Gevorg Sargsyan (Trade and Transport Facilitation); Ihsan Ajwad, Stephen Miller (Trade and Poverty), and Steve Jaffee (Agro-business and Standards). The Peer Reviewer was Jeffrey D. Lewis. Dolly Teju and Zakia Nekaien-Nowrouzassisted in the production of the report and RichardCarroll provided editorial support. The team wishes to thank CERMA and the Georgian Exporters' Association for their assistance in conducting the firm-level interviews, as well as Nia Sharashidze who helped coordinate the mission's work and compile relevant statistics. The report was disseminatedand discussed at a workshop held inTbilisi, Georgia, on September 29, 2003 with the participation of government officials, the private sector, and NGOs. The team would like to thank the staff of the World Bank Country Office in Georgia for their assistance in organizing the workshop. xi Executive Summary Introduction 1. Georgia i s a small transition economy with a populationo f fewer than 5 millionpeople and a per- capita GDP o f US$700. In Soviet times, Georgia exported agncultural and energy-intensive industrial products to the former Soviet Union (FSU) and was a popular tourist destination for the region. After independence in 1991, the outbreak of civil war, the loss of preferential access to FSU markets and of large budget transfers ledto an economic collapse. Output fell by 70 percent and exports by 90 percent', the worst decline suffered by any transition economy. 2. With the end o f the civil unrest and the start o f market-oriented reforms, the economy rebounded in 1996-97 (growing at 10.6 percent annually). However, growth has since weakened (to an average of 3.7 percent annually) and today, real GDP i s only 40 percent o f the pre-independence level. Growth has relied primarily on domestic absorption while the contribution o f exports has been modest. Although exports have grown faster than GDP since the mid-l990s, the share of exports intotal GDP2was still less than 20 percent of GDP in2002. Figure 1. Georgia: Real GDP Index and Exports to GDP Ratio I I 1990=100 ("/.I I 80 80 r 60 I 40 -I - 40 I 20 7 I 0 -~ ________.- 7 0 1990 1991 1992 1993 1994 1995 1996 1997 1998 1999 2000 2001 2002 ' Source: ECA Regional Databaseand Georgia State Department of Statistics Data on services in 1990is staffestimate. ' This percentage collapse may be exaggerated because during the Soviet period, economic aggregates were valued in nonconvertible Soviet rubles and then converted into dollars using an artificial exchange rate. Attempts to revalue these aggregates based o n international prices produced large estimates of the republic's GDP and intra- regional trade which are not strictly comparable with current estimates. Ofgoods and services. Although exports are thought to be under-reported by about 40 percent, GDP i s also believed to be under-reported by a similar proportion. xii 3. The initial fall in output and the recent modest economic growth have led to a severe decline in welfare. In particular, agriculture and industry: both traditional mainstays of export activity and important sources o f employment have virtually stagnated following their post-independence collapse. Georgia's annual income per-capita is 56 percent below the pre-independence level, unemployment rates are high (16 percent in 2001) and many Georgians are underemployed. The incidence of poverty has increased from 14 percent of the population in 1997to 23 percent in 2001 .'Moreover, inequality has also increased over the period. Georgia needs to achieve higher economic growth rates to reduce poverty and improve the welfare o f its population. Given the small size ofthe domestic market, sustainedhigh growth rates will only be achieved through a stronger expansion in export activities, especially of those in which Georgia has a comparative advantage and have the potential to generate new job opportunities, such as agro-processing.6 4. This report examines the opportunities for and constraints to achieving export-based economic growth in Georgia. It analyzes key aspects of both the internal and external environment, including macroeconomic risks, business environment issues, market access, transport and trade facilitation. An important consideration in the analysis, is the scope for enhancing the participation o f the rural and lower income segments o f the population in both domestic and external trade. Based on this comprehensive analysis a medium term program o f actions is developed and presented for Government consideration. An important methodological innovation is the use of qualitative and quantitative information obtained from interviews with 65 firms. These firms were selected from sectors where Georgia appears to have a comparative such as agro-processing (hazelnuts, horticulture and wine); light manufacturing (garments and wood processing); industrial minerals and stone processing; information technology and engineering; and tourism. The firm level interviews were used to gather qualitative information on the constraints faced by firms and, to the extent possible, quantitative data (e.g., cost structures) for the purpose of comparing firm performance with internationalcompetitors. Opportunities and Constraintsto Export Development 5. Georgia is well endowed with natural resources such as forests, minerals, fertile agricultural lands, scenic beauty, good climatic conditions. Unlike other low-income countries outside the region, Georgia has a well educated and relatively low-cost labor force which could allow it to be competitive in producing highvalue goods and services.' In addition, while much o f the country`s physical capital base has depreciated, there are still equipment and facilities that can be used in export activities. Georgia also has significant transportation infrastructure facilities and is located close to important regional and high- income European markets. Moreover, beingthe most direct link between the Black Sea and the Caspian Sea and the Central Asian countries, Georgia has the potential to become a regional transit hub, particularly for rapidly growing oil producing countries such as Azerbaijan and Kazakhstan. In the Soviet period, mining activities contributedabout 10 percent of output and for some towns was the major source of income and employment. While the incidence of poverty is relatively low, it is estimated that 60 percent ofthe populationis at risk o f falling into povertyat least once duringthe year. There is some, yet limited potential for import substitutionin a number of industries(Le., food processing) which could provideaplatformfor competitiveexports. 'Georgia's enrollment rates in basic education are almost universal, and while enrollment rates in secondary and tertiary education are decliningthey are still relatively high. In addition, the averagewage for a semi-killed/skilled worker is about US$55 per month, which is low by internationalstandards. XI11 ... 6. Despite the above advantages, Georgia's export base is currently very small and highly fragmented. Merchandiseexports amount to some US$325 million (or 10 percent of GDP).' The main exports include aircraft (exported to Turkmenistan under a debt-swap deal), scrap metal, wine, mineral water, fertilizer, ferrous alloys, and hazelnuts. Together they account for about half of merchandise exports. With a few exceptions-e.g., scrap metal and hazelnuts-Georgia exports consist mostly of traditional, low-value added products directed mainly to CIS markets. Remainingexports are very small invalue, typically amountingto less thanone milliondollars per year. Interms ofservices(10 percentof GDP), transport earnings have grown rapidly since the mid 1990s, mostly owing to increasedoil transit from the Caspian sea, but transit volumes are still only one third of what they were prior to independence. Tourism has recoveredsomewhat after collapsing to negligible levels, but the number of foreign visitors (mostly business related)to Georgia are estimatedto be less than 15 percent of what they were in Soviet times. Basic Conditionsfor Export-Based Growth 7. For a country to effectively compete in international markets and realize its comparative advantage, a number of basic macroeconomic and microeconomicconditions needto be in place. First, it requires a stable macroeconomic framework and a competitive exchange rate. Second, it should have a liberal trade regime and enjoy reasonablyeasy access to export markets. Third, it should have a favorable investment climate, including supportingtrade services and institutions. Fourth, it should have efficient mechanismsfor technology transfer and "learning" at the firm level. For a small transition economy like Georgia, it is particularly important to encourage firms to fundamentally shift their market orientation-- from being bulk, low-cost commodity suppliers--to become higher value-addedproducers serving distinct market segments. Such a shift requires moving away from old, `rigid' mass-productionsystems towards flexible technologies designed for fast market response and product differentiation. Some of these necessary conditions have yet to be establishedin Georgia, as discussed below, Figure 2. Georgia: Index of Real Exchange Rate Foreign Currencyhari (1995=100) 180, I60 120 :: Iaa +Russia 40 20i -W- Turkey 1994 1995 1996 1997 1998 1999 2000 2001 2002 Note: Increase indicates an appreciation o f the Lari Source: World Bank and IMF +REER 8. Basic macro competitiveness has been established. The stabilization program launched in the mid 1990s,has succeeded inbringing inflation to single digits and inmaintaining a competitive exchange rate. Georgia adopted a free floating exchange rate regime in 1998 in the wake of the Russian financial crisis, After amoderatedepreciationtriggered by this crisis, the real effective exchange rate has remained relatively stable over the past five years, despite the fact that the Georgian Lari (GEL) appreciated ~~ ~ As noted earlier, there is significant under-reporting o f exports, but reliable estimatesare not available. For more details see Chapter 2 of this report. By comparison it is estimated that commodity exports amounted to USS5.7 billion (or 57 percentofGDP) priorto independence. xiv substantially against the RussianRuble inthe years immediately after the crisis. Ingeneral, real exchange rate movements have reflected market conditions both internally and in major partner countries. However, with gross international reserves at less than two months of imports, Georgia is vulnerable to external shocks, especially given its high external debt burden. (see Chapter 1). This macroeconomic vulnerability is likely reflected inthe substantial riskpremiumobserved in Georgia. 9. Georgia has a liberal `statutory' trade regime andfaces no significant trade barriers in world markets. Georgia became a member of WTO in June 2000. It has low import tariffs and no quantitative restrictions. The VAT (20 percent) and excise taxes are equally applied to imports and domestic output. However, the implementation o f trade policies is undermined by corruption and poor customs and tax administration. Moreover, a new tariff schedule adopted inJanuary 2003 increased the number of tariffs from four to 22! and the top duty rate from 12to 30 percent. Although the weighted average tariff will go up only by a fraction of a percent and the new tariffs are in line with the upper bounds agreed with the WTO upon accession, such a schedule is a step back fiom the previous, simpler schedule. Georgia faces no significant trade barriers in world markets and main export destinations include the CIS region (45 percent)-e.g., Russia, Azerbaijan, Ukraine, and Armenia- where Georgia enjoys duty-free access, followed by Turkey (20 percent), and the EU(18 percent)-mainly Germany. 10. However, Georgia's unfavorable business climate undermines the competitiveness offrms. Like most CIS countries, the cost of doing business in Georgia is high and adds significant investment risk. Not surprisingly, outside of two large energy project^,^ foreign direct investment (FDI) in Georgia has been insignificant. According to the 2002 Business Environment and Enterprise Performance Survey (BEEPS)" conducted inGeorgia, taxation and corruption are the main obstaclesto doing business. Along with crime, these problems are somewhat worse in Georgia than its regional counterparts. Issues relating to regulations, the judiciary, infrastructure, and access to finance while still problematic appear more or less the same across the CIS region. 11. More specifically, the industry case studies conducted for this study identified several institutional constraints which significantly undermine the export competitiveness of Georgian firms and create barriers to entry, a critical issue for a transition economy. Notably, exporters do not have assured access to inputs at world prices, particularly o f those procured inthe domestic market, becauseof the lack of a functioning VAT refund mechanism. Moreover, the tax code is subject to frequent changes and its administration is unpredictable and highly corrupt. Transportation costs are high primarily due to considerable unofficial payments to border agencies and the road police. At the same time, widespread smugglingreflecting corruption and weak customs administration, means that formal firms are undercut from the domestic market which limits their possibilities to achieve economies of scale." This environment encourages the proliferation of informal and small-scale activities, creates a bias against formal domestic tradable activities, and does not allow the already small domestic market to become a platform for export growth. Relatedto the constructionof the Baku-Supsa pipeline and the privatization of the Tbilisi electricity company to AES. Io Survey conducted jointly by the World Bank and the European Bank of Reconstruction and Development (EBRD), covering6,000 firms in27 transition countries. `I With respect to food products, the problem is not simply competition from unrecorded imports but that a significant proportionof these imports are of adulterated or mis-labeledproducts, further erodingthe confidence o f the Georgianconsumer inpackagedfoods. xv Figure3. Georgia: Perceptionsof the BusinessClimate 2002 Financing +Worst case 1 Source: The World Bank and EBRD. BEEPS I1 12. In addition, firms also face problems getting access to finance, especially for investment, and when finance is available it is expensiveandrequireshigh collateral. Other constraintsincludethe lack of enforcement of intellectual property rights; national standards which are not recognized outside the CIS region; and inadequateand unreliable power and telecommunications services. 13. Hence, mechanismsfor technology transfer and "learning" are weak or absent. In the absence of significant FDI and visits to Georgia by foreign buyers, most Georgian firms have limited access to adequate technology and ways to learnmarketing which are essentialto be competitive in world markets. This often results in low labor productivity despite good education levels. For example, the industrycase studies found a substantialproductivity gap betweenGeorgianfirms andtheir internationalcompetitors in garments and wood processing(see Table 1). Moreover, productivity differentials between Georgia and its rivals are larger than their wage differentials, indicating that Georgia's low-wage advantage is being eroded by its productivity disadvantage. Georgia's high unit labor costs may explain why sectors that highly competitive internationally such as garments and wood processinghave not flourished in Georgia. Table 1: CompetitivenessIndexin Manufacturing2002 (Georgia=lOO) Task-level I Output Per I UnitLabor I Competitiveness I Source: Industry Case Studies, Georgia Trade Diagnostics Study, Chapter 7-Light Manufacturing. xvi A ProposedProgramfor Export Development 14. Interviews with approximately 65 exportingfirms conducted for this study, show that firms are beginningto move into importsubstitutionand many export activities. But, the situation is fragile, many firms are newly formed- most as a result of privatization-- and there are significant challenges ahead. The sections below summarizes the main constraints to export development identifiedby this study and propose recommendationto addressthem. Taxation and VATRefunds 15. Issues: Most firms complainthat tax administration is arbitrary and unpredictable. The tax code is complex, changes frequently, and is difficult to interpret. These difficulties give tax authorities too muchdiscretionand opportunitiesto extract bribes. Also, firms say that tax collectorsare not accountable and the appeals mechanism is weak. For example, under the law companies should be audited once a year, but some are auditedas much as once a month, especially smaller firms. Generally, tax authorities target firms that can pay, or firms that lack political protection,rather than non-payers, in order to meet their tax collection monthly target or extract a bribe. In response, firms become informal operators, under-report revenue, or forego entering certainbusinessesthat mightbe morevisibleto tax officials--like manufacturing--and/or buy politicalsupport. 16. VAT administration is another major problem for exporters. Exporters are supposed to get a refund on VAT paid on inputs, or they can put up a bank guarantee at the time inputs are imported and pay nothing, as long as the final product is exported within six months. Firms able to do the latter, generally have no problems. But for those that pay VAT, either at the border or to the local supplier, it is almost impossibleto get it refunded, unless they have "political connections". In addition, since many inputs are smuggled into the country, it is difficult to obtain VAT invoices from local sellers. Tax collectors often ask firms to pay VAT for inputsthat do not have proper invoices. To get around such problems an industry has grown up in Georgia to provide fake invoices which cost 8-10 percent of the value ofpurchases, but, of course, these costs cannot be deductedwhen goods are exported. 17. Recently, the Ministry of Financepresenteda tax packageto Parliament whichaims at raisingthe VAT threshold and simplifyingtaxes. Inaddition, it plans to allocate funds (about 5 percent of revenue) to pay VAT refunds inthe 2003 budget. While the proposed allocationmay be short of what is needed, it would be a step inthe rightdirection, ifactually implemented. 18. Recommendations. As documented by this report and others12,there is an urgent need to make the tax systemmorepredictableandto ensurethat exporters get their inputs at world prices. USAID has been providingtechnicalassistanceto the tax department for several years, but much is yet to be done to address current distortions. This will require striking a better balance between fiscal objectives and the need to promote private sector development, especially o f the export sector. More importantly, it will require a great deal of political commitment to enforce proper implementationof tax regulations and remove incentives for corrupt practices by tax inspectors. Immediateprioritiesare to stabilize revenues, improvethe tax environment for exporters and small businesses, and facilitate tax administration. Some of the proposedmeasuresare includedinthe above mentionedtax packagepreparedby the MoF. (i) Strengthen VAT implementation, by raising the threshold and limiting voluntary registration below the threshold, reducing exemptions, and providingadequate budgetary allocations to pay VAT refunds for exporters. l2 See Georgia: Public ExpenditureReview(PER), World Bank, November 25,2002. xvii (ii) Establish a simplified tax for small businesses, below the VAT threshold, to replace existing taxes. (iii)Limitinspectionsandauditsbytaxauthorities. (iv) Introduce a broader range of criteria to measurethe performance of tax authorities. 19. In the medium term, efforts must continue to develop the institutional capacity of the tax administration, includingcustoms (see below), broaden the tax base, and establish a business friendly tax environment. In this regard, it will be important to separate the collection, auditing and enforcement functions o f the tax department. As progress is made in these areas, it might be possible to consider options to lower the tax burden, for example, through reductions in the social security tax and/or the VAT. Transport and TradeFacilitation 20. Issues. While official transport fees (including ports charges) are comparable with international benchmarks, transport costs in Georgia are not competitive when one considers unofficial monetary expenditures and the time req~ired.'~ The main contributing factors include (i)highunofficial payments to border agencies-- including customs -- and the road police; (ii)excessive and often unnecessary documentation, particularly for transit goods; and (iii) additional costs incurred because of delays, long journey times, etc. Table 2. IndicativeLI isticalCost for a TEU Con1 h e r by Roadfrom Poti to Armen a Cost element cost $ 1Characteristic ProDosed mitieation measures QuantlJiable cost Incremental VOC caused by 50 OIA Roadrehabilitatiodmaintenance poor roads Paymentto border agencies 170 U/A Border agency modernizationand computerization Paymentto roadpolice 100-200 UIA Enforcement of Presidential Decree RoadFundPayment 0-410 OIA TRACECA analysis Transitdocuments 85 0-UIA Reviewtransit documentation requirement particularly underTIR Mandatory escort 0-50 UIA Removethis requirement "Pure" transportation costs 455 O/UN Subtotal: 885-1420 Residual non-quant$able cost 660-125 Longterm measures to improvethe Georgian andArmenian facilitation Total Logisticalcosts 1545 ~ ~~ ~ nsport andTrade Facilitation. 21. As shown in Table 2, the logistical cost for transporting a TEU container from Poti to Armenia is US$l,545 or over three times higher than the "pure" transportation cost. Quantifiable costs resulting from unofficial payment to border agencies and the road police in both countries can amount to US$370 (or 20 percent of the total costs). Additional official and unofficial charges incurred because o f unnecessary transit requirements (such as road fund payment, internal transit document, and mandatory escort) can cost up to US$ 720 (or 40 percent of the cost). Incremental costs due to poor road conditions are estimated at US$50. The residual covers potential additional costs linked to long journey time, security concerns, etc. l3Small volumes also contributeto hightransportation costs. xviii 22. Some of these incrementalcosts apply only to goods intransit, butthe costs of importinggoods is also expensive, due to bribes to customs officials and the roadpolice. For example, inmoving a generic container from NorthernEurope to Tbilisi, the Georgian leg accounts for 46 percent of the cost, despite representing a small portionof the distance. Unofficial payments account for 7-40 percent of the cost, mostlyto border agencies andthe roadpolice. 23. Recommendations. Given widespread smuggling in Georgia and the need to improve fiscal revenues, a trade and transport facilitation strategy needs to target both reductions in logisticalcosts as well as in illegal trade. Trade facilitation and revenue enhancing objectives need not be in conflict, as shown by the experience in South EasternEurope where increasedfiscal revenues were achieved along with lower processing time of transit goods. Meeting these objectives will require significant improvements in customs administrationand other government agencies dealing with foreign trade and transit, includingthe road police. In addition, well targeted interventionswill be neededto upgrade the transport infrastructure. In both cases, the improvement of road transit conditions seems to be the most urgentpriority. 24. Implementationof customs reform is critical to reduce transportation costs as well as illegal imports. While the Government has already articulateda sound reform strategy, it has achieved little in terms of implementation. Immediate actions need to be taken to set the basic conditions for improved customscontrolsandtrade facilitation: (i) Accelerate the implementationof ASYCUDA nationwide, to allow risk management and the integrationof a transit module, while limiting physical contact between traders and border agencies.(On-goingwith support ofU S Customs). (ii) Simplify transit procedures by establishing a single window and removing unnecessary requirementsfor transporters with TIR carnets; e.g., the VVT, transit insurance, transit road charge, andmandatory escort for non-excisegoods intransit. (iii)Publishproceduresforforeigntradeandtransitinauser-friendlyformat. (iv) Enforcethe 2002 PresidentialDecreewhich limits roadpolice inspections. 25. In the medium-term, efforts should focus on establishinga professionalcustoms administration. In this regard, particular attentionneeds to be given to improvinghuman resource management, through training, testing, and establishment of performance-based incentives and sanctions. In order to attract additionaltransit, particularly of products going to Azerbaijan, the Government may wish to consider a more focused institutionalapproach to transit. This would involvethe delegation of powers of all border agencies to a single transit administrationwhich would have overall responsibilityfor facilitatingtransit with oversightby an independentmonitoringbody. Inaddition, buildingonthe transit strategy developed by the Ministry of Transport and Communications, complementary measures are neededto upgrade the road infrastructure, according to economic priorities, and to harmonize rail tariffs. It is also important that steps are takento commercialize the operations of Georgianrailways. Access to Finance 26. Issues. Almost all firms interviewed for this study indicated that access to finance is a considerable impediment to business development, including exports. Main concerns include high interest rates (about 20 percent) and high collateral requirements (often twice the value of the loan). Firms also complain about the short maturity of loans, mostly less than a year, which make investment financingthrough credit very difficult. As it is often the case, well established firms are able to access credit at more favorable terms, while smaller firms are at a disadvantage. xix 27. Interviews with exporters in Georgia revealed that most are not used (or keen) to utilizing any export financing instruments such as letters of credit (L/C) and export guarantees. Some of this reluctance is due to the cost charged by banks for such facilities. Most importantly, the majority of buyers of Georgian exports inthe CIS region (which account for about halfof total exports) prefer to deal with direct payments (20-30 percent prepayments and/or payments after delivery) instead of using financial instruments.l4 28. In order to facilitate access to finance for exporters, the Government has recently introducedan interest subsidy scheme (up to percentof 70 percentof lendingrates), targetedmostly to exporters. While provisions have been made to ensure that the subsidy is paid only to compliant beneficiaries, the impact of such scheme is bound to be ad-hoc and limited (funds were only US$0.5 million in 2002). The Government also plans to establish an Export Guarantee Agency (EGA), to provide insurance and guarantee facilities to exporters, but this could be premature given Georgia's small export base and low demandfor this type of services. 29. Recommendations. The development of the financial sector and the real side of the economy are linked. Therefore, given Georgia's nascent private sector and adverse investment climate, it will take some time for the costs and risks of financial transactions to come down. Interest rates have been declining and are comparable to most CIS countries. Interest rate subsidies or credit lines with government taking all or part of the credit risk, can be ineffective and unsustainable. Besides, interest rates subsidiesprovided exclusively to exporters constitute a violation ofthe GATT of the WTO. Instead, the government should concentrate efforts on improving the business environment and take specific measuresto support the developmentof the financial sector. Short term priorities include: (i) Eliminateinterestsubsidyscheme (ii) Raisecapitalrequirementstoencouragefurtherbankconsolidation (iii)Establishlegislationto allow theuseofmovablecollateralandtheestablishment credit bureaus. (iv) Improve enforcement mechanismsand proper court rulings (v) Encourage leasing services by providing technical assistance to investors wishing to establish leasing companies, raising public awareness of the benefits of leasing, and monitoring implementationof leasingarrangements. (vi) Continue credit lines for back-to-back L/C financing. 30. While establishing an EGA may be premature at this time, the Government could start consideringoptions for implementation at a later stage. To ensure the financial sustainability of such an agency, an option could be to establish a regional agency for the Caucasus, for example. Over time, improved financial accounting by companies should facilitate the development of the securities market and of credit bureaus. Efforts should also continue to strengthen the supervisionof the rapidly growing insurancesector. Property Rights 31. The lack of protection of property rights is a serious problem for some export activities such as wine, mineral water, and information technology (IT). Despite having a sound framework of related legislation, administrative proceduresand a National IntellectualProperty Center, responsiblefor matters involving industrial intellectual property, actual enforcement of intellectual and industrial property rights is extremely weak in Georgia, and more generally within the CIS region. For example, in order to deal with counterfeiting, Georgia's mineral water company has been forced to change its bottling structures l4 Reportedly, CIS buyers prefer to under-reporttheir activitiesto avoid taxes. xx (includinglids) several times and has been actively involvedwith other private companies inthe Russian market to raise consumer awareness of mislabeled products. Although relatively successful, these initiatives create additional costs. In the IT industry, weak enforcement o f property rights also raises costs and product prices for local companies, particularly software producers and hinders the development o f IT services exports. Foreign software companies are reluctant to buy programming services from Georgian companies when they lack confidence that their source codes will be protected. They are also less than enthusiastic aboutjoint ventures and direct investments where property rights are not enforced. 32. Recommendations. Improved property rights protection will be critical to promote more foreign investment and to increase technology transfer to Georgia in IT and other sectors. Efforts will be needed to further strengthen the capacity of the legal system to enforce property rights in Georgia. Recommended endeavors mightbe: (i) Establishspecialcourtsdesignatedtoadjudicatecases. (ii) Provide training for legal professionals and private sector agencies on property rights issues. (iii) Foster private sector organizations to become more involved in assisting enforcement efforts and in educating business and consumers about the importance of property rights protection (e.g., through media advertisements). (iv) Collaborate with CIS countries, through Georgian embassies/commercial attaches in those countries, to draw attention to violations of Georgian 1abeMproperty rights. Standards 33. Lack o f adequate standards in Georgia, is an impediment to access non-CIS markets, especially for food and agro-processed products. Georgia has yet to adopt internationally recognized standards (Le,, CODEX) or harmonize its standards with that of potential trading partners (i.e., the EU). The country has numerous testing laboratories, but none are internationally accredited. It has a multiplicity of inspection and control agencies-cutting across different ministries-however official certifications (of safety, authenticity, etc.) are generally not recognized as valid. The result has been duplicative product testing (adding to costs), quality-related price discounts paid on Georgian products (reducing revenues), and missedmarket opportunities (ie., for products certified as organic). 34. Georgian legislation is in line with the GATT 1994 Agreement on Technical Barriers to Trade and the Agreement on the Application o f Sanitary and Phytosanitary Measures. Under the WTO agreement, Georgia must adopt by end-2003 a dual system comprising voluntary standards and mandatory international technical regulations, thus replacing the current GOST system.15 Despite the deadline approaching, the progress in the elaboration of technical regulations has been very slow. The stalling of the standards reform stems from powerful political pressures to retain the status quo, including pressures from the national standards agency, and to protect opportunities for rent-seeking. 35. Recommendations. The introduction o f an internationally recognized system o f product certification is necessary for Georgia to access new, higher-value markets, particularly outside the CIS region. Given the imminent accession to the WTO of large CIS trading partings such as Russia and the Ukraine, it is important that Georgia accelerates the process o f reform in this area. The main recommendations include: Is Technical regulations include not only the characteristics of the products but also the characteristics of technological processesinvolved, and the methodso ftesting. xxi Accelerate the transition to the dual (voluntary/mandatory) system of standards in accordance with Georgia's obligationswith the WTO. Complete the introductionsof the full system of mandatorytechnicalregulations as soon as possible. Increase awareness with and move to adopt internationally recognized standards (Le,, CODEX, ISO) Support initiatives such as the establishment of a laboratory for food testing sponsored by the GeorgianExportPromotionAgency (GEPA). Initiate steps to obtain organic certification and forestry certification, through the private sector. Strengthenthe awareness and capacities ofprivate firms to adopt internationally recognized food safety (i.e., HACCP) and environmental (i.e., I S 0 14000) management systems. Support industry-basedinitiatives to develop and apply `codes of practice' to cover quality assurance, worker safety and/or other dimensions. Infrastructure 36. Firms report that unreliable power supply is the biggest infrastructure problem affecting their operations'6. Frequent power outages stop production and reduce productivity, increase wastage of raw material, and increase operating costs. Most companiesuse generators to deal with this problem and note that, while still problematic in some areas, the electricity situation is beginningto improve. 37. In the IT sector, Internet services and high-speed data transmission are reported to be underdevelopedand quite expensive relative to competitor countries at similar levels of income. Also, enhanced services like broadbandare costly and difficult to obtain. These IT infrastructuredeficiencies are hamperingthe efficiency of IT companiesand constrainingtheir ability to develop services exports. 38. Recommendations. The continued unreliability of power supply, reflects modest progress in restructuring the sector. Despite adjustments in tariff rates, collections are low, because of theft and corruption. The problem is particularly serious outside Tbilisi where the distribution companies are still instate-ownedhands. (i) Implement energy sector reform program, focusing on improving collection rates, particularly outside Tbilisi. (ii) Develop broad-bandsystems to improve conditions for the informationtechnology sector. Technology andMarketing Skills 39. A number of factors may contribute to low productivity at the firm level: (i)low-value added market segments (e.g., "cut-make-trim" garments, juice concentrate, timber, etc.), which means that earnings per factor of production are low; (ii)inadequate technologies, often old Soviet machinery designedfor mass production and cheap energy, which cannot be adapted to flexible production runs; (iii) weak management skills and training; (iv) lack of specialization as firms tend to produce too many products for too many market segments, partly as a means of diversifying risk; (v) lack of economies of scale, linked to the lack of specializationand to small size of the domestic economy; (vi) overstaffing and workers' attitudes, inheritedfrom the Soviet times and have not adaptedto market realitie~.'~ l6Accordingto the BEEPSfor Georgia, there are 60 days of with power cuts inthe year. l7For example, some Georgianfirms retainolder workers as a form of social safety net. xxii 40. To a large extent, low productivity at the firm level reflects weak technical and marketing capabilities. Part of the reason is that most of the learningmechanismsfirms usually rely on are weak or missing. There is very little FDI, buyers and suppliers are not visiting Georgia in large numbers, and companies often do not have the resources or do not understandhow to go about visiting buyers in other countries. In fact, the majority of firms interviewedfor this study do not make an effort to visit foreign buyers inperson, unless it is throughoccasionaltrade fairs. 41. Recommendations. Strengtheninglearningmechanisms for bothtechnology and marketingskills will depend largely, but not exclusively on the quality of the investment climate. Direct foreign investment and the number of buyers and suppliers travelingto Georgia will not increase much without significant improvements in the political climate, personal security and the administration of public institutions. However, a sound investmentclimatealone will not generatehigherproductivity. Enterprise learningis also required. When firms cannot meet their learningneedsthroughtheir own efforts, there is a strong case for the Government to intervene by supporting existing efforts to strengthen learning mechanisms. Mainareas of focus include: (i) Expand cost-sharing grant programs such as the marketing scheme currently run by the GEPA, to assist firms in hiring industry consultants, developing in-firm training, and searchingfor newtechnologies andmarkets. (ii) Continue training and consulting services by organizations such as the IDA-funded CERMA project. (iii)Assist technicaland vocationalinstitutions(public and private) to cooperate with the privatesector indevelopinginnovativetrainingprograms. (iv) Provide technical assistance to the packaging industry, which is essential for successful marketing. Upstream Policiesfor Resource-BasedActivities 42. Issues. Some resource-basedexport activities are also constrained by inappropriate upstream policies which affectthe firms' access to raw materials and the efficiency of downstream production. In the case of wood processing,, the pervasivenessof illegal felling of trees leads to the wastage of forestry resources. In addition, the small area and short duration of felling licenses are inadequate to ensure predictability of supplies over the long term and prevent firms to plan investments. In the case of industrialmineralprocessing, the state continues to own most of Georgia's mines and mineral reserves, for example for manganeseand natural stone. State-owned mines are managed inefficiently and do not permit integrationbetweenminingand processing. These mineshave not been privatized, partly because of lack of foreign investor interest and their large outstanding debts. Finally, in amo-processingthere are concerns about the sustainability o f supplies due to aging perennial crops (e.g., apples) and vineyards. These problems reflect to some extent the lack o f basic agricultural support services for farmers, e.g., research and extension services and access to fertilizer and improvedseeds, due to weak integrationwith agro-processors and other marketingintermediaries. In fact, agro-processors are increasingly relyingon their own land plots to source their inputs, which has adverse consequences on the welfare of rural households. 43, Recommendations. The development of downstream production depends importantly on the sustainability and predictabilityof natural resource inputs. Unless these issues are properly addressed, Georgiawill not be ableto realize its comparative advantage inthese sectors. (i) Reduceillegalfelling and increase the size anddurationof licenses; (ii) Privatizeremainingmines and/or grant long-termminingleases to the privatesector; (iii) Support researchandextension services for farmers as well as out-growingschemes. xxiii TradePolicy and Market Access Issues 44. Tariff Regime. As mentioned earlier, the new tariff schedule recently adopted by Georgia is a step back from the previous, simpler schedule. Clearly the rationale for setting this schedule has been to serve the interest of groups lobbying for increased protection. In an environment characterized by poor customs administration, the new schedule will only increase the opportunities for corruption and rent seekingactivities as well as worsen economic distortions. 45. CIS Markets. Free trade agreements (FTAs) with a number of CIS countries provide duty-free market access to important regional markets, such as Russia and the Ukraine." Georgia can compete in these markets, despite current institutional weaknesses, because these problems are also common to the region. Inaddition, Georgiaenjoys protection from international competitors which face import duties in the CIS markets. For example, Georgian exporters of frozen vegetables are able to compete with Polish suppliers in Russiabecause the latter face duties of 18 percent. However, dealingwith CIS markets does not currently provide incentives for integration with global markets (e.g., old Soviet GOST standards which are recognized in the CIS region are not recognized in the rest o f the world; CIS countries do not rely on L/C financing for exports and other financial instruments). In addition, FTAs incorporateproduct exemptions and are subject to unilateral action by the parties involved and there is no settlement mechanismincase o fdispute. 46. Non-CIS Markets. As a member of the WTO, Georgia enjoys most favored nation (MFN) treatment. In addition Georgia is beneficiary of the Generalized System of Preferences(GSP) of the EU, US, Canada, Switzerland, Japan, Turkey, Polandand Estonia. But, despite being a low-income country, the preferencesthat Georgia receives under the GSP are not as deep as those granted to least developed countries (LDCs). Tariffs for Georgia in the EU are relatively high for sensitive products, such as agricultural products and textiles. Moreover, available preferences under the EU GSP are not fully utilized owing to lack of information and difficulty in complying with complex rules of origin. Georgia could obtain deeper preferential treatment on textiles on account of its sound labor legislation, but it has not made an application in this respect. In addition, as stated earlier, Georgia is constrained in trading outside the CIS by its weak systems of quality assurance and standards and by weaknesses in enforcing trade and intellectual property rights (TRIPS). 47. Recommendations.The FTAs provide a favorable framework to foster regional trade and have the potential for helping member countries to integrate into the world trading system (e.g., in the case of harmonizedstandards), if large trading partners such as Russiaand Ukraine become members of WTO in the near future, as it is anticipated. This underscores the need for Georgia to decisively address current institutional weaknesses and to position itself to compete in a more demanding regional environment which, at the same time, will helpto achievegreater integrationwith world markets. (i) Reducethenumberofimportdutiestonomorethanfiveandlowerthemaximumrate. (ii) Increase utilization of GSP by better dissemination of available schemes, including information about rules oforigin. (iii)Seek deeper preferential treatment through bilateral agreements with EU and other industrialized countries, and obtain deeper preferences for textiles based on compliance with labor legislation. (iv) Enforce property rights and introduce standards consistent with WTO as discussed in earlier sections. Georgiahas fi-ee trade agreements with Armenia, Azerbaijan, Kazakhstan, Russia, Turkmenistan, and Ukraine. xxiv 48. At the same time, it is important that as a poor country, Georgia obtains preferencescomparable to those granted to LDCs. Otherwise, other things being equal, foreign investors will decide to locate in LDCs where such preferencesare available. Trade and Poverty 49. As discussed in earlier sections, several 'behind the border' constraints prevent the Georgian economy from successfully integrating internally and into the world trading system. The lack of internal integration affects the productivity of the smallholder agricultural sector in rural areas and indirectly affects industry in urban areas. This has serious poverty implications, since agriculture accounts for half of employmentand given industry's potential for generatingwage employment. Internal Market Integration 50. Market integration is an important determinant of poverty. Recent analysis shows that there is a close correlation betweenthe poverty rates of Georgian rural householdsand the extent to which they are linked to markets (expressed as percentage of households with land not recording a single transaction selling agricultural products during the whole year of ob~ervation).'~However, on average almost two thirds of rural household agricultural production is for self-subsistence. Many Georgians, especially in rural areas, are effectively isolatedfrom the national economy. Infact, it is estimatedthat about a fifth of all rural households do not trade at all. There would appear to be incentives for rural householdsto rely on self-subsistence and limit their interactions with markets. In such an environment, there is a risk that households will tend to produce many products and not benefit from returns to specialization and scale. In addition, households that rely on subsistence generally have lower yields, mostly due to low use of improved seeds, fertilizer and other inputs. 51. Corruption. In addition to having an adverse impact on welfare levels, the prevalence of corruption in Georgia affects the ability of rural households to integrate with domestic and external markets . At the householdlevel, about 3 percent of household income is allocated to bribes. Almost 40 percent of rural households report paying bribes, while less than 20 percent of urban households report paying bribes. Much of these bribes are paid during interactions between farmers and the traffic police, who extract payments when farmers travel to markets to sell their produce.20More indirectly, corruption affects the ability of the poor to engage in trading activities in other ways. First, the poor are generally less efficient producers and are unable to compete with illegal imports. Second, small and medium scale enterprises, which are more likely to provide employment opportunities for poor people, face a higher incidence of bribery on a day-to-day basis and are more vulnerable to competition from smuggled goods than are larger firms. Third, high transactions costs discourage the development of marketing channels, such as wholesalers. 52. Intermediaries for Small-holders. The shift from central planning required the emergence of intermediate private agents to take goods to the market; provide research and development of better farming techniques; and facilitate access to inputs and finance. However, Georgia's unfavorablebusiness environmenthas not been conduciveto the emergence of intermediate agents taking on these roles. There are no wholesalers, there is minimal development of farmer-based organizations, and generally weak linkages betweenfarmers and agro-processors. Inaddition, little farm size consolidation has taken place, due to underdevelopedland markets andthe lack of alternativenon-farm wage employment. At present, a relatively small and probably decreasing number of smallholder farmers are active in export-oriented l 9See WorldBankForthcomingPovertyUpdate (2003), Social and EconomicInfrastructure inRuralGeorgia. 2o Interviews with farmers suggest that police at checkpoints stop cars based onthe extent to whichthe car is loaded with produce. Carsthat are filled with agriculturalproduceare almost guaranteedto be stopped. XXV production. In some sub-sectors, includingwine, the emerging trend is toward backward integrationby vintners into own primary productionon leased land. This may well be an appropriate strategy in that industry, although more generally, there is a needto strengthen rurallfarmorganizations and facilitatethe development of out-grower support andmarketingarrangements. 53. Rural Roads. Althoughroaddensities are relativelyhighin Georgia, feeder roadsare in generally badconditionand are particularlychallengingduringinclement weather. The badquality of feeder roads can be an important impediment for certainregions and certain communities. In these cases, improved conditions can make an important difference in the welfare of poor households by creating more opportunitiesto link upwith the nationaland internationaltradingsystem. Wage Employment 54. Ingeneral, employment status explains a large part of householdwelfare, whether the headofthe householdor other householdmembers are employed. Between 1991and 1999, wage employment rates in Georgia declined from 91 percent to 57 percent, but the impact has been mitigatedby a substantial increase in self-employment. Increasingexports can help job creation, although the underemployment will probably fall first before unemployment. An incidence analysis exercise conducted for sector employment in Georgia suggests that employment increases will generally benefit the middle quintiles morethan other quintiles. However,job creation inthe agro-processingsector will have a very beneficial impact in that it tends to attract a significant number of poor people. On average, the processing sector pays about 35 percent higherwages than the agriculturesector and, hence, would contributean important increase in householdwelfare. Similarly, the hotelandtransportation sectorspay about 45 percent and42 percentmorethanthe agriculturesector on average. Recommendations 55. Corruptionaffects most Georgians, especially the poor, so measures must be taken to curtail its adverse effect on economic activity. This should go a long way toward facilitating internal trade, and connecting it with marketsabroad. Inaddition, the agriculturesector must be revitalizedbecauseGeorgia has a comparative advantage in this area and because it has the potential to benefit the poor. Greater opportunitiesfor wage employment in the processing sector and tourism will also help improve welfare levels, especially inurbanareas. The recommendedmeasuresfor reducingpoverty include: i. Removingobstacles to domestic market integration,by strengthening ruraltransport and market infrastructure,promotingrural/farmer organizations, and reigningin petty corruption alongmarketroutes; ii.Raisingtheproductivityofruralfarmers,byfacilitatingthepropagationandsaleofimproved seeds and other plantingmaterials and strengthening advisory services through collaborative publicandprivatesector initiatives iii.Support initiativesto enhancethe competitivenessofselectedindustrieshb-sectorswhere there is evident growthpotentialand scope for considerable employment-generation, such as tourismand several fields of agro-processing Conclusion 56. The main objective of this study was to identify a program of actions to accelerate export development inGeorgia. A summary ofthe mainrecommendations is providedinAnnex 1. 57. Gettingincentives and institutions"right" to foster a better investment climate is the first order of business. As stated in this report and others, Georgia has put in place most o f the necessary laws and xxvi regulationsneededto provide a favorable trade and investment regime, but poor implementationremains a major constraint. Improved implementation will require taking decisive action to fight corruption-- which has become pervasive in both public and private spheres- and to build functioning trade support institutions. In particular, progress intax and customs administrationwill be critical to measure success and to render credibility to the reform process. Support will be also needed to assist companies in meeting product standards and in enforcing intellectual property rights both to consolidate their market shares and gain access to new markets outside the region. Regional cooperation in these areas could speed up the pace of reform and enhance the chances of success. Similarly, the establishment of a regional export guarantee agency, for examplefor the Caucasus, could be an option beneficial for Georgia and other small countries which presently cannot ensure financial sustainability of such an agency because of their small export levels. 58. As progress is made in addressing institutional constraints, parallel efforts will be needed to improve technical and marketing capabilities at the firm-level The Government and donors, can play a key supporting role in this area, but firms need to become more active in getting themselves organized and in identifying their technical assistance needs. Continuedand further support from Governmentand donors to organizations, such as GEPA, CERMA and the GHA, will be needed to assist companies to developproduct and marketing strategies andto improve technologiesinuse. 59. However, improvements in the investment climate alone will not guarantee the necessary expansion in investment--especially in FDI-- that is needed for a strong export orientation. Georgia's ability to attract FDI, will also depend on the terms of access to developed markets. Thus, Georgia needs to participatemore actively in multilateral forums dealingwith the internationaltrade system, along with other low-income CIS countries, to obtain comparable market access preferences as those available to LDCs. Otherwise, other things beingequal, investorswill chooseto locateelsewhere. 60. From a poverty perspective, taking measures to fight corruption will go along way in improving the welfare of the population, especially of the rural poor who are proportionately more affected. In addition, the development of Georgia's exports will help create new employment opportunities and achieve productivity increases that are neededto raise householdincomes. Specifically, there is a needto support initiatives to enhance the competitiveness of selected industrieshb-sectors where there is growth potential and scope for considerable employment-generation. This is likely to include several fields of agro-processing and tourism. Agro-processing requires complementary measures to enhance the productivity of rural farmers through agricultural extension services, as well as the farmers' capacity to effectively interactwith markets, by supportingfarmers' associationsand cooperatives. xxvii e e . . ; e . e . e . . e ... j . . . e . I . . . ... U8 *$ BJ3 . . 0 . e hP Chapter 1. Macroeconomic Settina I Chapter 1. Macroeconomic Setting Recent Economic Developments 1.1 Georgia, a country of fewer than 5 million people, with a geographicalarea of 70,000 kilometers, borders the Black Sea, Russia, Turkey, Azerbaijan and Armenia, making it a natural transit corridor for the land-locked countries of Central Asia, and between Russia, Europe, and the Middle East. Prior to independencein 1991, per capita income was US$1,600, ranking it inthe middle of the 15 former Soviet republics. During the Soviet period, Georgia exported agricultural, metal and industrial products to the Soviet market, often under preferential terms, and was a very popular tourist destinationfor the rest ofthe Soviet Union. It was also among the largest recipients of energy and other subsidies (on a per capita basis). Georgia's transition to an independentstate was very difficult Large transfers were cut-off, trade disrupted, and preferentialmarket access eliminated. The outbreak of a civil war and hyperinflation inthe early 1990s ledto an economic collapse worse than inany other CIS country. By 1994, output had fallen by 70 percent and government revenues fell to levels that severely impaired the public sector's ability to deliver social services. Real wages were 90 percent below the 1990 mark and unemployment registered 20 percent. Stabilization and Structural Reforms 1.2 Upon the cessation of internal conflicts in 1994, the Government initiated market-basedreforms aimed at dealing with the economic devastation that followed the first years of independence. These reforms are discussed below and are summarized inBox 1. 1.3 Stabilization. The stabilization program launched in the mid 1990s succeeded in eliminating hyperinflation and the rate of inflation was brought down to single digits by 1997. Tight fiscal and monetary policies have helpedto maintain single digit inflation. There was a brief upswing in inflation in 1999, that was linked to the devaluation of the Georgian Lari (GEL), after the fall of the Russian Ruble during the financial crisis of 1998. At the time, the exchange rate regime was fully liberalized and the real effective exchange rate depreciated significantly in late 1998 and early 1999, but has remained roughly stable over the last five years (see below). However, domestic interest rates, though declining, are still high (about 20 percent inreal terms), reflecting relatively high risk premiums. 1.4 While good progress has been made in stabilizing prices and the exchange rate, Georgia's fiscal and external situation remain fragile. Domestic arrears accumulatedduring much of the period, and both government revenue and expenditure levels (as percent of GDP) are low by regional standards. With gross foreign reserves of less than two months of imports', the country is extremely vulnerable to external shocks. Georgia's external debt service obligations absorb a considerable share of central government revenues (about one third in 2002). The most recent debt sustainability analysis (DSA), carried out in collaboration with the Fund, indicates that concessional debt relief will be required to keep debt service obligations at manageable levels beyond 2002, when the current Paris Club rescheduling agreement expires. 1.5 Structural Reforms. First generationreforms such as trade liberalization and mass privatization were completed early in the reform process. Subsidies were eliminated, most prices liberalized (with the exceptionof commercialtransport andpublic utilities), and a simplified tariff schedule adopted. By 1996, small scale privatization involving about 15,000 enterprises and the distribution of land to small farmers had beenvirtually completed. I Of goods and services. Table 1.1: Georgia: Selected Macroeconomic Indicators 1995 1996 1997 1998 1999 2000 2001 2002 Annual RealGDP Growth("'0) 2.6 10.5 10.6 2.9 3.0 1.9 4.7 5.4 GDP Level(1990=100) 26.9 29.7 32.8 33.8 34.8 35.4 37.1 39.1 Average Annual Inflation, CPI ("'0) 162.7 39.3 7.0 3.6 19.1 4.0 4.7 5.6 MoneySupply Growth(%) 135.2 42.0 46.0 -1.2 20.7 39.0 18.5 17.9 FDI(millionUSD) 6.3 54.4 236.3 221.0 61.7 152.6 79.9 129.9 BudgetDeficit, as %GDP -8.1 -7.3 -6.8 -6.1 -6.7 -4.0 -2.0 -2.0 Tax Revenues, as YOGDP 7.0 10.6 12.7 12.8 13.8 14.2 14.3 14.8 TotalTrade, as %GDP 28.6 28.8 33.0 29.6 30.0 32.2 31.1 30.4 Current Account, as % GDP -11.3 -8.9 -10.5 -10.7 -8.5 -5.4 -5.6 -6.9 Gross ForeignReserves (ImportCover) 2.3 2.2 1.5 1.0 1.2 1.o 1.4 1.8 ExchangeRate, LariNS$(Annual 1.280 1.250 1.297 1.39 2.02 1.98 2.07 2.20 Average)" Domestic interestrates (lending,as of 33 26 23 23 24 end-December) XI)^' Source: World Bank, IMF and Georgia State Department of Statistics. a/ The Lari was introducedin October 1995. b/ 2002 data is as ofend-October. 1.6 After a rapid start, the privatization of larger enterprises stalled, partly due to low investor interest. Some 1,300 medium and large enterpriseswere converted intojoint-stock companies and about 1,000 were privatized totally or partially, mostly to local investors. Today, the governmentstill controls a few large industrial enterprises originally slated for privatization (most with negative net-worth) and strategic infrastructure in public utilities (water, power, telecommunications) transport (ports, railways). The Tbilisi electricity distribution company was sold to a strategic foreign investor (AES), but in the absence of reputable buyers for regional companies, the Government has opted for private management contracts, a model recently adopted to run transmission, dispatch, and the wholesale electricity market. The Government is inthe process of granting concessions for the operation of port terminals, but progress has been slow due to legal disputes over land ownership of port's container terminal. Efforts to privatize telecom land lines, through internationaltenders have provedunsuccessful due to lack of investor interest. The cellular phonemarket has been liberalized. 1.7 Following the adoption of several market-basedpolicies and laws, in June 2000 Georgia became a member of the World Trade Organization (WTO). However, implementation remains poor in critical areas such as customs and tax administration. Weak institutional capacity and poor governance are the major causes. Notably, widespread corruption has tilted the playing field for business and encouraged informal sector activities and a large "shadow" economy (see below). Surveys o f domestic and foreign investors indicate that administration and regulation, policy instability and corruption are main obstacles to investment. These factors have increased the costs of doing business and added significantly to investmentrisk. The effect has been to slow the growth o f existing enterprises and to stifle entry of new businesses, the leading driver of growth in the more successful transition economies of Central and Southeastern Europe. Chapter 1. Macroeconomic Setting 3 Box 1. Key Steps of Reform Program in Georgia 991-1994 Liberalization o f pricesand trade 1998 Tbilisi electricity company privatized Establishmentof Central Bank Law on securities marketadopted Export tax to non-CIS removed Free floating exchange rateregimeadopted Unified import tariff structure introduced Foreigndebt restructuring 995 Trade regulations streamlined 1999 Registrationo fagricultural landtitles begins Voucher privatizationbegins Oil pipelineBaku-Supsacompleted Large scale privatization begins Council o f Europemembershipapproved New currency (Lari) introduced New licensinglaw approved 996 Competition law adopted 2000 Stock exchangetradingbegins Voucher privatization ends WTO membershipapproved First bank privatized Full current accountconvertibility introduced 991 Bankruptcylaw adopted 2001 New privatization law adopted InternationalAccounting Standards introduced for all banks Electricity law adopted ParisClub debt rescheduling Independentelectricity regulator established New procurementlaw approved Treasury bills market initiated New Tax Codeapproved TheEconomy 1.8 Growth. The economic response to the reforms launched in the mid 1990s was dramatic at first, with real GDP growth rebounding at an annual average of 10.6 percent in 1996-97. However, adverse exogenous shocks together with unfinished reforms and a poor business environment have hampered economic growth in subsequent years. During 1998-2000, real GDP growth slowedto 3 percentannually with the impact of the 1998 Russian crisis and severe droughts in 1998 and 2000. Although real GDP growth picked up in2001-02, to an average of 5 percentannually, today's real GDP has recoveredto only 40 percentofthe 1990 level. 1.9 Growth has relied primarily on domestic absorption while the contribution of exports has been modest. Although exports have grown faster than GDP since the mid-1990s, the share of exports in total GDP2was still less than 20 percent of GDP in 2002. By comparison, in other small CIS countries with similar economic structures such as Moldova and the Kyrgyz Republic, exports represent 55 and 40 percent of GDP, respectively. 2 Ofgoods and services. Although exportsare thought to be under-reportedby about40 percent, GDP is also believedto be under-reported by a similar proportion. Chapter 1. Macroeconomic Setting 4 1990=100 Figure 1.1. Georgia: Index of Real GDP and Exportsto GDP ("/.I 1 120 , , 120 20 1 40 O I l o 1990 1991 1992 1993 1994 1995 1996 1997 1998 1999 2000 2001 2002 Source: ECA Regional Databaseand GeorgiaState Departmentof Statistics. Data on services in 1990 is staffestimate. 1.10 Growth has been uneven over the past five years, with agriculture declining in real terms and industry virtually stagnating (see Figure 1.2). Transport has been the fastest growing sector, growing at over 20 percent annually because of the rapid expansion of oil transit from the Caspian Sea. Although transport turnover has tripled, it is still one third the pre-independence level. Other fast growing sectors includeconstructionandfinancial services. Trade has grown slightly faster thanoverallGDP. Figure 1.2 Georgia: Index of Sectoral Growth (1996=100) Agriculture, Forestry, IO0 Fishing X +Industry X m '00 - -A- Construction 50 - -x-- Trade, Restaurant & Hotel services 00 - - x - Transport & Communications -o- Financial intermediation 500 ~ 1996 1997 1998 1999 2000 2001 2002 +GDP Source: GeorgiaState Department o f Statistics. 1.11 Economic Structure. Agriculture, industry, trade and transport dominate the structure of the Georgian economy. Agriculture is the largest sector accountingfor just below 20 percent of GDP and 50 percent of employment. However, its share in GDP has decreasedsteadily (from over 30 percent o f GDP in 1996). Industry contributes about 14 percent of GDP and 6 percent of employment. Although Chapter 1. Macroeconomic Settinp 5 declining in some years, its share remains constant. The share of transport and telecommunications has nearly tripled from 4.6 percent in 1996 to 12.1 percent in 2002. Table 1.2: Georgia: Share of the Shadow Economy - (inpercent ofGDP) 1996 1997 1998 1999 2000 2001 2002 Industry 46 43 40 39 37 37 39 Agriculture 15 12 9 9 11 9 8 Construction 38 35 38 38 60 56 54 Transport 38 35 36 37 35 39 44 Telecommunications 23 23 19 24 22 18 17 Trade 66 60 57 56 64 69 67 Restaurant,Hotel 62 61 60 64 67 70 70 GDP 29 28 28 29 33 33 34 Source: Georgia State Departmentof Statistics. 1.12 The "Shadow" Economy. The shadow economy in Georgia accounted for an estimated 34 percent of total output in 2002, and is increasing. This share has increased by 17 percentage points since 1996. The shadow economy is estimated to account for over one half o f total activity in construction, trade and services (such as hotels and restaurants). Also, the "unobserved activity" is said to be as much as 58 percent of total output within the enterprise or business sector. Poverty 1.13 Poverty and income inequality have increased sharply in Georgia since independence. The initial fall in output and subsequent low rate o f growth over the decade resulted in a severe decline in real income for many people. Today's per capita income of US$700 per annum is 40 percent the pre- independence level. The civil war in the beginning o f the period, as well as conflicts in Abkazia and South Ossetia generated an influx of refugees (about 300,000) into the large towns of Georgia, adding to the poverty problem. 1.14 Currently about one quarter o f the population lives in poverty and 60 percent are at risk o f falling below the poverty line. According to Georgia's household data, the incidence o f poverty increased from 14 percent in 1997 to over 20 percent in 1998-2000.4 This increase in the incidence o f poverty is consistent with the observed increase in the unemployment rate from 11.4 percent of the labor force in 1997 to around 16 percent in 2001. Weak economic growth duringmuch o f the period accounted for the increase in poverty. Also, economic growth was concentrated in communications, financial intermediation, and transport, whose share in total employment is less than 5 percent. Agricultural activity, which accounts for 50 percent o f total employment and plays a safety net role in Georgia, sufferedsevere droughts in 1998 and 2000. In2002 output was below the 1997 level. This affected both rural and urban incomes, the latter by impacting seasonal employment for harvest activities. The accumulationo f large arrears inpublic sector wages and pensions during 1998 and mid-2000 (amounting to about US$135 million or 4.5 percent o f GDP) also reduced household incomes.' Accordingto World Bank estimateo f poverty line. See: GeorgiaPoverty Update, World Bank, January 10,2002. Chapter 1. Macroeconomic Setting 6 Figure 1.3. Georgia: Employment by Economic Activity (1999) Agriculture Trade, Restaurant& Hotel services Industry Transport and communications Construction Financialintermediation 0 10 20 30 40 50 60 %ofemployed population , Source: Georgia State Departmento f Statistics. 1.15 Inequality has also increased over the past decade. The Gini Coefficient o f income per capita in Georgia increased from 0.29 to 0.43. The poor have suffered disproportionately from inadequate access to health and education services and from deteriorating basic infrastructure, especially water and electricity. International Price Competitiveness 1.16 The Real Effective Exchange Rate. A country's international price competitiveness can be measured by the evolution o f its real effective exchange rate (REER).6 InNovember 1993, the Georgian coupon was introducedas an intermediary currency to replace the Russian Ruble, and in October 1995 the Georgian Lari became the national tender. During 1994-96, the REER appreciated substantially (by 167 percent) mostly on account of much higher inflation inGeorgia than inits two major trading partners (Le., Russia and Turkey), as the country was still dealing with triple digit inflation. However, aside from temporary changes, the REERhas remained relatively stable since 1997 (see Figure 1.4).' 1.17 The relative stability o f the REER since 1997 masks off-setting movements of the Lari against two major currencies: the Turkish Lira and the Russian Ruble. For example, the Russian financial crisis triggereda significant nominal depreciation ofthe Lari against the TurkishLira(and the US dollar) in late 1998 and early 1999, but this effect was largely off-set by a nominal appreciation o f the Lari against the Russian Ruble (as the latter depreciated more sharply against the U S dollar). On balance, however, the REER depreciated by 9 percent between 1997 and 1999. In 2000, the REER reverted back to the pre- crisis level and remained around that level in 2001. Again, in 2001, the relative stability of the REER reflected compensating effects, with the Lari appreciating vis-a-vis the Turkish Lira (as the Lira plummetedagainst the U S dollar ) while depreciating against the RussianRuble. It should be notedthat Real exchange rate = eJkp,dpk,where e is the nominalexchange rate, p price of traded goods, andj and k index of major tradingpartners. The real exchange rate measures a country's competitive positionresultingfrom changes in the nominal exchangerate and cost-price relationships relativeto its trading partners. The price series is used as a deflator and can be based on consumer prices, producer prices, the GDP deflator, or unit labor costs. Many studies o f country macroeconomic price competitiveness favor the use o f unit labor cost as a deflator, because it shows the joint effects of changes in labor productivity and in wages. Unfortunately, a consistent time-series of aggregateunit labor cost is unavailable for Georgia. As a substitute, the consumer price index is used, which allows comparability with other countries. ' REER is calculated based on trade weighted average of Georgia's exchange rate vs. that o f its 16 major trade partners; Russia, Turkey, Azerbaijan, Germany, US, Ukraine, UK, Armenia, Italy, Bulgaria, Switzerland, Turkmenistan, Romania, France, Greece, and Netherlands. , Figure 1.4. Georgia: Index of Real Exchange Rate Foreign Currencynari (1995=100) 160- 140- I20 ~ 100. 80- 60 +Russia 40 20 +Turkey 1994 1995 1996 1997 1998 1999 2000 2001 2002 -m-us Note: Increaseindicates an appreciationin Lan Source: World Bank and IMF +REER in2001compared to 1997, the Lari was still appreciatedinrea1te m s against the RussianRuble (22 percent) while it was depreciated against the U S dollar (24 percent) and the Turkish Lira (8 percent). REERdepreciated further by 7 percent in2001-2002resultingmostly from its declining value against the TurkishLira(15 percent). 1.18 Cost of Non-tradables. The costs o f non-tradables (such as labor and infrastructure) also play an important role in determining a country's competitive position as a location for footloose foreign investors, particularly in 1abor-intensive manufactures. A s T able 1.3 s hows, c ost trends for these key non-tradables has been moving moderately upward since the mid 1990s, but are still relatively low by international standards. 1.19 Average real wages for b0th slulled and unskilled1abor have increased considerably over the period, albeit from a very low base. In US dollar terms, the average wage paid to skilled workers increased from US$34 per month to US$55 per month in 1998, which i s low by international standards. Also, the wage paid to shlled workers was only 38 percent higher than the wage paid to unskilled and semi-skilled workers (US$40 per month). Table 1.3: Georgia: KeyNon-tradableCosts, 1996-2002 Wages (monthly average) 1996 1997 1998 1999 2000 2001 2002 Real Wages (Index) Unskilled and semi-skilled 100 103.8 137.0 139.8 134.0 128.8 137.1 Skilled 100 123.0 145.4 143.9 155.6 164.5 186.7 Nominal (inUS$) Unskilled and semi-skilled 33 36 46 39 39 38 40 Skilled 34 43 50 40 46 49 55 Electricity (US$cents/KwH) 2 3 4 4 5 5 6 Water (~~$cents/m~) 32 45 43 30 30 29 47 Source: Georgia State Department o f Statistics. 1.20 Although the wage differential between skilled and unskilled (and semi-skilled) labor has widened somewhat since 1999, it is still relatively narrow. A number o f factors may explain currently low wage differentials, including (i) Georgia's relatively more homogenous education levels, particularly in terms of post-basic education; (ii)highlevels of unemployment--estimated at 16 percent of the labor force in 2001- resulting ina surplus o f skilled labor; and/or (iii) low labor productivity linkedto outdated capital equipment and technologies. Chapter I. Macroeconomic Setting 8 1.21 Georgia has steadily adjusted electricity tariffs since the mid 1990s, bringing them closer to international levels in U S dollar terms. In 2002, the average tariff was US$0.06 per KwH, while the average for OECD countries was US$0.07 per KwH. Water charges, however, have remained well below international levels throughout the past decade. Infact, having declined from US$0.45 per m3in 1997 to US$0.29 per m3in2001, water tariffs were raised to US$0.47 per m3in2002 which is still less than half the average for OECD countries (US$ 1.05 per m3). It should be noted that actual payments for both electricity and water services are rather low, suggesting that tariff increases may not fully carry over to firms' costs. However, poor reliability o f water and electricity services has meant that firms have had to incur additional fixed costs (such as generators) to secure adequate supplies. The Business Climate 1.22 Georgia has made progress in liberalizing the trade regime and establishing reasonable price incentives, such as a competitive exchange rate, but competitiveness at the firm level i s reduced by an unfavorable business environment. Even though countries in the CIS region have similar problems to those inGeorgia, Georgia's are deeper, particularly inthe area o f governance, as discussedbelow. 1.23 The Business Environment and Enterprise Performance Survey (BEEPS) conducted in 1999 and 2002,' indicates that the business climate in most transition countries improved relative to 1999. The report acknowledges that part o f the improvement in firms' perceptions may be influenced by the more positive business cycle that followed the Russian crisis. Indeed, transition economies have been able to sustain investment levels despite the sharp decline in global FDI flows over the past two years. For example, Russia moved from 32ndto 17thplace inthe latest annual global investment attractiveness study by the consultancy firm AT Keamey. Such a huge leap may reflect greater confidence in the Russian economy which has been growing by over 10 percent in recent years.' Even adjusting for growth, however, the BEEPS found that the business environment improved both in terms o f the perceptions of firms as well as a number o f more quantitative indicators. 1.24 Inthe case of Georgia," the BEEPS also found that between 1999and 2002 the business climate improved in all areas, with the strongest gains reported in the areas of access to finance and reducing corruption. Still, Georgian entrepreneurs see taxation and corruption as the biggest obstacles to business, with taxation faring the worst. Since there are some questions about the comparability o f the two BEEPS," it is probably safer to c ompare Georgia with the rest o f the CIS region based on the 2002 results. As shown in Figure 1.5, Georgia fares worse than the region in the areas o f corruption, taxation and the rule o f law (i.e., street crime, mafia). Regulations, the judiciary and infrastructure are perceived as less problematic in Georgia and in these areas the country fares slightly better than the CIS average. Access to finance inGeorgia is about the same as inother CIS countries. The BEEPS, developed jointly by the World Bank and the European Bank for Reconstruction and Development (EBRD) surveyed over 4000 finns in 22 transition countries in 1999, and 6,000 firms in 27 transition countries in2002. At the same time, it is reported that investment outflows were also large making net FDI flows negative during 2000-01. lo Of the 174 firms interviewed inGeorgia, more than halfwere located inTbilisi, and 75 percent were considered small businesses. The questions and sample used inthe two surveys are often different. Climate2002 Financing +Worst case --&-Georgia Source: World Bank & EBRD, BEEPS I1, 1.25 The biggest single problem for Georgianbusinesses is taxation, both administration and high tax rates, which leads to under-reportingof sales in order to avoid taxes. As shown in Figure 1.6, Georgian firms report only 60 percent of their sales in order to avoid taxes, comparedwith an 80 percent average in the CIS. I Figure 1.6. Share of Annual Sales Reported for Tax P n m n r P r . 2 0 20 40 60 80 100 9'0 I Source: World Bank & EBRD, BEEPS 11. 1.26 Several quantitative indicators were used to measure corruption. The "time tax"-the amount of time senior managers spend in dealing with public officials regarding the application of laws and regulations- is quite high in Georgia, about 12 percent versus less than 8 percent for most CIS countries. Another indicator is the percentage of sales spent in bribes was 2.7 percent in Georgia comparedto less than 2 percent inthe CIS (see Figure 1.7). 1.27 The BEEPS results are consistent with the recently completed Georgia's Cost of Doing Business Figure 1.7 Share of Annual Sales Paid (CDB) survey, which compares data between 2000 and in Bribes, 2002 2002. The CDB survey found that while regulatory ,w) constraints (e.g., for licensing and inspections) have 2 decreased, associated bribes have actually increasedover 1 the period. The practice of side-payments has been formalized and firms tend to use "intermediaries" to cope 0 with these constraints. In addition, the regulatory rgia environment continues to be perceived as volatile and unpredictable. This is particularly problematic for Source: World Bank & EBRD, BEEPS 11, foreign investors who have not bought local protection. Chapter 1. Macroeconomic Setting 10 some foreigners feel that court decisions are biasedtoward the local partner, incontraventionof Georgian laws. Also, foreign investors have beentargets of violence, including kidnapping for ransom. 1.28 Similarly, an earlier study on administrativebarriers conducted by the IFC's Foreign Investment Advisory Service (FIAS) in December 2000, indicated that Georgia is perceived as having significant obstacles to investment inthe areas of taxes and regulations,policy instabilityhcertainty and corruption. Moreover, constraintsto business operationsfor Georgian enterprises are worse inall categoriessurveyed by FIAS inthe Europe and CentralAsia region, excludingthejudiciary and anti-competitive practices. 1.29 It should be noted that both the BEEPS and the FIAS surveys found that macroeconomic instability is still a major concern for Georgian businesses. A more detailed breakdown of the BEEPS results, indicates that macroeconomic instability is the third most serious constraint for Georgian firms, after tax administration and economic policy uncertainty. Figure 1.8 Perceptionof Major Obstaclesto BusinessGrowth 2002 Businesslicensmg& permits Access to financing Functioningofthejudiciary Cost of financing Anti-competitivepractices Elecmcity Customs&trade regulations Tax rates Corruption Macroeconomicmstability Econonuc policy uncertainty Tax administration 0 S I O IS 20 25 30 K of firms 35 40 45 ource: World Bank & EBRD, BEEPS I1 Chapter 2. Trade and InvestmentPerformance External Trade Merchandise Trade 2.1 The disruption of traditional trade links with the former Soviet Union ledto the collapse of output and trade in Georgia. While the economy began to recover in the mid-1990s, its true level is not fully captured by official statistics because of the large size of informal sector activities. Inthe case of external trade, smuggling o f imports and exports is significant owing to Georgia's porous borders, weak customs, and corruption. 2.2 Official trade data are collected by the State Customs Department (SCD) and reported by the State Department o f Statistics (SDS). The National Bank o f Georgia (NBG) adjusts SDS data with estimates o f unrecorded trade based on the information from Georgia's major trading partners.l2 However, partner trade data from Russia, Georgia's main trading partner, appearsto be underreported and NBGuses an adjustor which is not based on hard data.13 The gap between SDS and NBGdata has been narrowing over time, but both data differ markedly from partner data reported by the UN COMTRADE database. The latter, however, seems to be the least reliable o fthe three data sources.14 Table 2.1: Georgia Trade Statistics Comparison of Data Sources - Exports (million dollars) 1994 1995 1996 1997 1998 1999 2000 2001 SDS (official data) 152 152 199 240 192 238 330 320 NBG 381 363 417 494 478 477 505 434 UNCOMTRADE" 110 224 251 343 288 405 633 617 Imports (million dollars) 1994 1995 1996 1997 1998 1999 2000 2001 SDS (official data) 337 395 687 942 880 602 651 684 NBG 746 700 768 1052 1164 1013 908 963 UNCOMTRADE" 359 532 534 978 951 729 788 791 I/UNpartnertradedata. 2.3 Given the poor quality of the data, it is difficult to analyze trends. Nevertheless, a few points can be made on relative levels. According to SDS data, total trade averaged around 30 percent o f GDP during 1995-2001. In 2001, the NBG estimated the size of the unrecorded trade at an average of 36 percent of official registered exports and 44 percent o f official registered imports. With the adjusted figures the trade to GDP ratio would be 44 percent, but ifGDP, which is also believed to be underestimated by some 30 percent, were also to be adjusted, the actual trade to GDP ratio would be around 34 percent. It can be also ascertained that Georgian trade was in chronic deficit throughout the period, peaking at nearly 20 percent of GDP in 1997-98. Estimates by NBG are also unreliable.NBG collects partner data from Georgia's seven major trading partners, and adjusts SDS data according to proportional differences with NBG for each partner after correcting for cif-fob differences. But only afew reportregularlyand insome cases, such as Russia, partner data are also under-reported. In this case, NBG assumes an adjustment ratio which is not based on actual information. The IMF relies on NBG estimates for reportingof Georgiantrade statistics. l3 The data reportedby Russia is actually lower than that reported by Georgia. l4 The coverage o f CIS reporting countries in the UN COMTRADE database is not comprehensive. Some CIS partners of Georgia began reporting to COMTRADE only from 1997. There are also problems with misclassificationo f goods intransit as exports from Georgia. This is particularly the case with exports of oil and oil products from Azerbaijanintransitthrough Georgia. Table 2.2: Georgia: Trade Balance, 1994-2002 1994 1995 1996 1997 1998 1999 2000 2001 2002 Exports(m$) 152 152 199 240 192 238 330 320 325 Imports(m$) 337 395 687 942 880 602 651 684 720 Trade balance(m$) -186 -243 -488 -702 -688 -364 -321 -364 -395 GDP (m$) 823 1909 3072 3576 3620 2804 3043 3210 3302 ExportdGDP 18 8 6 7 5 8 11 10 10 Trade/GDP 59 29 29 33 30 30 32 31 30 Trade balance/GDP 22.6 12.8 15.9 19.6 19.0 13.0 10.5 11.3 12.0 Source: Georgia State Department o f Statistics. 2.4 Exports. According to SDS data, the value Figure 2.1 Georgia: Exports by Country Groups o f merchandise exports more than doubled between l 1995 and 2001, but based on NBG data the increase was only 20 percent. Either way, export levels are modest, accounting at best for 13 percent of official GDP. Estimates of export volumes are not available and have not been estimated given unreliable value series. It is therefore difficult to link trade flows with other macroeconomic indicators such as the exchange rate. It has been reported however that the appreciation o f the Lari against the Russian Ruble in 199419951996199719981999.200020012002 1999 and the Turkish Lira in 2001 had an adverse Source: GeorgiaStateDepartment of Statistics impact on Georgian exports to these markets. 2.5 Imports. On the import side," part of the growth recorded in 1997-98 was the result of capital 1 Figure 2.2 Georgia: Imports by Country Groups ~ imports associated with the construction of the Supsa oil pipeline connecting Azerbaijan to the Black Sea. The completion o f the project in 1999 coupled with the depreciation of the Lari led to a 0 Others significant decline in the value of imports that year. Despite the considerable real appreciation of the Lari I CIS vis-a-vis the Turkish Lira in 2001, imports from Turkey did not increase much, possibly because at the time the real exchange rate was still depreciated 19941995199619971998199!?200020012002 relative to 1997.16 Source: GeorgiaState Department of Statistics 2.6 The following sections analyze the direction and composition of trade basedon SDS data, as it is the only source which compiles this information on a consistent basis. 2.7 Direction of Trade. The number of trading partners of Georgia increased from 79 in 1996 to 107 in 2001. According to SDS data, the CIS countries have remained Georgia's main trading partners (namely Russia, Azerbaijan, Armenia, Turkmenistan" and, Ukraine), but their share appears to have l5 Georgiadepends on imports for most of its energy requirements. Russia supplies oil and gas, Turkmenistan only gas, and Russiaand Azerbaijanbothsupply electricity. l6 Imports from Turkey increased by about 1 percent in 2001compared to previousyear according to official data. The NBG adjusted data on importsfrom Turkey show an increaseof 8.4 percent in 2001. Real appreciation o f Lari a ainst lira was 25 percent. I` Trade with Turkmenistan is determined by Georgia's high naturalgas requirements, particularlyduringthe winter months, as well as paymentsinkindrelatedto debt owed from gas deliveriesinthe past. decreased considerably over time. Trade with non-CIS has been expanding and is led by Turkey which has been an important source for imports of consumer goods. Exports to Turkey increased from 13 percent o f total in 1996 to 23 percent in 2000 replacing Russia as the main export market in that year. However, exports to Turkey decreased by 8 percent in 2001 as the Lari appreciated against the Turkish Lira. Exports have also been growing to more non-traditional markets such as the EU (Germany, UK, and Italy), Switzerland, and the US. 2.8 The share of CIS intotal Georgia's export declined from 62 percent in 1995 to 45 percent in2001 while imports from CIS declined from 40 percent to 37 percent. Duringthe same period, the share of exports to the EU more than tripled from 5 percent to 18 percent. In particular, Germany has become a major export market with its share raising from 2 percent in 1996 to more than 10 percent in 2000. Exports to "Others" increased from 10 percent in 1996 to 18 percent in 2001. Similarly, on the imports side, the share of "Others" increasedfrom 23 percent of total imports in 1996 to 27 percent in2001. 2.9 Composition of Trade. Georgian exports consist mainly o f natural resource-basedproducts (from mining and agriculture). Exports of ferrous alloys have declined over the last few years; their share in total exports in 2002 (4.4 percent) was less than half of their share in 1998 (12 percent). Besides aircrafts that have heldthe highest share in total exports in 2001-2002, scrap metal has been the leading export in the last couple of years, accounting for 10-11 percent of total export value. Turkey and Russia are the main export markets for the Georgian scrap metal. Exports of scrap metal were temporarily banned in 1995-1999 and again in 2002 (from January to June). Gold has also emerged as an important export with its share increasing to 9 percent of total exports in 2002. Table 2.3: Georgia: Major Export Categories 1996 1997 1998 1999 2000 2001 2002 (percent o ftotal) Total 100 100 100 100 100 100 100 Aircrafts 0.2 0.3 0.3 8.0 2.1 11.2 12.6 Scrap Metal 7.9 7.3 0.5 9.9 11.8 10.3 10.3 Wine 6.3 5.2 8.0 6.1 8.8 10.1 10.3 Gold 0.0 0.0 0.1 0.0 0.0 3.7 8.8 MineralWater 2.5 7.3 3.7 1.1 2.9 3.6 4.9 Ferro-Alloys 3.9 6.5 11.6 8.4 4.1 5.5 4.4 Fertilizer 6.0 5.8 5.5 4.8 4.9 1.4 3.4 Freshand Dried up Nuts 1.o 2.2 4.9 6.4 5.9 3.1 1.9 Electricity 6.6 5.0 2.8 4.1 2.2 3.4 1.8 Crude Oil 3.4 6.0 3.O 2.0 3.9 2.9 1.8 Tea 8.5 5.8 4.6 4.8 1.8 1.8 1.3 Oil and Oil Products (except crude oil) 8.7 5.6 4.8 3.O 2.0 1.5 1.1 Source: Georgia State Department of Statistics. 2.10 Within the food and agricultural products category, wine, hazelnuts, mineral water and tea are among major exports of Georgia. Wine exports have had a nine fold increase from US$4 million in 1995 to US$36 million in 2002. About three quarters o f Georgia's wine exports are to Russia, although Georgia has begun to export small volumes to a number o f other countries as Hazelnut is also being established as a new export product, mainly to Turkey, with exports reaching US$22 million in 2000.'9 Exports of mineral water had the highest share of total exports in 1997 (US$17.6 million) but lost more than $10 million by the end o f 1998 due to the crisis in Russia. Since 2000, the value o f exports of '* Ukrainei ~~~ ''A s the second largest market for Georgian wine (10 percent) followed by the US (3 percent). special government commission has beenestablished by presidentialdecree to support and coordinate hazelnut productioninGeorgia. mineral water has been rising and by 2002 had increased to above US$17 million, or about 5 percent of total exports. 2.11 Main commodity imports include oil and gas products; wheat and flour; medical supplies; and sugar. The share of registeredimports of oil productsas well as wheat and flour has been declining since 1996 due to increased levels of smuggling, especially of diesel fuel. Part of the problem in controlling smuggling is that large volumes of these products go through Georgiaintransit to other countries such as Armenia andAzerbaijan. Table 2.4: Georgia: Major Import Categories 1996 1997 1998 1999 2000 2001 2002 (percentoftotal) Total 100 100 100 100 100 100 100 Oil and Oil Products(except crude oil) 23.3 16.2 14.8 9.6 11.1 12.9 12.0 Oil Gas and Hydrocarbon 12.8 8.0 6.2 10.4 7.5 6.9 7.0 Medical Supplies 2.1 3.8 4.1 6.9 5.2 5.7 6.2 Cane and Radish Sugar 4.8 4.1 1.8 2.7 3.8 3.5 4.6 Motor vehicles 0.4 4.8 7.4 6.3 2.6 1.8 2.9 Wheat and Barley- Mix and Flour 16.5 10.0 6.6 5.1 6.5 3.8 2.8 Cigars and Cigarettes 4.5 11.4 0.9 5.8 4.5 2.8 2.5 Electricity 2.1 2.8 2.9 2.4 2.3 2.0 2.0 Source: Georgia State Department of Statistics. Tradein Sewices 2.12 The services sector contributes with about 40 percent of total export receipts in Georgia. Both transport and tourism basically collapsed after independence, but began recovering in 1995. Earnings from transport services increasedmore than 2.5 times from US$74 million in 1996 to US$193 million in 2002 mainly becauseGeorgiais atransit country for trade within region. This trade representednearly 60 percent of official merchandise export in that year. Freight transport, particularly through railways, has had the biggest share of total transport earnings throughout the period 1996-2002 with the exception of 1997.20Service charges from transportation of cargo earnedGeorgiamorethan US$104million in 2001. 2.13 Trade in travel services is more dominated by business travel as compared to personal travel. Receipts from business travel has on average been almost twice that of the personaltravel during 1996- 2002. The travel service,activities were particularly strong during 1997-1998, the period of pipeline construction, especially payments related to business travel in that period. Although travel related services slowed down in 1999 and 2000, it has since recoveredrapidly. The balanceon net travel services turned positive in 2001 amountingto US$lO million and more than doubledto 23 million in2002. 2o Services data has the same shortcomings in accuracy and coverageas the merchandisetrade data. Inthat respect, the 1997 data here showing an exception to the trend might simply be a data error, or the increase inrevenues could be from the services associated with the construction ofthe pipeline in 1997-98. ChaDter 2. Trade and Investment Performance 15 Foreign Direct Investment Table 2.5: Georgia -Transport and Travel Services POI) (million dollars) 1996 1997 1998 1999 2000 2001 2002 2.14 Foreign Direct Investment Transport,Credit 74 91 150 97 102 169 193 (FDI) into Georgia has been small Passenger 9 28 41 13 9 19 21 and declining (as a percent of Freight 36 24 73 67 70 104 99 GDP) in recent years. This o/w Railway 14 13 71 54 51 73 85 explains to some extent the low Other 19 39 27 10 16 16 43 level of development of the export Pipeline 10 0 9 7 16 31 31 Transport,Debit -78 -67 -80 -86 -89 -98 -107 sector.21 According to official Passenger 0 -14 -13 -5 -19 -29 -40 sources, FDI to Georgia amounted Freight -59 -36 -33 -36 -45 -52 -58 to US$977 million during 1997- Other -18 -17 -34 -44 -25 -17 -8 2002. The highest levels of FDI Travel, credit 8 47 188 118 97 117 133 were recorded during 1997-98, at BusinessTravel 8 34 117 83 68 72 81 US$243 million, and 265 million, PersonalTravel 0 13 71 35 29 46 52 respectively, largely reflecting Travel, Debit -10 -156 -226 -130 -110 -107 110 investments for the constructionof Business Travel 0 -147 -189 -91 -77 -62 64 the Baku-Supsa oil pipeline and Personal Travel -10 -9 -38 -39 -33 -45 46 the Supsa terminal. The pipeline Source: GeorgiaState Departmentof Statistics. openedinApril of 1999, the first pipeline to carry oil from the Caspianbasinthrough Georgiato the west. Subsequently, most of recorded FDI flows were linked to the privatization of energy distribution and thermal plants to AES, which has brought around US$250 million to Georgia since 1999. Excluding these two largeprojects, FDIflows averaged only US$5 million ayear. 2.15 Other investors currently in Table 2.6: Georgia Foreign Direct Investment - Georgia arrived around 1996-97, (million dollars) during a period of opportunity for 1997 1998 1999 I I 2000 2001 2002 niche businesses, including those FDI 1I 243 II 265 1I 81 132 I1 110 II 146 that emerged in the context of As percent o f Georgia's privatization program. Investment 67.0 65.8 16.0 25.6 19.8 26.2 According to many of these GDP 6.8 7.3 2.9 4.3 3.4 4.4 investors, political links (for example through diplomatic channels), also played an important role. Currently, there are only about 100 companies in Georgia with foreign capital, out of a total of 2,000. 2.16 From a regional perspective, however, Georgia is not worse off than most CIS countries of similar size and natural resource endowment. Overall FDI flows into the CIS region have been rather modest, representingonly 3 percent o f total flows to developing countries.22 In 2001, FDI flows to the CIS countries amounted to US$7.2 billion, which were well below those to Latin America (US$ 85 billion), EasternEurope (US$27 billion) and even Africa (US$lO billion).23 Most of FDI flows into the CIS region have been linked to natural resource exploitation (e.g., oil and gas development) or/and privatization of state-ownedenterprises, which is now winding down. In absolute terms, over 80 percent of FDI within the CIS region was directed to Kazakhstan and Russia. In per-capita terms the main The quality of official FDI data is even weaker than that for foreign trade. Until 1999 estimates were based on imports entering the country tax free under the special regime for foreign investment. For subsequent years, SDS appliesnotional ratesto estimatethe share ofFDI intotal imports. 22 FDIdata inthis section is takenfrom UNCTAD, World InvestmentReport,2002 unless stated otherwise. 23 IncludingNorthAfrica. ChaDter 2. Trade and Investment Performance 16 recipients were Kazakhstan and Azerbaijan, with Georgia faring better than most CIS countries, including Russia and Ukraine.24 Figure 2.3 Average FDIPer Capita, 1992-2001 ~ 90 % 60 50 40 30 20 10 n Private Income and Transfers 2.17 Private income and private transfers including workers' remittances have been an important source o f foreign exchange earnings in Georgia. Although they have been declining since 1999 and only started their recovery in 2002, their contribution has averaged more than 65 percent o f exports during 1997-2002. Private transfers reached their highest level at US$197 million in 1999, close to 2.5 times the size o f FDI inthat year. It has since continuedto generate more than (or at least equivalent to) the size o f FDIfor the Georgian economy. 1 Figure 2.4. Georgia: Private Income, Transfers, and FDI +Workers remittances +FDI "",""" - --CPrivateIncomt 50,000 0 1907 IQQX IQQO innn inn1 2002 "'+--Total Pnvate Source: Georgia State Department of Statistics. Transfers 24 Russia, Poland, the Czech Republic, Hungary and Slovakia accounted for three-quarters o f the Central and EasternEuropeanregion's inflow's in 2001. Table 2.7: Georgia PrivateIncome and Transfers - (million dollars) 1996 1997 1998 1999 2000 2001 `2002 Income Receipts 1 181 236 211 179 94 90 Transfer Receipts 32 180 211 197 156 143 149 Workers Remittances 103 137 149 95 87 110 Other Private Transfers 32 77 74 48 61 56 39 Source: GeorgiaState Department of Statistics. Note: Income receipts represent eamings of workers abroad for less than one year. Remittances are earnings of workers abroadfor more thanone year. Chapter3. Trade Policy and Market Access The Trade Regime Import Regime 3.1 The IMF rates Georgia's trade regime at "2" at the scale from "1" (the most liberal) to "10" (the most restrictive), due to the country's low statutory tariffs and minimal non-tariff barriers. The 2002 import tariff schedule had five ad valorem tariff rates - 0, 5, 12, 20, and 30 percent, and some specific rates.2s The tariff schedule contained a mild escalation aimed at protecting producers o f final products, e.g., with inputs facing lower tariff rates. According to the MEITT,the average import-weighted tariff in 2001 was about 10.8 percent, compared to an effective rate o f 2.5 percent. Customs fees, at 0.15 percent of the value of the consignment, are in line with those of other CIS countries. 3.2 In January of 2003, a new tariff schedule consisting of 22 (!) tariff rates was adopted (see Table 3.1). The average tariff and tariff dispersion are still moderate in comparison with other transition economies26and the weighted average tariff will go up only a fraction of one percent. Although the new schedule is within the bounds agreed with the WTO upon accession, it is a step back from the previous, simpler schedule. The new schedule seems to have no other purpose than to serve the interests o f groups lobbying for increased protection. Inthe current environment, it is likely to lead to misclassifications and further exacerbate already serious corruption at customs. It will also enhance market distortions due to the increaseddifferential taxation. 3.3 Georgia uses the six (Brussels) methods o f import valuation approved by the GATT/WTO, with the transaction value method as the primary method. Although Georgia abolished minimum prices in 1998, which is not allowed under the Agreement of Article VI1o f GATT 1994 (Customs Valuations), the Customs Code still provides for minimumprice valuation and needs to be amended inthis respect. 3.4 Non-tariff barriers in Georgia have been eliminated, except for health, security, and environmental reasons. There are no quotas or tariff quotas at this time. Import documentation 21 25 The 12 percent rate was the basic rate applying to the majority o f imports. The zero rate applied to a few pharmaceuticals (16 categories), medical equipment (Le., wheel chairs), and baby foods. The 5 percentrate applied to other pharmaceuticals and medical supplies, most capital goods, and inputs. The 20 and 30 percent rates were introducedin June 2002 and coveredasmall number of products where industriallobbies were strongest (20 percent on tea and mineralwater and 30 percentrate on fruit and vegetablejuices). 26 See table below on selectedtransitioneconomies and the EU for comparison: Country Simple average tariff Standard deviation Coefficientof variation Azerbaijan(2002) 14.1 10.5 0.74 Albania (2001) 7.2 4.8 0.67 Bulgaria (2002) 9.6 8.1 0.84 Czechand Slovak Customs 4.5 3.8 0.84 Union (2001) Estonia (98) 0 0 0.00 Georgia (2002) 13.7 8.6 0.63 Hungary(96) 15.2 18.2 1.20 Poland(95) 17.7 12.7 0.72 Romania (91) 17.0 8.5 0.50 Slovenia(96) 10.6 7.8 0.74 EuropeanUnion (2001) 4.7 4.6 0.98 Source: The WorldBank. Azerbaijan Trade DiagnosticIntegrationStudy (dra)). Washington, DC, 2003. 27 Licenses are required for imports o f certain agricultural chemicals, wild animals and plants, medicines, arms, explosives, nuclear materials, industrialwaste, and tobacco products. Chapter 3. TradePolicy andMarket Access 19 requirements are relatively simple although some are superfluous.2s For example, importers are often required to obtain a certificate o f conformity from the State Department o f Standards, even when they provide valid certificates issued by the country o f origin. Laws on Safeguard Measures and anti-dumping have not been adopted yet, and no attempts have been made thus far to raise domestic protection through these means. Table 3.1: Georgia-2003 Import Tariff Schedule 1.1 Tariff rate (percent) Number of tariff lines As percent of total 0 668 6.2 2 753 6.9 3 22 0.2 4 1791 16.5 5 1212 11.2 7 433 4.0 8 1048 9.7 9 364 3.4 10 228 2.1 12 3700 34.1 13 80 0.7 14 43 0.4 15 110 1.o 16 6 0.1 17 26 0.2 18 39 0.4 20 105 1.o 22 25 0.2 24 19 0.2 25 20 0.2 27 66 0.6 30 81 0.7 Total 10,839 100.0 Source: The World Bank staff calculations basedon the tariff schedule of Georgia. 3.5 The Customs Code stipulates ten customs regimes for imports, o f which three are o f particular importance: importation for free circulation (the regular regime), temporary importation for inward processing (i.e., processing o f imported goods inside Georgia with the exportation o f outputs within one year period (this regime requires a license issued by the Customs Department), and temporary importation (for re-export duringone year period).29 Only goods imported for free circulation pay customs duties and the VAT. However, a list o f tariff exemptions for imports under free circulation regime is in effect. The most important exemptions include: imported inputs for the production o f exports, goods financed by grants or concessional credits with the grant element o f at least 25 percent, and goods imported as humanitarianaid or disaster relief.30 3.6 Georgia follows the destination principle o f value added taxation, i.e., it taxes imports rather than exports. A VAT rate o f 20 percent, which is in line with most CIS countries, is applied on the customs value plus import duty and excises. According to the Tax Code, the following products are exempt from ** These include: invoice, customsdeclaration, the certificate of origin, and transport documentation. 29 Other regimes are: re-importation, transit shipment, importation into a duty free shop, processingunder customs control, and placementand use of goods in a free warehouse or in a free customs zone. 30 Goods brought by natural persons valued at or below 300 GEL (per entry) are also exempt. Other exemptions include imports by foreign diplomatic missions and their staff; literary, artistic or scientific works of Georgian citizens published abroad; and aviation fuel and lubricants. Chauter 3. Trade Policy and MarketAccess 20 the VAT: inputs designated for export production, fixed assets and spare parts, goods supplied as humanitarian assistance and disaster relief, goods financed by grants or concessional external credits (with the minimum 25 percent grant element, pharmaceuticals, and baby food. Excise taxes apply to imports of tobacco, alcohol, cars, fuel products, and caviar. The Tax Code stipulates the same excise schedule for importsand domestic products. Table 3.2: Georgia Taxation of Imports, 1997 - -2001 1997 1998 1999 2000 2001 Total taxes on importsas 'YOoftotal tax revenues: 30.6 32.3 30.1 30.2 29.3 Compositionof trade taxes (as percentoftotal): Custom duties 34.3 32.0 14.0 20.6 19.8 Excisetax on imports 26.9 20.1 43.9 31.0 24.5 VAT on imports 38.8 47.9 42.1 48.4 55.8 Share of taxes on importsin totalcollectionof the giventax (%): Excisetax 91.0 92.7 87.8 88.4 76.2 VAT 35.8 44.9 40.9 43.O 43.6 Average effective import tariff rate (as %of merchandise 4.5 4.1 1.6 2.7 2.5 imports) Source: The World Bank. Public Expenditure Review for Georgia. Washington, DC, 2002. 3.7 Trade accounts for about 30 percent of tax revenues (see Table 3.2), with VAT and excise taxes contributingby 56 percent and 25 percent, respectively. The contribution of customs duties (20 percent) has decreasedboth innominalandrelativeterms in line with a decline inthe effective importtariff rate to 2.5 percent in 2001--or one fourth of the weighted average rate (10.8 percent). This difference can be explained by the large proportionof duty-free imports from the free trade area (within the CIS) and the proliferationof customs regimeswith tariff exemptions. 3.8 A serious problem for import taxation is the large scale of smuggling, resulting from weak customs administrationand lack of control over the borders in conflictareas. In a recent study, the State Department of Statistics (SDS) estimated that 71 percent of selected products consumed in Georgia in 2001 were smuggled: tobacco - 66 percent, TV sets - 67 percent, matches and cigarette lighters - 89 percent, mobilephones-73 percent, electric appliances - 50 percent, cleaners - 85 percent. Widespread smugglingalso distortseconomic incentives. Statutory tariffs and other importtaxes have little impact in determiningrelative prices. Under the circumstances, effective protectionto local industry is probably uneven, unstable, andoftennegative. Export Regime 3.9 Export restrictions in Georgia are limitedto arms, ammunitions and objects of nationalheritage, which are prohibited. In the past few years, exports of scrap metal and unprocessedtimber have been subject to temporary bans (or licensing) aimed at stemmingtheir rapid depletion. In practice, however, such restrictionshave only encouragedrent seekingactivities. 3.10 The foreign exchange regime is liberal, with a single floating exchange rate. Foreign currency surrender requirements do not exist and there are virtually no restrictions on the movement of foreign currencies. There are no free trade zones and no subsidy of any kind is offeredto exporter^.^' Exporters 3 1The Government planned to establish free economic zones in Poti and Batumi, but the Parliament rejected the draft Law on free economic zones. using imported inputs for export production can obtain exemptions from tariffs and the VAT on imported inputs. The most used mechanism to access tax free inputs is the temporary import regime for inward processing, which gives exporters a period of 6-9 months betweenthe time inputs are imported and the final product is exported. 3.11 Officially, the VAT paid on inputs - either imported or domestically produced - is subject to reimbursement. In the case of imported inputs, a tax credit is issued to the extent that such inputs are incorporated in the exported product. In the case of domestically produced inputs, there is a need for a cash refund. However, in practice,these refunds occur too late or not at all, due to Georgia's tight fiscal situation. According to the Ministry of Finance, VAT refunds are also complicated by the proliferation of fake invoices. As of 2002, the VAT refundclaims amountedto GEL75-80 million, but the validity of 60- 70 percent of this amountwas questioned. TheInvestment Regime 3.12 The legislative framework governing foreign investment is in line with international standards and compares favorably with other former Soviet Union countries. Georgia allows foreign investment in all but few strategic sectors and there is no local ownership req~irement.~~There are no restrictions on profit remittances, debt service, etc., and the law provides for full compensationincase of expropriation. 3.13 Georgia entered into bilateral investment agreements with 22 countries including the U.S., Canada, China, the CIS, European countries, and Middle Eastern countries, which eliminate double taxation of investment. To date, the U.S. Overseas Private Investment Corporation (OPIC), has provided political risk insurance to three projects amounting about US$20 million. OPIC has provided a loan in the amount of US$26 million for the construction of two Marriott hotels, the first of which is already in operation. The Multilateral Investment Guarantee Agency (MIGA), part of the World Bank Group, has not yet provided any political risk guaranteeto any Georgianproject. 3.14 Most capital goods are subject to a 5 percent import duty and to a 20 percent VAT. There are currently no preferentialtax incentives available to foreign investors in Georgia. An earlier law granting tax holidays to foreign investments in certain activities was repealedin 1996, but foreign companies that obtained licenses under this law were given exemptions for a period of five years. Such tax incentives have not played any significant role in attracting investment, because of the country's still difficult investment climate, as evidencedby the minimal level of non oil and energy relatedFDIduring the 1997- 2001 period. Terms of Market Access Free TradeAgreements with CIS Countries 3.15 The CIS free trade area was established in 1992, but two multilateral free trade agreements - signed in 1992 and 1994 - have never been ratified by the parliaments of Russia and Georgia and therefore remain ineffective. These agreements have been substitutedby a number of bilateral free trade agreements among the CIS members. Georgia has now six free trade agreements (FTAs), one each with Armenia, Azerbaijan, Kazakhstan,Russia, Turkmenistan, and Ukraine. Georgia is not a party to any FTA outsidethe CIS. ~ 32 Under the Law on Promotion and Guarantees of Investment Activity, the government must retain controlling interest in air traffic control, shipping traffic control, railroad control systems, defense and weapons industry. Georgiaalso restricts foreignownership o f agriculturalland. Chaster 3. Trade Policv and Market Access 22 3.16 The agreements provide for duty-free trade ingoods, with (unspecified) potential exemptions, and free transit of goods through the signatories' territories. Exemptions introduced in the Protocols to the above FTAs, which are elaborated annually by respective bilateral trade commissions. To date, exemptions from free trade apply to the Georgia-Russia trade (sugar, alcohols, beer, and tobacco products) and to the Georgia-Kazakhstan trade (sugar, alcohol and non-alcohol beverages, and tobacco). Exempted products are subject to normal, Most FavoredNation (MFN) tariff rates. Also, Azerbaijan has recently introduced unilaterally a 15 percent tariff on steel products. Trade between Georgia and other FTA participants is 100 percent free. 3.17 Current FTAs pose a number o f problems: (i)parallel bilateral and multilateral agreements undermine transparency and hamper the efficiency o f the free trade area; (ii)exclusions, including quantitative restrictions, can be imposed unilaterally while bilateral or multilateral settlement is rather weak; (iii)lack o f permanency, Le. each bilateral agreement is subject to annual changes (in the case o f the exclusion o f goods from free trade), or even more frequent changes (in the case o f safeguards). At present, exclusions cover only a small percentage o f intra-CIS trade, but there is no guarantee that this situation will not be reversed. 3.18 Rules of Origin. The rules o f origin applicable inthe CIS free trade area were established by the 2000 Decision o f all 12 CIS Government Heads.33 The signatories elaborated a certificate o f origin o f a special type for the CIS free trade area (type ST-1). This certificate is issued in Georgia by the MEITT or the Chamber o fCommerce.34 3.19 The rules o f origin allow for full cumulation o f origin: All value added in the free trade area is included in the share o f sufficient domestic processingkreatment while that from outside the free trade area is excluded.. This i s an important incentive for trade integration among the CIS countries which avoids the adverse effects o f the hub-and-spoke pattern (Baldwin, 1991)35where the benefits o f free trade agreements are captured by the dominant member(s) o f the free trade arrangement (i.e., Russia) leadingto income diversion within the free trade area. 3.20 According to the rules o f origin, exports subject to the free trade treatment must be conducted by tax residents in the free trade area. There is at least one case when an import from the free trade area was charged customs duties in Georgia. That was an import o f flour from Ukraine executed by a Swiss company, a non-resident o f Ukraine. The company went to a Georgian court and lost the case. 33 See TheRules of the Determination of a Country of Origin of Goods. 34 According to the basic rule of origin (rule of sufficient domestic processing/treatment), a product may be considered of Georgian origin, if it is fully produced in Georgia or, when imports are used in its production, if the designation of the product is different from the designation of the inputs according the 4-digit CIS trade nomenclature(which is equivalent to the Harmonized System at this level of aggregation). However, a long list of goods specified in the Annex to the Rules of Origin are exempted from this rule. The Annex includes two other important applicable rules of origin :(i)when specifiedtechnological operations are performed in the free trade area for a particular product; and (ii)when specified shares of imported materials or value added in the price of final production are met (ad valorem rule) for a particular product. The specified share of value added in the final price ofthe product is normally set at 50 percent. 35 The hub-and-spokepattern is as follows. Suppose, countriesA, B, and C have bilateral FTAs amongthemselves. However, value added in country C is not counted towards sufficient processing intrade betweencountries A and B. Such an arrangementexists among the EU and the CEE countriesthat have bilateral FTAs with the EU. Under this arrangement, the value added, for example, in Macedonia is not included in sufficient processingif, Croatia exports to the EUa good producedin cooperationwith Macedonia (see Kaminskiand de la Rocha, 2002). ChaDter3. TradePolicv andMarketAccess 23 3.21 CIS Standards. According to the CIS Agreement on Standards, the standards of member countries are harmonized and members should honor each other's certificates of conformity and quality. This is an important trade advantage for the CIS members since their national standards, which are based on the Soviet GOST system, are not recognized in the rest of the world. The Interstate Council on Standards, established under the Agreement, has been gradually introducing new standards in line with I S 0 standards, but more than half of positions in the standards nomenclature are still based on GOST. The Council can potentially act as a vehicle of integrationof the CIS into the world trading system ifthe evolving CIS standards system is built in accordance with the I S 0 guidelines and WTO agreements. In any event, Georgia is committed to reform its standards system in line with WTO regulations by the end of 2003 (see para. 3.35). 3.22 In sum, Georgian exports enjoy an easer access to the CIS markets than to other destinations. Along with trade preferences described above, the traditional economic ties still play an important role, albeit less significant than in the past. However, informal trade barriers and corruption, rampant throughoutthe CIS trade area, undermine formal free trade. Market Access to Non-CIS Countries 3.23 By virtue of its WTO membership, Georgia enjoys MFN treatment by all 144 WTO members. Georgia has a Partnership and Cooperation Agreement (PCA) with the EU, ratified in 1999, which provides for trade restrictions on sensitive sectors such as textiles, coal, and metals, unless specific sectoral agreements stipulate otherwise. Under the 1993 Agreement on Textiles signed between Georgia and the EU, Georgia's textile and clothing exports could be subject to quantitative restrictions in the EU market if the exported volume exceeded 0.35 to 4 percent (depending on the product) of the total EU imports in the previous year, or ifGeorgia exports at abnormally low prices. However, no quantitative or extra tariffs on Georgian exports have been used by the EUas of to date, presumably becausethey are so small. 3.24 Generalized System of Preferences (GSP). Georgia is a beneficiary of the GSP of the EU, the U.S., Canada, Switzerland, Japan, Turkey, Poland, and Estonia. The GSP gives import duty reductions on a list of products that satisfy the requirements stipulated by the country administering the GSP, including the rules of origin. To satisfy the rules of origin requirements under the GSP, the MEITT has the authority to issue the certificate of origin A accepted inthe countries administeringthe GSP. 3.25 The preferences Georgia receives under the GSP are not as deep as those granted to less developed countries (LDCs). Despite its low income per capita, Georgia is not considered an LDC becauseof its relatively high level of humandevelopment. Also, to speed up the WTO accession process, Georgia did apply to obtain an LDC status. However, Georgia, along with other poor countries in transition, has been granted the IDA status by the World Bank at par with LDCs, which would support grantingdeeper preferentialtreatment to Georgiaunderthe GSP. 3.26 Despite current GSP arrangements, some important Georgian exports face statutory tariffs in the EUwhile LDCs face zero tariffs onthe same products. For example: Ferro-alloys-arangeoftariffrates including 2.2 percent and 2.7 percent, ammonium nitrate fertilizer -3 percent, wines -a range of specific duties including 13.1 and32 per 100 liters, mineral waters - 6.1 percent, suits of synthetic fibers - 9.7 percent, applejuice concentrate- 14.5 percent, and cigarettes-40.3 percent. These tariffs are rather high for "sensitive" productssuch as textiles and temperateagricultural products. 3.27 Georgia could obtain additional duty reductions (generally 5 percent) under the EU GSP by claiming compliance with EU-defined basic labor rights. For textiles and clothing the available duty reduction is 40 per cent of the MFNrate comparedto 20 per cent under the standardGSP. Chapter 3. TradePolicv and Market Access 24 3.28 The actual utilizationof granted preferencesis low. Only 51 percent of Georgian exports to the EU eligible for GSP preferences actually receive those preferences. The other 49 percent of exports pay full non-concessionaltariffs. Several factors account for the low utilizationof the GSP preferences: (i)ignoranceabouttheGSPanditsdocumentrequirementsonthepartofGeorgianexportersandforeign importers; (ii)administrativehassle and bribes associated with obtainingthe special certificate of origin; (iii)a desire of exporters to conceal as much as possible their foreign trade activities from the Government in order to minimize taxes. The level of preference take-up, however, has improvedover time, thanks to the awarenesscampaignby the Ministry ofForeignAffairs. 3.29 Georgiahas notbeenatarget of anti-dumpingactions by any developedcountry so far. However, the Georgian steel producershavenot submittedthe recent questionnaireson steel productsdistributedby the EU thus exposing themselves to potentialanti-dumpingactions. Georgia has a large former Soviet steel mill inRustaviwhich is still inoperation albeit at a very low productionlevel. 3.30 Technicalbarriers. Technicalbarriers to trade (TBTs) for the Georgianexports to the developed- country markets are rather restrictive. Georgia does not have agreements with these countries on mutual recognition of quality certificates. Also, Georgian firms often find it difficult to maintain consistent standards and quality due to technologicalproblems. Europeancertifying institutionsused by Georgian exporters are located in Europe, which adds considerable expense and creates extra uncertainty. According to the ISO, 260 firms in Georgia hadbeencertifiedas complyingwith I S 0 9000 standards at the end of 2001. This compares with 1 firm inAzerbaijan, 41 in Kazakhstan, 202 inLithuania, and 1026 in Slovenia. The Georgiannumber appears high ifcomparedwith other CIS countries, but it is still low as a percentage of all Georgian firms. Most Georgian exporters to developed countries (outside of the mineralextraction sector) do not conduct their own marketingactivities, but rely on contract processing or distributorswho buy their products on ex-factoryterms. 3.3 1 Iran and the Middle East are potentially importantdestinations for Georgian exports, because of their geographical proximity, low transport costs, and relatively high market purchasing power. However, with the exception UAE free trade zone, access to these markets is difficult. In Iran, for example, restrictions include quotas, high tariffs on selected products, and burdensome document requirements(such as licenses). Relations with the WTO Georgia'sAccession to the WTO contractually guaranteedMFN status from all the WTO member^.^' Membership benefits in the WTO 3.32 Upon its accession to the WTO on June 14, 2000,36Georgia receivedpermanent, unconditional, include: (i)assuring a liberaltrade regime and greater transparency in Government support for domestic 36 Georgia's accessionprocess started in 1994 when it gained observer status in GATT. After the establishment on January 1, 1995 of the WTO as the successor to the GATT, Georgiaobtainedthe observer status (June 1996). After Georgia submitted the schedules o f concessions and commitments on goods and the specific commitments on services, negotiations started in March 1998 and were concluded on October, 6, 1999, when the WTO General Council adopted the report of the Working Party on Georgia's accession. The Georgian representative signed the MarrakechAgreement (establishing the WTO) and the Protocol of Accession which were ratified by the Georgian Parliament on April 20,2000.0n June 14,2000 Georgiabecamethe 137thmemberofthe WTO. 37 The US extended non-discriminatory treatment to Georgia in December 2000. Georgian products were previously subject to discrimination under the Jackson-Vanik amendment to the U.S. Trade Act o f 1974, on the basisof a lack of freedom o f immigration. The amendmenthad been waived annually since 1993. industries; and (ii) providing certainty with respect to market access in other WTO member countries, a dispute settlement mechanism as well as opportunities for active participation in the multilateral trade negotiations within the WTO framework. 3.33 In addition to the 29 mandatory WTO agreements, Georgia joined the following sectoral initiatives (which, with a few exemptions, stipulate zero import tariffs): civil aircraft and information technology, pharmaceutical products, metal products, wood products, and agricultural machinery. Georgia also agreed to start negotiations on joining the Agreement on state procurement, though it is behind schedule. 3.34 To speed up its accession process, Georgia agreed to a short (or no) transitional period for a number o f WTO agreements. For instance, Georgia negotiated the Aggregate Measure o f Support for agriculture at five percent o f agricultural GDP, which corresponds to the obligations o f a developed country. Also, Georgia offered very liberal market access in the service sector. In fact, Georgia applied its domestic regulations to and did not discriminate against foreign suppliers in banking, insurance, security trade, auditing, legal services, and tourism. Post-Accession Issues 3.35 Georgia did not negotiate any transitional period for two important agreements: the General Agreement on Trade in Services and the Agreement on Trade-Related Intellectual Property Rights (TRIPS). 3.36 Tri s. accession?' Specifically, Georgia hadjoined a full range o f international convention^^^ and its legislation Georgian legislation was generally in line with the TRIPS Agreement at the time o f provided for the protection o f copyrights, trademarks, and service marks, etc., including appropriate civil judicial and administrative procedures. However, like in many developing and transition countries, the enforcement o f the TRIPS legislation is very weak. A department for the protection o f intellectual property has been established under the Ministry o f Internal Affairs (the police) and the Intellectual Property Expert Center has been under the Ministry o f Justice. A handful o f showcase operations to seize unlicensed products have been carried out by the police, but weak control o f the borders prevents the effective protection o f trade-related intellectual property rights. International companies producing products with high intellectual content exert weak pressure, if any, to strengthen the enforcement o f intellectualproperty rights o f Georgia's low visibility. 3.37 A weak enforcement o f intellectual property rights hinders foreign investment in knowledge- intensive industries, such as the information technology. A foreign counterpart must be sure that his intellectual property (such as the source code in the programming industry) will be protected during the operations performed by a Georgian firm. Ifthere is no such guarantee, cooperation will fail to develop. 3.38 Standards. Georgian legislation is in line with the GATT 1994 Agreement on Technical Barriers to Trade and the Agreement on the Application o f Sanitary and Phytosanitary Measures. The agreements stipulate non-discrimination against imports in applying standards in the mandatory technical regulations and conformity assessments and the establishment o f national inquiry points (notification centers). Georgia has established three notification centers: for phytosanitary measures at the Ministry o f 38 As noted inthe Report of the Working Party on theAccession of Georgia to the WTO (WTO, 1999a) 39 Georgia joined the World Intellectual Property Organization and the Paris Convention for the Protection of Industrial Property (January 18, 1994); the Patent CooperationTreaty (January 18, 1994); the Berne Convention for the Protection of Literary and Artistic Works (May 15, 1995); and the Protocol Relating to the Madrid Agreement Concerningthe International Registration of Marks (August 20, 1998). Chauter 3. TradePolicv andMarket Access 26 Agriculture; for technical barriers to trade at Sakstandarti; and for trade in services at the Ministry of ForeignAffairs. 3.39 Under the WTO agreement, Georgiamust adopt by end-2003 a new standards system comprising voluntary and mandatory international technical regulations, thus replacing the current GOST system.40 The current Law on Standards, passed in 1999, includes clauses about the division of standards into voluntary and mandatory. The 2001 Presidential Decree put forward a timetable on the movement to the two-tier system of voluntary and mandatory standards. In2002, the number of mandatory standards was reduced from 120 four-digit codes under the Harmonized System to 78 codes. However, the progress in the elaboration of technical regulations has been very slow. The stalling of the standards reform stems from powerful political pressures to maintainthe status quo, including the national standards agency. An overly-controlled standards system offers strongopportunitiesfor rent-seekingand corruption. 3.40 Special Treatment. As mentioned above, Georgia did not pursue the LDC status during the accession. However, at the Doha ministerial conference, the Georgian delegation asked that the preferences granted for developing countries should as well be applied to the low-income transition countries, in particular, in agricultural trade. Also, the Georgian delegation insisted that the low-income transition countries be eligible for external debt relief. However, both the developed and developing countries were, in principle, against these requests since Georgia had accepted the non-preferentialstatus at the time of accession (Beruchashvili, 2001). 3.41 Funding of Post-AccessionActivities. The funding of post-accession activities is inadequate. Although the WTO agreements were ratified upon accession in 2000, they have not been published in their entirety due to a lack of funding. This creates aproblem for enforcement, since the legal institutions do not have the texts of the agreements. There is even a problem with paying the annual WTO membership dues, which amount to a mere $15,000 a year! The functioning of notification centers is also funded very poorly. The Center on technical barriers to trade in Sakstandartihas practically stopped operationsdue to the lack of funding. 3.42 TechnicalAssistance. Georgiareceivedadequate technical assistance on WTO mattersduring the accession period, through the Georgian-EuropeanPolicy and Legal Advice Center (GEPLAC) funded by TACIS and the Center for Institutional Reform and the Informal Sector funded by the USAID. Going forward, Georgianeeds technicalassistance inthe following key areas: 0 Reform of the standards system; 0 Implementationof the TRIPS Agreement; 0 WTO matters (publications, strengthening capacity to participate in the Doha development agendavia advisory services andfunding of WTO-related activities); 0 Training public servants andthe business community on the trade agenda. Trade and InvestmentRelatedInstitutions 3.43 The formulation and implementation of trade policies in Georgia involves a number of government agencies. The MEITT provides interagency coordination in the area of foreign trade and conducts economic analysis. Along with the Ministry of Finance, it formulates the main parameters of trade policy - the import and export regimes. The Ministry of Foreign Affairs is responsible for 40 Technical regulations include not only the characteristics o f the products but also the characteristics o f technological processes involved, and the methods of testing. Chapter 3. TradePolicv andMarket Access 27 multilateral trade relations and relations with the WTO. The National Bank formulates the exchange regime policies and monitors the balance of payments. Other line ministries fulfill their sectoral responsibilities in the area of forei n trade (e.g., the Ministry of Transport; the Ministry of Agriculture; and the State ProcurementAgency ) are also involved. A 3.44 Coordination among the various agencies is weak and there is no clear articulation of the objectives and priorities for trade policy. For instance, it is not clear what rationale, if any, was used to substantiatethe recent changes inthe tariff schedule, which increased the number of tariffs bands from 5 to 22!. Also, better cooperationbetweenthe MEITT and the MoFA on WTO issues would be desirable, especially to ensure a proper implementation of new standards and the TRIPS. In general, because of Georgia's tight budgetary situation, fiscal considerations tend to drive policy decisions while trade facilitation objectives are either ignoredor overlooked. There are also a number of subordinate agencies dealingwith trade and investmentissues inGeorgiawith limited impact. 3.45 The Georgian InvestmentCenter, established in 1997, is funded by both the Ministry of Foreign Affairs and the UNDP. In addition to being the secretariat of the GBC, establishes contacts with investors, and promotes investment in Georgia. The Center producesprinted material for investorson an annual basis. The main functions of the center include investment servicing, investment generation, and policy advocacy. In practice, however, GIC is mainly involved with limited promotion activities abroad as well as organizing site visits for prospective investors who visit Georgia. Issues surrounding policy advocacy seem to be primarily handledby the GBC. 3.46 The InvestmentAgency, which reportsto the Ministry of Economy, was establishedin2002. The agency's primary role is to facilitate access to finance to enterprises, mainly exporting firms, by providing subsidieson interest rates. While provisions have been made to ensure that the subsidies are paid only on compliant beneficiaries, the impact of such scheme however is bound to be limited and ad-hoc, given availablefunds (GEL1 million in 2002). 3.47 The Foreign Investment Council, under the State Chancellery, deals with policy issues. The Council, which also serves as an advisory body to the President, is currently involved with implementing the recommendations of the FIAS on administrative barriers to investment (December, 2001). The FIAS measures have been incorporatedinthe Presidentialdecree of April, 2002, "Of the Presidentof Georgia on Implementation of the Action Plan in Order to Eliminate Administrative Barriers for Improving the Investment Climate in Georgia". Implementation has been slow and there is no particular focus on exports inthe actionplan. 3.48 The GeorgianExport Promotion Agency (GEPA), establishedin 1999, reports to the Ministry of Economy and is supportedby EUand Dutchfunding. GEPA focuses on (i) providing market information to Georgian exporters; (ii)introducing Georgia and Georgian products to companies around the world; (iii)assistingforeigncompaniesinsourcingproductsinGeorgia;(iv) offeringonlinetradeleadsbothfor Georgian exporters and overseas importers; and (v) assistingGeorgian companiesindevelopingan export marketing strategy. GEPA is very much involved with Georgian exporters in lobbying the Government. InMay, 2001, GEPA developeda concept for export development, which was presented to Government as a draft export concept note, and which had been subsequently accepted by Government. GEPA has also been involved in export certification processes, and in June, 2002, UNDP initiated the process of establishing a quality certification system in coordination with GEPA, which will result in an EU 41 The State ProcurementAgency will be the responsible agency for the implementation of the WTO agreement on state procurement,which Georgia intends to join inthe nearest future. 42 FIAS is a joint service of the World Bank and the International Finance Corporation (IFC) which helps developingcountrygovernmentsimprovetheir investmentenvironments inorder to attract FDI. Chavter 3. TradePolicv and MarketAccess 28 accreditation for testing food products and such for exports. GEPA also has a internet database o f Georgian exporting companies for those who may be interested in importing Georgian products. 3.49 These organizations have some direct interaction with enterprises and also through their links with the Georgian Business Confederation (GBC), which is the body where usually firms turn to for assistance. The GBC, comprising many foreign investors and associations, was founded in 2001, through a memorandum of understanding among the American Chamber o f Commerce in Georgia, the International Chamber of Commerce in Georgia, and the Taxpayers Union of Georgia. The GBC became registered as a union o f business associations in 2002, and that same year the Georgian Investment Center joined the Confederation, and currently serves as its secretariat. Further, many of the GBC's board members sit on the advisory committee to the Foreign Investment Council. The GBC has been instrumental inforcing investment issues to the forefront, and lobbying the government for change. Conclusion 3.50 Georgia has a liberal statutory external trade regime with low import tariffs and no quantitative restrictions. The VAT and excise taxes are equally applied to imports and domestic output. However, weak customs administration results in large scale smuggling which undermines the implementation of trade policies and creates a "non-level" playing field. Moreover, the new tariff schedule adopted in January 2003, whereby the number of tariff rates was increased from 5 to 22, is likely to lead to misclassifications and further exacerbate already serious corruption at Customs. A simpler and flatter tariff schedule needs to be reinstated. 3.51 VAT refunds do not work effectively due to the tight state budget and the proliferation of fake invoices. This hinders the development o f exports, but also o f domestically produced inputs. In the absence of a functioning VAT refund mechanism, exporters favor imported inputs (which can be procuredtax-free under the existing temporary regime) over domestically produced ones (for which VAT payments cannot be recovered). 3.52 The CIS free trade agreements provide a favorable framework to foster regional trade and have the potential for helpingmember countries to integrate into the world trading system (e.g., in the case o f harmonized standards). But, the web of bilateral and multilateral agreements leads to lack of transparency and inefficiencies inthe free trade area. Also, agreements lack permanency and provide for unilaterally imposed and frequently changed trade restrictions. Finally, a difficult trade climate undermines free trade within the region. 3.53 Georgia should have access to the same trade preferences granted to LDCs under GSP programs, if it is to move into developing higher value added exports. Meanwhile, it can obtain additional preferences, for instance intextiles, inthe GSP EUunder a special clause relating to the implementation of basic labor rights. Also, existing GSP preferences should be more fully utilized. Technical barriers for trade imposed by developed countries should be mitigated with a fundamental reform of the national standards system. 3.54 There is a needfor technical assistanceprogram to strengthen trade-related institutions, especially the standardization system, customs administration, and institutions related to the protection o f intellectual property rightsand to the WTO matters. Chapter 4. Transport and TradeFacilitation in Georgia 29 Chapter 4. Transport and Trade Facilitation in Georgia International Transport Analysis TransportSector 4.1 The transport sector represents 12 percent of GDP and has grown 20 percent on average annually since 1997, primarily owing to the rapid expansion of oil transit from the Caspian Sea. Although transport turnover (both railway and road mode) has tripled since 1994, it is still 1/3 the pre-independence level. Transit generates significant budgetary resources and an estimated minimumof US$200 million of direct economic activity. Each ton of general cargo transit generates between US$20 and US$55 o f income to various transport intermediaries inGeorgia. Year FreightTransport Passenger Transport (million ton-km) (million passenger-km) P Railwa s Roads Pipelines Rai1ways Roads For hire, Reward and Own account PrivateCars and Buses 2000 3,913 475 4,953 453 4,510 1999 3,138 420 3,213 349 4,310 1998 2,574 385 397 3,910 1997 2,006 304 294 3,400 1996 1,350 131 380 1,615 1995 1,246 130 371 1,607 1994 955 84 1,165 1,135 1993 1,554 121 1,003 954 1992 2,985 388 1,03 1 2,147 1991 8,482 1,653 1,718 7,110 1990 10,834 2.577 1,969 8,335 1989 11,989 2,60 1 2,267 8,545 Source: ECMT; original data gathered from MOTof Georgia. 4.2 International transport for Georgia is dominated by oil transit which amount to over 10 million tons compared to 2 million tons in non-oil transit and about 2.6 million tons43o f imports and exports. Transit flows are rather unidirectional with oil moving west from Azerbaijan and Kazakhstanto the Ports of Batumi and Poti, mostly transported by rail (oil transit accounts for 75 percent o f Georgian railway turnover), but pipelinetransportation i s becoming increasingly important. Most non-oil transit moves east and is transported by both road and rail. About 30 percent o f exports are shipped by road and the remainder by rail while import transport is equally distributedbetweenthe rail and road.44 4.3 Roads. The poor condition o f the majority of Georgia's road network4' is a significant barrier to trade.46 The length of roads used for transit and foreign trade is only slightly above 1,000 km (less than 5 43 Exportwere 1.2 milliontons and importswere 1.4 milliontons in2000. 44 2000 data from TRACECA data base. See detailedTable inHalcrow (2002). 45 The road network of Georgia consists of 21,600 kilometers of roads. Approximately, 9,720 kilometers of these roads are pavedand 11,800 kilometersare gravel or earth roads. Ofthese, 1,221 kilometersare classifiedas national (trunk) roads, 4792 kilometersas secondary roads and the remaining 15,564 kilometersas localroads. percent of total network), but many of these segments require further rehabilitation of access to both local markets and to international markets. In 2000, a review of the main road network indicated a potential reduction in vehicle operating cost of more than 15 percent [over more than 400 kilometers]. A review o f presenttransport infrastructure conditions is beingundertaken by TRACECA. Table 4.2: Freight Transport Indicators 1997-2001 for Georgia Inthousandsoftons 1997 1998 1999 2000 201-41-42 FreightTransport 19,700 24,120 25,911 30,091 14,601 Rail 7,200 8,495 9,492 11,500 5,984 Road 12,200 15,000 16,000 18,500 8,600 Sea 300 625 419 ... . * * Source: (IMF 2001) on Georgia. 4.4 Rail. The Georgian rail network (which is entirely electrified and extends only 1,583 kilometers) plays a key role inthe movement of oil and oil products. The main route runs across the country, starting from the border with Azerbaijan, via Tbilisi to Samtredia and then on to Batumi and Poti port. The condition of rail infrastructure is pretty poor, particularly between Ayrum (Armenian border) and Sadakhlo (Georgian border), despite the significant Georgian Railways' cash-flow. The network's backlog of recurrent maintenance forces speed restrictions (15 km/h on some segments). The current capacity of the Georgian railway is 20-25 million tons annually, which is about double of the present turnover. Investment to improve efficiency and service quality and reduce costhime are the priorities. 4.5 Ports. The Black Sea ports are the main external gateway for Armenia and Azerbaijan and the closest access to maritime transportation for Central Asian countries. Georgia has three ports, Batumi near the Turkishborder, Sukhumi in Akazia in the north-west not far from the Russian border, and Poti in the central coastal plain. The two major ports of Georgia, in Poti and Batumi, handled respectively 3.4 and 8.4 million tons in 2001.47 The oil terminal Supsa, connected to Poti, four miles south, handles a substantial part o f oil transport. Sukhumi is used primarily for passenger traffic and has only limited cargo facilities. Its operations have been affected by the conflict with Abkhazia. Tensions sometimes impact the operations of the Batumi port, located in the Adjara autonomous republic. (See Annex for a more detailed review.) Transport Costsfor Tradeand Transit through Georgia48 4.6 Georgia's port tariffs for non-oil commodities are broadly in line with international benchmarks, even though port dues are somewhat higher. (see Table 4.3). Tariffs for oil transport are below the internationalaverage. Tariffs, set by the Ministry o f Transport and Communication, are the same for both ports which does not facilitate competition between the ports. The prospective privatization of stevedoring activities is likely improve port competitiveness. ~~ 46For example, in2002 Georgia spent on average only US$1,100 per kilometer, comparedto US$4,000 per kilometer inthe Baltic countries. 47 With on average four vessels and two vessels aday, respectively. 48 Basedon a survey o f forwarders inthe three South Caucasus countries. 1 Cargo HandlingTariffs Port Dues BaggedCargo $It I Bulk Cargo $It Containers $120' $ ton Burgas 8.0 6.5 27 0.9 Constanza 7.5 3.1 64 0.6 Illyichevsk 5.2 2.2 104 2.9 Odessa 5.2 2.2 104 3.O PotA3atumi 6.0 3.5 50 2.1 Baku 3.5 3.2 36 0.4 Aktau 8.0 8.0 30 1.5 Turkmenbashi 10.0 5.0 40-50 1.1 International 5.0 1oo2' 0.7 I/TRACECA: UnifiedPolicyonTransitFeesandTariffs-ProgressReportOctober2002. 2/ The rate is an approximate average. For examplePotterdam i s 68, Po; Kelang, Malazia is 53, Kartachi is 69 and Hong Kong is 142. 4.7 Transport costs in the Caucasus are not competitive when one considers unofficial monetary expenditures and the time required. For example, the transport cost (US$/km) of a TEU container by road from Baku to Poti is nearly three times higher than that from Baku to Bandar Abbas (in Iran). The US$/km cost by road from Poti to Yerevan i s nearly 5 times higher than that from Yerevan to Bandar Abbas. Transporting a container from Yerevan or Tbilisi to Moscow is nearly twice as expensive than a journey o f comparable length from Yerevan or Tbilisi to Bandar Abbas. The long transit time through Georgia, despitethe relatively short distance, adds to the overall cost o f inventory for the goods intransit. 4.8 The significance of the national and regional elements of the total logistical cost, despite their modest part in the total logistics chain, is high. For example, in moving a generic containerized consignment from Northern Europe to Tbilisi, the Georgian leg by road accounts for nearly 46 percent of total costs, with unofficial fees representing7-40 percent o f total costs (6-35 percent on the rail mode). In moving a similar consignment from Northern Europe to Yerevan, the Caucasus leg by road accounts for 67 percent o f total costs (including 27 percent for the logistics cost in Armenia), with unofficial fees accounting for 22-25 percent of the total costs (6-13 percent on the rail mode). A similar cost structure is found inthe movement o f consignments to Baku. 4.9 Rail transportation from Armenia and Azerbaijan to Georgian ports is less than half the cost o f road transportation. For example, the transportation o f one TEU from Poti to Yerevan via railway is US$885 (US$1,545 via road) and relatively faster (see Table 4.4), althoughthe quality of services is poor. The more limited interactions with the Georgian border agencies and traffic police result in smaller unofficial payments. Via rail to Armenia, the unofficial fees reported by users were between 6-13 percent o f the total cost while via road they amounted to 22-25 percent. The Georgian railway is still not competitive with Russian railways. The latter transports one TEU from Almaty to Riga (5,000km) for US$1,100. Table 4.4: Indicative Time and Money Expenditures I Km [ US$ Hours US$ Hours Yerevan 650 1545 50-80 885 24 Baku 950 1700 100-120 875 24-48 Baku Moscow 2500 2300 120 1100 288 Bandar Abbas 2800 1500 168 ... ... Poti 950 1300 100-120 875 24-48 Tbilisi 600 970 80-100 * * . ... Tbilisi Moscow 2500 3500 120 1500 360 Bandar Abbas 3300 1800 192 ... ... Poti 350 450 12 375 Yerevan 300 660 24 ... Baku 600 970 80-100 ... Yerevan Moscow 3000 3800'' 140 2100 480 BandarAbbas 2800 1700 200 ... ... Poti 650 1000 50-80 885 24-48 Tbilisi 300 660 24 ... ... 1/ Average cost quoted for the transporto fa 20 foot container. Usually includes the unofficial and official charges that the transport companies have to pay directly. 2/ This figure assumes a Georgian plated truck is used, so excludesthe cost ofthe "for 02" service. Explanatory Factorsfor Excess Transport Costs 4.10 There are a number of factors that explain currently high transportation costs. Some o f these factors apply even for empty trucks. 4.1 1 Unofficial payments to border agencies. There is a whole spectrum of agencies, e.g., border guards, customs, phyto sanitary control, veterinary services, and even the road fund represented at the Georgian borders. Duringa survey carried out inthe spring 2002, transporters o f goods to/from Armenia reported the needto pay "unofficial fees" of around US$lOO (in cash or inkind) to border guards, around US$50 to customs officials, and a range of US$10-2049 to the requisite phyto-services. Unofficial payments are often paid to dock workers to speed up the process, but these are relatively modest. 4.12 Unofficial payments to the roadpolice. Payments to the Georgian police are an inevitable part of the journey, despite the fact that formal police checkpoints have been abolished since early 2002. In October 2002 there were on average around 60 informal police checkpoints on the road from Sadakhlo to Batumi (1 checkpoint per 8 km)." Unofficial payments to the police can be as much as US$200, with an average o f US$l00. 4.13 Road Fund Charge. A roadfund payment o fUS$410 per truck is collected on vehicles registered outside o f Georgia. According to bilateral and multilateral agreements with virtually all TRACECA and many European countries, the holders o f permits issued under the quota system should be exempted from transit fees. Georgian Officials frequently ignore this exemption. In addition, Georgia gets the highest rate of complaints for insufficient number o f road transport permits under bilateral agreements and ranks `'Halcrow 2002, Armenia survey. Bank's October 2002 TTF missionobservation. Chapter 4. Transport and Trade Facilitation in Georpia 33 3rdamong TRACECA countries (after Kazakhstan and Uzbekistan) interms ofunjustifiable fees5' related to internationaltransport. 4.14 Excessive documentation. As shown in Box 4.1, multiple document requirements add to both unofficialand official costs. For instance, the internal transit document (VVT) should not be requiredfor cargo traveling under a TIR Carnet. Box 4.1. The Official and UnofficialCosts of Importing to Georgia 4 Poti Port - After the ship has docked at Poti-port, the Customs Broker receives a statement from the shipping ?.gent to allow the consignmentto crossthe border. This documentneedsto be approved by Customs, and the agent, Nho is usually dealing with multiple statements at any one time, needs to queue, with all the necessary jocumentation, to receive the official approval. This processcan take 4-6 hours, but `favored clients', who pay an mofficial payment in advance, may go to the front o fthe queue. The unofficial rate is US$5 per statement. 4fter approval, the Customs Broker can return to the Line Arrangement and collect the container; the terminal service issues the cargo manifest (CMR), to allow the carriage of the container, which is officially free, but may require a small `gratuity' of US$ 5-10. The Customs Broker returns to Customs with the manifest, and the latter will then provide the internal transit document (VVT), even in the case of cargo traveling under TIR Carnets. The official fee for this is US$5 per document, for each separate consignment. This requires stamping by the Operating Department,the Finance Departmentand the VVT Department. The Customs Broker will issue a Customs Declarationfor Transit, which is completed and printedby the Broker, as an official cost of US$45for a road movement, and US$90 for a rail movement. There is an occasional unofficial charge of about US$lO. Either a Customs Broker, or Customs itself, then has to issue a special license, Customs Carrier Documentation in two hard copies, one of which goes to the regional customs house in Poti, and the other goes with the Driver. At this point, the truck is authorizedto leavethe port in one of two daily slots; 4pm or 7pm in a convoy of not more than 30 trucks, but in reality the last condition is frequently breached. The official charge for the convoy service is US$5-10, but the unofficial chargecan be US$50. The Customs convoy takes a hard copy of the VVT from the driver, and stays with the convoy until the first checkpoint, when it departs and makes it own way to Tbilisi. The convoy continues, getting stopped at all intermediate checkpoints, about every 8 kilometers, frequently making unofficial payments of US$ 5-10 to the traffic police, prior to being forced to spend the night at Agara, 80 kilometers west o f Tbilisi. It arrives at Lilo Terminal, the following day, and frequentlyhasto wait for arrival ofthe VVT. Source: Survey and interviews; Halcrow (2002). 4.15 Mandatory Convoy. Each transit consignment must be escorted by customs officials. This restricts the departure time from Poti to two slots daily and causes delays as the convoy is usually held over night due to the ban on night travel. The convoy service is officially free, but occasionally a `facilitation payment' of US$O-50 is required. There is also a convoy service ("02" service) provided by the Traffic Police which is imposed on Armenian truckskonsignments crossing Georgia toward Russia. This service was introduced in the early 1990s to protect Armenian consignments movingthrough Azeri enclaves in Georgia at the time o f conflict between Armenia and Azerbaijan and civil unrest in Georgia. Unofficial payments by Armenian transporters reportedly reach up to US$2,000. The removal of this service is seen a priority and an important indicator towards the potential success of intra-regional trade and transport facilitation services. "TRACECA: Unified Policy on TransitFeesandTariffs -Progress ReportOctober 2002" Chapter 4. Transport and TradeFacilitation in Georgia 34 4.16 Bad roads. The bad quality o f roads on main transit routes (apart from the segment Tbilisi-Poti which is in relatively good shape) increases vehicle operating costs. Additional direct vehicle operating costs due to road condition for a regular truck from Sadakhlo to Poti is about US$50 per trip/~ontainer.~* Poor infrastructure also significantly increases journey time and accidents. The IDA-supported roads project, co-financed by the Kuwait fund, should substantially improve conditions o f these main roads. However if Georgia fails to provide funds for adequate maintenance these roads will again collapse within a short period o f time. Many other local access roads for Georgian trade would require additional investments and periodic maintenance. Table 4.5: Indicative"L a isticalCostfo ITEUContai !rby RoadfromPotito Armenia Cost element cost $ Characteristic Proposedmitigation measures 1. Quantifiable cost IncrementalVOC caused by 50 OIA Roadrehabilitatiodmaintenance poor roads* Paymentto border agencies 170 UIA Border agency modernizationand computerization Paymentto roadpolice 100-200 UIA Enforcemento f Presidential Decree RoadFundPayment 0-410 OIA TRACECA analysis Transit documents 85 O-UIA Reviewtransit documentation requirementparticularlyunder TIR Mandatoryescort 0-50 UIA Removethis requirement "Pure" transportationcost* * 455 OIUN Subtotal: 885-1420 2. ResidualNon-quantifiable 660-125 cost Longterm measuresto improvethe Journeytime Georgianand Armenianfacilitation Security concerns environment Discriminationof foreigntrucks, driversvisas Behaviorof border agencies 3. TotalLogisticalcost*** 1545 )-official. U-unofficial/A-avoidable. iN-unavoidable. ***EstimatedadditionalVehicle OperatingCost (VOC) on the Georgianroadsegment due to badroadcondition. ***EstimatedVOC onthe Georgianroadsegment for road in goodcondition(roughness=2.5). Basedon prices offeredby the market. 1/ Basedon interviewsof truckers transportingcargo betweenPoti and Yerevan. The costs per trip vary dependingon the type of cargo, the time sensitivity,the countryof origin and the type of vehicle. 4.17 There are also other factors that are difficult to quantify but that are not less important in explaining the hightransport costs in the region. These include: (i) longjourney time - delays caused by the mandatory convoy system, the ban on night travel, etc. mean that a truck journey Yerevan-Poti and Baku-Poti take takes up to 80 and 120 hours, respectively, instead of 15-20 hours.; (ii) poor safety-- drivers, particularly foreign ones, are concerned with the risk of being kidnapped or robed; (iii)discriminationagainstforeign trucks- unofficialpaymentstotraffic policeandborderagenciesare usually higher for foreign trucks and visas are expensive and often difficult to obtain; (iv) inadequate cargo volumes--costs are higher for loads which are either smaller than a full truck load (typical for SMEs) or exceed standard dimensions (typical for oil equipment); and (v) inefficient rail services-- 52 Accordingto the economic analysis carried out under the IDA-supportedRoads Project. ChaDter 4. Transportand TradeFacilitation in Georaia 35 freight forwarders surveyed by TRACECA indicated that official railways costs in the region are not competitive. Rates are not published, and need to be negotiated individually, and there are hidden charges (i.e., for demurrage, wagon clearing, handling), that cannot be anticipated. Forwarders stated traffic volumes could increase significantly iftariffs were reduced.53 The lack o f consignment tracking, security and lack of one-shop window were added concerns. About half of forwarders were willing to pay extra for these services, while 40 percent considered that they should be part o f current services. Current and PotentialTransit Current Transit 4.18 At present Georgian transit is limitedto close markets such as Azerbaijan and Armenia. Over 70 percent of pipeline oil exports from Azerbaijan are routed through the Baku-Supsa pipeline (5 million tons in 2001) through Georgia and the remainder is transported via the Baku-Novorossisk Russian-state controlled pipeline. The capacity of the Baku-Supsa pipeline is increasing rapidly (from 110,000 b/d in 2001 to a projected 165,000 b/d in 2003). While the pipeline through Russia could be expanded, higher transit fees, quality issues related to oil blending, and frequent closures have made this option less attractive. However this may change ifthe situation in Chechnya stabilizes. 4.19 The Azeri traffic accounts for 40-50 percent oftotal turnover ofGeorgian ports. About 40 percent o f non-oil transit turnover at the Georgian ports was Azeri traffic in 2001. Most Armenian foreign trade (about 1-1.5 million tons annually) is also transported through Georgia. A limited volume of Armenian trade is transported through Iran, but restrictions (Le., alcohol, petroleum products are not allowed) and the absence ofdirect rail linkbetweenArmenia and Iran limitsthe usefulness o fthis route. 4.20 Despite beingthe closest maritime gateway to basically all Central Asian countries, the Georgian route is a negligible portion of the foreign trade of these countries, representing less than 17 percent of Poti and Batumi non-oil transit turnover in 2001 (about 0.3 and 0.07 million tons, re~pectively).~~ Instead, Central Asian countries use ports in Iran, Russia and Baltic Countries, despite the fact that distance is at least 2 to 3 times longer. Moreover, these countries often prefer to use Russian railways as well as some southern routes to transport cargo to/from Europe and other CIS countries. Azerbaijan and Armenia are also tryingto use alternative routes to the possible extent. 4.21 The TRACECA initiative has not succeeded in capturing potential transit traffic from Central Asia and increasing traffic from the Caucasus except for oil. The multiple borders that transporters have to cross to reach Central Asia through the Caucasus and the number o f times cargoes need to be handled, together with the associated legal and illegal payments and delays, explain to some extent the TRACECA challenge compared to alternative routes. Furthermore, shippingcostsS5across the Caspian Sea are high by internationalstandards56and create, in themselves, an additional barrier. The shippingfreight rate of a 53 According to forwarders, a reduction o f 10 percent may result in 5 percent increase in oil, glass bottles, general cargo; a reductiono f25 percent in a 10 percent increase inoil, cotton, glass bottles, canned food, oil products, wine, metal, agro products, machinery and equipment, bulk and liquidcargo; areductiono f 50 percent in an increase of 20 percent in oil and inadditionto above tobacco products, timber, constructionmaterials and humanitariangoods. 54 Source - Poti and Batumi ports administration. This information is inconsistent with the TRACECA UniJicationof Transit Tar@ Progress Report, October 2002 which reports cargoes through the Black sea ports of 1.2 million tons of alumina transported from Greece and other countries to an aluminum refinery in Tajikistan, 534'000 tons of other transit cargoes(pipes, other oil equipmentand chicken) to Kazakhstan.. 55 US$0.023 to 0.026iton-km for bulk and dry bulk and US$O.O7-0.1l/ton-km for a TEU container. 56 An estimatedUS$O.OlS/ton-kmto US$0.025 for aTEU container. ChaDter 4. Transportand TradeFacilitationin Georgia 36 TEU container between Baku and Turkmenbashi is US$400 for 305 km, compared to US$925 from Rotterdamto Poti for 6,000 km. TheFuture of Transit 4.22 Georgian transport infrastructure could handle significant additional traffic with limited new investment, particularly in the railways. Most of the rail network operates at an adequate speed of 60km/hour for freight, although technical limitations exist both on the section to Armenia and in the mountainoussegments of the East-Westcorridor. The GeorgianRailway estimates it could handle double the present traffic. The same applies to port traffic, where new investments will double the handling capacity. The road sector requires further investments in maintenance particularly between Georgia and Armenia (being upgradedunder a World Bank project). This explains inpart the low roadtraffic levels at main border crossingpoints (30 and 80 trucks a day toward Armenia and Azerbaijan, respectively). West-East Transit 4.23 Oil equipment. Large oil-related investment in the Caspian Sea (estimated at more than US$10 billion over the next five years) will leadto the transport of largevolumes of equipment, pipes and construction materials. The odd shape of oil equipment makes it more suited for transport through the Volga-Don canal, as shown by presenttraffic. But, the canalsuffers from serious limitations, particularly on vessel size (3000 DWT), icy condition during winter months, high transit fees, special permit requirementsby Russia, and lack of shipping service competition. The economic gains of capturingpart of this transit would be very large, but require the entire chain of transport operators to demonstrate its ability to deliver complex shipments on time, in good condition and with minimal hassle by border agencies. Foreign investors are considering a partnership with the Azerbaijani railway to transport such equipment. 4.24 Humanitarian and reconstruction support to Afghanistan. TRACECA countries agreed during their Tashkentmeeting(April 2002) to facilitate transit of humanitariangoods andreconstructionmaterial to Afghanistan. This approachhas beenclosely coordinatedwith major forwarding companies to offer an attractive cost and quality-wise solutions. The present official tariffs for humanitarian goods are competitive. Results of these efforts will become available inthe near future. While the transport volume may not be very large or sustainable in the long term, attracting this type of cargo will demonstrate the capacity of the TRACECA countries to act with a common strategy. 4.25 Containerized consumer goods to oil countries. Increased revenue from oil exports is likely to result in a significant increase in demand for consumer goods in Azerbaijan and Kazakhstan. Russia currently dominatesthe marketto CentralAsia through low tariffs for its railway services. Time sensitive goods also tend to be transported by road from Turkey and through Iran. The route through Iran is already favored by importers of construction materials and capital goods, even at a cost premium. The Azerbaijan market provides, however, a reasonable potential if the quality of the logistic chain through Georgian is improved. The willingness of Azerbaijan to become a regional consolidation center for the region may leadto additional flows. 4.26 Machinery and equipment for Azerbaijani/Armenian/Central Asian SMEs. A major economic priority for Azerbaijan and Kazakhstanis to diversify their source of income by stimulating SMEs. These countries are therefore likely to increase imports of machinery and equipment for their emerging industries. Costly pieces of equipment will be required, calling for high quality integrated transport services and consolidationof shipments. The same SME focus applies for Armenia and most of Central Asia. East-West Transit 4.27 Cotton exports. Cotton transit through the Caucasus has failed to materialize. The historic route via Russia and the port of Riga (Latvia) has progressively been replaced by a new route using the highly competitive ports of Bandar Abbas (Iran) and Dubai (UAE) from where low shipping rates can be obtained to Asia, a primary destination. This traffic exceeds one million tons. With the impediments linkedto crossing the Caspian Sea and the less competitive shipping services from Black Sea ports, it is unlikelythat Georgiawill attractthis transit activity. 4.28 Oil and gas transit. Oil and gas transit are likely to generate additional revenues for Georgia in the foreseeable future. Additional crudeoil flows are expectedfrom Azerbaijan, Kazakhstan, Uzbekistan and Turkmenistan, but transit capacity will not be sufficient untilthe Baku-Tbilisi-Ceyhan (BTC) pipeline is built. In fact, Kazakhstanhas already startedrerouting crude oil through new pipelinescrossingRussia. The BTC pipeline will enable the bypassing of the congested Bosphorus Straits. The capacity of the pipeline is expected to be 1.5 million b/d and it will be able to absorb most of Azeri oil exploration together with the other pipelines. In addition, the ongoing construction of a new pipeline from Kazakhstan to Russia by the Caspian Pipeline Consortium and a proposal to expand the BTC pipeline further to Kazakhstanwill shift transportofcrude oilaway from the railways. Therefore, crude oiltransit by rail will cease to be a major source of income. Oil products and LPG transport to and from Central Asia would offer better longterm opportunities. Potential Impact of Conflict Resolutions in the Region 4.29 A reopeningof the border betweenArmenia and Turkey would reduce Georgia's transit cargo by some 70,000 tons (the figure could be higher since some cargo frodto Turkey is imported to Georgia first and then re-exportedto Armenia.)57 While rail transit through Georgia may still continue, the highly competitive Turkish road transport industry would probably attract significant portion of cargo currently transportedby the Georgianrailways. 4.30 A resolution of the conflict over Nagorno-Karabakhwould allow both Armenia and Azerbaijan to gain access to alternative maritime gateways (e.g., via the Turkish ports of Trabizon in the Black sea and Mesin inthe Mediterraneansea). The Mesin route would be particularly attractive as it would bypass the congestedBosphorus Straits. Although the Trabizon port does not currently have a rail link the missing segment is a short one and the Government of Turkey has a program to connect it to the railway,58plus the rail link with Turkey is included in TRACECA corridors. This could reduce total transportationcost by 25 percent to 65 percentsgInaddition Armenia, Azerbaijan and CentralAsian countrieswould get rail linkto Iranvia the Nakhichevanenclave. This would provide rail access to the ports of BandarAbbas in the Persian Gulf and of Bandar Enzeli in the Caspian sea and would significantly increase the attractiveness of Southern direction. Armenia would get an alternative railway link with Russia via Azerbaijan. 4.3 1 The resolution of the Abkhazia conflict would restorethe direct railway link betweenGeorgiaand Russia and most likely boost trade between the two countries, but would have little effect on transit to/from other countries, with the possibleexceptionof Armenia. 57 Polyakov, E. (2001) "Changing Patterns of Trade after Conflict Resolution", Policy Research Working Paper 2593. "Conceptof prospectivedevelopment ofports on Georgiancoast ofthe Black sea, Georgia, 2002. 59 Polyakov,E. (2001). Chapter 4. Transport and TradeFacilitation in Georgia 38 4.32 Oil transit, the main cargo through Georgia, will be transportedby pipeline instead of rail in the near future. Increased transit of non-oil goods through Georgia will not be captured unless there are visible improvementsinGeorgia. Competitors have managedto increase their market share over the past few years, particularly Russiaand Iran. Inorder to attract transit traffic, Georgia will need to implement an integratedstrategy covering all transportmodes and addressingshippers' concerns. Proposed Strategy and Recommendations 4.33 Given the high level of unofficial transport costs in Georgia, a trade and transport facilitation strategy needs to focus on significantly improving customs administration and other border agencies dealing with foreign trade and transit. In addition, well targeted interventionsare neededto upgrade the transport infrastructure. In both cases, the improvement of road transit conditions seems to be the most urgent priority. Trade facilitation objectives need not be in conflict with revenue enhancing ones, as shown by the experience of reforms in South EasternEurope where fiscal revenues increasedalong with lower processingtime oftransit goods. (see Box 4.1). InstitutionalDevelopmentofBorderAgencies Implementation of CustomsReform 4.34 Without a professional customs service it will not be possible to turn Georgia into an attractive regional hub for trade and transit. The 2002 Development Strategyoffers an initialbasis to improve trade facilitation in the medium to long term. The strategy is based on the following pillars: (a) improving human resources, including through reductions in the number of customs officials to 1000, testing for qualifications, possibly hiring new agents, and developing comprehensive training programs; (b) upgrading legislation, with support from the EU, to bring it in line with European standards; (c) upgrading the information systems, through the full implementation of ASYCUDA; (d) transferring payment collection to the banking sector; and (e) upgrading checkpoints and customs offices. These should be supplementedby the development of detailed, operational internal procedures, including those required for transit, which should be available to users. The human resource strategy needs to be supported by the definition of a compensation package including performance-based incentives and enforcementof sanctions for non-compliance. Priority needsto be given to the following reforms. 4.35 Computerization. The application of ASYCUDA nationwide, now available at the Lilo clearance terminal, should helpto harmonizeproceduresand reduce the scope for personalcontact betweencustoms officials and traders which results in illegal practices. It should include risk management systems and the integration of a valuation database. The ASYCUDA system could be expanded to include a transit module, allowing data exchange with Armenia and Azerbaijan for vehicles under the TIR regime. The computer package would includea system of advanced declarations allowing shippersto send all relevant information ahead of arrival to allow transit processing to be completed upon arrival. Shipments requiring additional review would be pre-identified by the system, enabling agency staff to focus only on these shipments. The estimated cost is US$200,000 for software and US$1 million for hardware and networking. 4.36 Strengthen existing mobile units andpost-release controls. Existing mobile units should include Customs and interact with all other border agencies to capture illegal cargo and build the intelligence component of the Customs information system. Their outreachwould extendto the controlled territory of Georgia. Post-release controls procedures would supplement the trade facilitation efforts and selective processing. Chapter 4. Transport and TradeFacilitation in Georgia 39 Box 4.2. Trade and TransportFacilitationProgramin SoutheastEurope Under the TTFSEprogram, SoutheastEuropeancountries haveselectedpilot sites where they measureprocessing performance, particularlyprocessingtimes. A comparisonbetweenprocessingtimes (declining lines) and revenue collectedby Customs(increasing line) for Bulgariaand Croatiaover the pasttwo years indicatesthat revenue collection(US$6 billion for bothcountries in2002) increases with better facilitation. See www.seerecon.org/ttfse for more information includingperformanceindicators for SoutheastEurope. Collected Revenue versus Processing Times at Pilot Sites -Time index BG I 250 I -Customs Revenue index BG (100 = in 2000) 'c1 xa 2oo 150 *Timeindex HF 100 50 Customs Revenue O I index HR (100 I I in 2001) 2000 2001 2002 _ _ _ _ _ ~ ~ ~ 4.37 Simplification ofprocedures for transit trade. Simple changes can have a large impact on trade facilitation, as demonstrated by the experience in Southeast Europe. Changes that directly impact users should take place with a well specified timetable, after proper training. The following measures are recommendedto improve transit trade. Remove unnecessary transit procedures for transporters with TIR carnets; e.g., eliminate the VVT, the transit insurance, transit road charge (as per international agreements), and the mandatory escort for non-excise goods in transit. This could result in a 40 percent decrease in logistical costs for the Poti-Armeniaroute. Allow truck travel at any time, at the truckers' own risk and align opening hours o f border agencieswith traffic flows. Enable shippers to obtain all necessary permits in their country o f origin, prior to arriving at the border, or at the border, especially in the case o f neighboring countries. Designate a Single Window (cashier/electronic transfer) for payments of duties and fees for all border agencies, and transfer all payments to banks. Allow traders to clear imported goods at any clearance facilities in the country, based on their business needs. Introduce selective control rules even in locations with a low level of automation. Introduce simplifiedprocedures for consolidated shipment, typically usedby SMEs. Chapter 4. Transportand TradeFacilitation in Georgia 40 Simplify and harmonize control procedures (for vehicles, cargo and passengers) at border crossing points across the Caucasus and Central Asia (being addressed with the support of TRACECA). 0 Ensurea sound legalframework for distribution of responsibilities amongborder agencies (being addressed with EUROCUSTOMS). I Box 4.3. Creation of a Transit Service Unit: An Option for Discussion Given the strategic importance of transit trade as a potential source of export revenue for the country, the Government may wish to consider the establishment of a Transit Service (TS) unit dedicated solely to facilitate transit. The proposed TS would coordinate all government agencies involved in transit, acting as a single entry point to ensure a strict fulfillment of transit procedures and suppress unnecessary interference and unofficial payments. It would not be a new institutionbut would pull staff from the various agencies concerned, under the leadershipof Customs or the Special legion. The TS could be under the supervisiono fa board with representatives from GEOPRO. Their duty would start from the time a vessel bertha port inGeorgiaor the time a truck crossesthe border, until the time the shipment leaves the country (and vice versa). Other border agencies would have the right to intervene only under the TS control, in the spirit of integrated border management. The TS would also be responsible for improving transit procedures to reducetime and remove unnecessary steps. (The estimated cost to define an appropriate institutionalmechanismis US$200,000). The creation o f similar interfacing services will be also suggested in Azerbaijan and in Armenia to ensure coordination from the port of unloading to the final destination. The TS creation should be accompanied by improvedhumanresourcemanagementand pay-scale,and bonuses in linewith the responsibilities. This couldtake the form of a contract with the TS, whereby any legitimate transit would have the choice to be processed within a pre-defined time frame against a special fee which would help fund operations (e.g., posting of officers in Azerbaijan and Armenia; paymentof performancebonuses; and infrastructure and computer maintenance). The TS staffwould be heldaccountablefor any wrong-doingand subjectto civil and criminalcharges. Monitoring service quality. The TS would measure systematically the transit time performance, based on transit targets set in consultation with shippers. The TS would issue explanatory notes each time a consignment exceeds this target and share it with the shipper, the transport company and the border agency concerned. The TS would produceregular reportson overall transit performance, identifyingsystemic issues, and recommendingmeasuresfor improvement, The TS would present this report to the Government and to GEOPRO, and issue it on the internet, once approved. A specific incentive scheme, based on performanceindicators could be built into the system. This could be combined with the proposed GSM-based tracking system proposed under TRACECA and its hotline initiative (Estimated cost: US$200,000). Cost of implementing the TS concept, performance measurement and transit informationsystem is estimatedat US$1.5 million per year of recurring cost, that would be self-funded by user fee, andUS$2.1 millionto launch. 4.38 Publication trade and transitprocedures. All governmentalentities involved inthe movement of consignments should systematically cooperate at national and regional levels (with Armenia and Azerbaijan) to provide, in a uniform format, all official requirementsrelatedto trade andtransport intheir respective country, using both a website and bookletsa6' It should build on on-going efforts such as the recently published Customs set of procedures. Transit trade for all border agencies should be covered by a separate booklet (estimated cost: US$lSO,OOO). 4.39 Performance monitoring. Teams of selectedrepresentativesof governmental entities involved in the processing of transit should be placed at border crossing points. These teams would propose simplifiedproceduresto increase revenue collections and facilitate transport. Both of these targets would 6o An example of similar mechanism in Southern Europe, due for release in March 2003, is available at www.ttfse.org. Chapter 4. Transport and TradeFacilitation in Georgia 41 be linked to specific performance measurements to be integrated in the processing. In addition, independent audits should be conducted on the application of the legal and regulatory framework at border crossing points and clearance facilities, inclusive of aspects impliedby internationalconventionto which Georgia adhered. 4.40 Strengthen private-public sector dialogue. A critical element for the successful implementation of proposed reforms is to strengthen consultation with the private sector. The recently established trade and transport facilitation committee, GEOPRO, could serve as a means to: (i) conduct regular dialogue on the trade and transport facilitation; (ii) consult business representatives prior to introducingnew laws and regulations; and (iii)deliver programs of technical assistance affecting the trade and transport environment. The committee will require, in particular, direct support to formulate concrete proposals, generate momentum and follow up on the implementation of proposals. The estimated cost is US$150,000). Upgrading Transport Infrastructure 4.4 1 Transport investment priorities. Investmentdecisions in Georgia remain ad-hoc with limited use of economic criteria, and limited comparison of priorities across modes. Given Georgia's budgetary constraints and limited external financial resources for transport, it is recommended that the Ministry of Transport prepare a multi-annual and multi-modal investment plan based on traffic forecast, economic evaluation and impact on the Poverty Reduction and Economic Growth strategy. The estimated cost is US$150,000 inaddition to the TRACECA feasibility study. 4.42 The financing of investment is transport infrastructure could come from user charges, concession arrangements (port, rail) and IF1 lending (road, rail). The on-going TRACECA work to produce a Unified Policy on Transit Fees and Tariffs and its feasibility study on road infrastructure needs will be instrumental to define charges and fees that can be sustained by the market demand and estimate financing needs for donor or IF1support. 4.43 Continue the Transport Sector Restructuring. In particular, efforts need to focus on (i)the commercialization o f railway services, to capture new types of commodity flows; (ii)the stimulation of competition inthe ports. The estimated cost is beingestimated by the MOTC. Chapter 5. Finance Sumort Services 42 Chapter 5. Finance Support Services 5.1 Almost all of the business surveys carried out for Georgia show that access to finance is a considerable impediment to business development, includingexports. Among the financialobstacles are high interest rates and high collateral requirements. These conditions reflect the low degree o f development ofthe financialsystemandrelativelyfragile macroeconomic environment. The Financial System 5.2 Georgia's financial system is dominated by the banking sector. But, despite rapid growth in recent years, the sector is still small by regional and internationalstandards, with assets accounting for about 15 percentof GDP (as of end ofDecember2002). Figure 5.1. Banking Sector Development: Cross Country Comparison In Percentageof GDP (2001) 90% _ _ 3 80% 70% 60% 50% 40% 30% 20% 10% 0% Source: Extracted from IMF's IFSdataset. The figures from IFS differs significantly with that of National Bank o fGeorgia. In this context the author decidedto also illustrateGeorgiafigures basedonNational Bank data. 5.3 The Georgiansecurities market is very smalland illiquid,6'despite the significantdevelopment of its infrastructure. Further development is constrained by the lack of valuable enterprises trading in the market and by weak corporate governance. Measures to develop a secondary market for treasury bills and to privatize state owned companies through the exchange should improve the sustainability of the market. It is unlikely, however, that the Georgian capital market will become a significant source of new capital for enterprises in the foreseeable future. The insurance sector is also small but growing very rapidly. Its size has doubled since 1999to reachUS$12million in gross premiumincome in 2002. The insurance market already provides important products such as automobile insurance6*, construction insurance, financial guarantees, cargo insurance, performance bonds, fire insurance, etc. Insurance services for import/exportbusiness have not developed, partly reflectingthe poor reliability of customs and other public agencies involved in the clearance of goods. Inaddition, the regulatoryand supervisory frameworkfor the insurancesector is very weak. 61 During2001, the number of trades executedinthe Georgian Security Exchangewas 1591 with overallvolume of just over 10 million shares, overall value o f GEL 13 million, and average dailyturnover of GEL 128,000. Car insuranceis compulsory and holdsthe biggestshare ofthe insurancemarket. ChapterS. Finance Suuuort Services 43 TheBanking Sector 5.4 The low level o f banking sector depth in Georgia reflects, to some extent, the fragility of the country's macroeconomic environment, particularly on the fiscal side. Tax collection (as a percent of GDP) is low, because of tax evasion and corruption, and domestic expenditure arrears are a chronic problem. Georgia's external current account deficit is large, because of its heavy reliance on imported energy and the country's high external burden. With gross foreign reserves covering less than two months o f imports, Georgia is highly vulnerable to adverse external shocks. Sluggish economic growth also limits development of the financial sector by constraining the profitability o f investment projects and raising credit risk. Figure 5.2. Number of Banks in Georgia, 1993-2002 250 , v) 200 YC r 150 0 2 L s 100 50 0 1992 1993 1994 1995 1996 1997 1998 1999 2000 2001 2002 Source: NationalBank of Georgia. 27 banks include 25 Georgianresidentbanks and 2 branches. 5.5 The country is still over-banked, despite progress in reducing the number of banks from 228 at the end of 1994 to 27 by December 2002. Most of these banks, apart from former state-owned banks, were small-scale operations, often established to serve the interests of their founders with little emphasis on deposit mobilization. Further consolidation, enhancedresource mobilization, and increased efficiency of banks are required to allow successful banks to exploit economies of scale. This will need to be supported by a coherent exit strategy for failed banks. Figure 5.3: Level of Bank lntrmediationin Georgia, 1996-2002 80 0% 70 0% 60 0% 50 0% 40 0% 30 0% 20 0% I O 0% 0 0% 1996 1997 1998 1999 2000 2001 2002 Source: National Bank o f Georgia. 5.6 Georgia's low degree o f financial intermediation, reflects low confidence in the system. Main contributing factors are (i)the adverse experience o f hyperinflation in the years immediately after independence which eroded the public's stock o f savings; and (ii) bank failures inthe recent past resulting in losses for depositors. Although there has been an encouraging trend o f increased bank deposits, the size o fthe currency stock outside the banking system is still over 40 percent of broad money. 5.7 Effective demand for bank loans is limited because o f the scarcity o f bankable projects that can pay the high interest rates required by banks to cover the high risks o f loan default. Moreover, the difficulty o f collecting on collateral and the high coverage typically demanded by the banks result in a shortage o f effective collateral. The lack o f a credit culture, weak governance, and the absence o f reliable company financial statements further inhibit bank lending. Cash flow-based lending, which is widely used in developed financial systems, accounts for only about one-quarter o f banking credit to the private sector. This reflects the unreliability o f company financial reports as well as the inability o f most households and enterprises to contribute acceptable amounts o f their own funds for the purchase o f assets. Also, the lack o f credit bureaus, or reporting agencies, deprives businesses and individuals o f the ability to build a credit record that is accessible by prospective lenders who may not have first hand knowledge o f the borrower. Several o f the largest banks in Georgia are getting together to develop a credit bureau, but few regulatory and infrastructure procedures will have to be put in place before such a system could be established. 5.8 The legislation governing collateral and security enforcement, is considered adequate (Le., Civil Code o f 1997 and the Law on Civil Procedure o f 1999), but there is much dissatisfaction with court rulings as well as enforcement. Despite a noticeable increase in the number o f repossessions of real estate, courts rulings and enforcements are still subject to significant delays and corruption. The government is considering the introduction o f out o f court procedures for notarized contracts which should help to improve lending environment. 5.9 The Public Register that provides for the registration o f both movable and immovable property seems to operate satisfactorily, although it is not centralized and, in some areas, is not computerized. The country would benefit from the adoption o f a modern specialized secured transactions law dealing respectively with both movable and immovable property. Table 5.1: Georgia: Monetary Indicators (million dollars) Dec-98 Dec-99 Dec-00 Dec-01 Dec-02 Total BankingAssets (December) 252 304 368 427 534 Loansto the State Institutions N A 17 17 13 3.2 Loansto Private Sector (excluding inter bank) N A 144 192 249 29850 Volume o f credit lines grantedby international organizationsto Small and Medium 14 21 29 36 46 enterprises Credit to the enterprisesSector funded by GeorgianCommercial Banks N A 124 163 213 246 Non Bank and Bank Deposits N A 112 166 207 291 Source: NBG. In some cases the January data was usedinstead of December. 5.10 The 2002 law on "leasing promotion", which was effectively a clarification o f existing amendments, has not yet translated into significant leasing transaction and/or foreign inve~tment.~~ Potentially, however, leasing could be an important (and cheaper) source o f capital for enterprises. 63 The only leasing contract that has been concluded since the enactment of the new law is for few motor vehicles connected to a hotel. 5.11 Lending to Private Sector. The total assets of the bankingsector grew by 25 percent in 2002 to reach GEL 1067 million (US$534 million) which is significantly larger than nominal GDP growth. During the same period the top eight banks further increasedtheir market share to over 80 percent of assets and liabilities. 5.12 The size of loans to the privatesector is growingand is considerably larger than the size of loans to public enterprises. Credit lines64from external donors account for about 16-17 percent of all credit lines. Table 5.2: Georgia: Structure of Lending by Sectors (percent) 1998 1999 2000 Sep-2001 * Total 100 100 100 100 Agriculture 5 5 5 3 Industry 21 19 19 21 Electric Power 3 1 2 1 Construction 5 7 6 6 Trade 27 62 67 68 Transport & Communication 1 4 0 0 Other-Services 38 2 1 2 Source: NBG. * From September 2001 NBG changed the sector categories. To illustrate the historic trend, the author decided to use the previouscategorization. 5.13 Loans to the enterprise sector are heavily concentrated in the trade and industry sectors, and lendingto constructionhas been growingrapidly. Agriculture, which makes up 20 of GDP, but accounts for only 4 percentoftotal loans eventhough over 10percent of external donor credit lines are allocated to this sector (as of June 2001). Many factors explainthe low share of agriculture,includingcurrently high cost o f lending, as well as highrisk attachedto agriculturalactivities. 5.14 Interestrate spreads in Georgia are significantlyhigher than in other countries inthe ECA region (see Figure 5.4). This couldbethe reflectionofthe higherrisks of lendingin Georgia. 5.15 Despite a decreasingtrend (see Table 5.3), with the rate of inflationrunningat 5 percent annually, lendingrates in both foreign currency and Lari denominated loans are very high in real terms. Spreads are lower for US dollar denominated transactions-13 percent for U S dollar denominated loans vs. deposits, and 17percent65for Lari dominated loans vs. deposits. 64 There was approximately a 30 percent decrease inthe outstanding balance for foreign credit during the months o f June and July 2002. The balance has since increased to the same level as o f May 2002. The reason for this sharp downfall is unclear but it could be due to: (i)write-off o f a large credit line balance in one o f the commercial banks that went into liquidation, and/or (ii)the number o f credit lines reached their maturity and were paid back by the commercial banks. 6s There has been a sudden jump in the Lari denominated long term deposit rate (from 2 percent to 13 percent), possibly reflecting banks' desire to reduce the dolLarization o f their balance sheets and/or to have additional finds to invest in highly lucrative treasury bills with longer maturities (which trade at over 40 percent). II Figure 5.4: The Spreads Charged by Georgian Commercial Banks 35% I 30% 25% 20% 15% 10% 5yo 0% Georgia Kyrgyz Ukraine Russian Croatia Belams Macedonia Azerbaijan Armenia Albania Bulgana EU Republic Federation Accession Source: IMF IFS, Quarter 2,2002. Table 5.3: Georgia: Average Interest Rates Dec-98 Dec-99 Dec-00 Dec-01 Oct-02 Interest on Loans(Lari) 33 26 23 23 24 Short Term 33 26 24 25 25 LongTerm 26 27 18 16 19 Deposit (Lari) 7 3 4 3 7 Short Term 7 4 4 4 6 LongTerm 8 2 2 2 13 Interest on Loans (US$) 36 30 27 24 23 Short Term 40 32 30 26 24 LongTerm 22 23 20 20 20 Deposit (US$) 15 13 13 10 10 Short Term 15 13 13 10 10 LongTerm 32 13 12 11 12 Interest rate under credit lines 21.7 22.4 20.5 21.2 21 5.16 Despite high spreads, the basic business of lending is not very profitable when full account is taken o f loan-loss provisioning (see Table 5.4). Reported net profits o f the banking system were marginal in 2000 and 2001 as banks were forced to recognize inherent losses to meet new asset classification and provisioning requirements. For 2002, the banking system has reported considerable profit margins which could over the medium to long- term, be translated to reduced interest rate spreads. Table 5.4: Georgia: Profit Margins of Commercial Banks (US$) 2000 2001 2002 Total Capital 114 132 136 Total Net Profit 2 6 19 Ratio of Profit to Capital 1.4% 4.8% 14.0% 5.17 A positive recent development is the increase inthe average maturity o f bank loans. This reflects, in part, the availability o f externally funded credit lines (EBRD supported mortgage lending could provide loans with upto 7 year maturity) but also banks' willingness to lend longer term to their preferred customers. Indeed, the share o f externally funded credit lines has stayed the same (see Table 5.9, while the share o f loans with a maturity o f 1 year and longer has increased from 24 percent in 1998 to 37 percent in 2002. A limited number of companies with an established credit history has been able to get long-term credits (up to 5 years) and lower interest rates (16-18 percent). However, most of the private sector continues to face limited access even to short-term financing mainly because they are still considered as highrisk by banks. 5.18 The deposit to lending ratio has increasedover the last few years, which could be a sign that the increased confidence of depositors inthe banking sector has not translated into similar growth in lending. This trend illustrates that commercial banks are not finding bankable projects at the same rate they are attracting deposits and have recently started to invest their excess liquidity in Government treasury bills. The total outstanding treasury bill market has grown to Lari 64 million in January 2003 with average yield of 46.1 percent and average maturity o f 122days. Table 5.5: Georgia: Maturity of Bank Loans (percent) Dec-98 Dec-99 Dec-00 Dec-01 Oct-02 Total Credits 100 100 100 100 100 Less than 1 month 7 6 6 10 10 1-3 months 16 18 14 11 9 3-6 months 23 17 15 13 10 6-12 months 29 35 31 30 34 Over 1year 24 24 34 37 37 Total Deposit as ercentageof Total Credits,P NA 74 87 90 104 Source: NBG. I/Depositsincludebankandnonbankdeposits. Export Finance 5.19 Interviews with exporters in Georgia revealedthat most o f them are not used (or keen) to utilizing any export financing products such as letters of credit (L/C) and financial guarantees. Some o f this reluctance i s due to the cost charged by banks for such facilities. The cost to open an L/C can be as much as 1 percent66o f the total transaction, which is about twice the cost charged for an average L/C in the West. Part of this expense is due to confirmation charges by international banks. Most importantly, the majority of buyers of Georgian exports in the CIS region (which account for 50 percent of total exports) preferto deal with direct payments (20-30 percent prepayments and/or payments after delivery) instead o f using financial instruments. It would appear that buyers from the CIS countries prefer to hide the exact value of their imports to their own authorities and avoid taxation and excise duties. Also, the majority o f exporters and traders in Georgia are not aware o f the full benefit o f financial instruments to their businesses. Many o f the commercial banks have started to hold workshops to increaseclient awareness in these areas. 5.20 Currently there are two donor-funded facilities in Georgia aimed at export and import promotion - approximately US$2.5 million from Black Sea Trade and Development Bank for exporters, and US$ 8 millionfrom EBRDtrade facilitation project for imports and exports. 66 1 percent includes 0.3 percent for issuing L/C, 0.3 percent for administrativecosts, and 0.3 percent per quarter for confirmation. ChauterS. Finance Sumort Services 48 Government's Initiatives to Increase Access to Finance 5.21 The Government o f Georgia is considering different options to increase firms' access to finance and reduce the cost o f finance, mainly targeting exporters. Some o f these options are described in detail below. 5.22 Interest rate subsidies, The Government has just started, through the recently established Investment Center (see Chapter 3), a scheme to grant interest rate subsidies targeted mainly to exporters. So far, eight companies have been selected to receive such subsidies (up to percent o f 70 percent6' o f lending rates). While some provisions have been made to minimize risks, such as granting the subsidy upon payment o f interest due on the related loan, experience in other countries shows that such subsidies are usually ineffective, difficult to administer, lead to corruption and may even endanger the health o f the banking sector. Such schemes tend to benefit businesses which already have access to finance and weaker banks could use the subsidies to charge the enterprises additional costs over and above the interest rates. 5.23 Export facilitation grants with the government taking part or all of the credit risk. In several countries, different export facilitation grants have been introduced to promote exports. Some o f these facilities were set up as revolving funds, which the participating banks were able to access to finance enterprises for their export trade. In an effort to reduce the cost o f finance, the governments took part or full risk of such lending. While some o f these funds were successful, inthe majority o f cases these funds were abused by the participating banks for connected lending and for purposes o f refinancing and cleaning up their problem loans from the portfolio. So it is essential that before any such intervention by the government is introduced, an adequate assessment o f demand for such intervention is done and the required institutional capacity, governance and sustainability is established. 5.24 Exportfacilitation loans withparticipating banks taking all of the credit risk. There are a number o f existing credit facilities in Georgia that provide credit to enterprises through participating banks. While these facilities are available to all enterprises, they are commonly accessed by well established exporting firms. For example, EBRD68and IFC6' alone provide about US$27 million o f such credit facilities. In addition, there has been a large amount o f other externally funded credit lines, like World Bank ADP credit line. These funds could be recycled to enterprises usingthe same terms and stringent supervision techniques used by the international institutions in an effort to increase the flow o f credit to enterprises in Georgia. However, introduction o f similar credit lines may not automatically lead to reduced cost o f lending. For example, the lending rates to participating banks from EBRD and IFC are about 5.5 percent (which equates to 4 percent above LIBOR) but the on-lending rates to enterprises are above 20 percent. ' 67Total commitment for the interest subsidy of the eight project is US$ 260,000. Two out of the eight projects are located in Tbilisi and six in the regions. The projection for the Interest rate subsidy for 2003 is estimated by overnmentto be approx. US$4 million. EBRD facilities include a newly developed US$15 million program for SMEs, and US$5-8 million for micro enterprises,but does not includethe US$8 millionTrade Facilitationprogram. 69 IFC provided several large revolvingcredits to participatingbanks amountingto US$15 million, of which US$3 millionhas maturedandUS$6 millionhasrecently been introduced. Box 5.1. Georgia: Trade Financing Facilities Black Sea Export Facility is designed for exporters to the Black Sea and in some cases to other destinations. Up to now, this facility has worked well for large exporting companies and not for small enterprises. The facility provides a pre-shipment credit line to exporters. Participating banks submit applications from their clients to the Black Sea export facility and receive funds, which they on-lend to their exporting client. The charge from Black Sea facility ranges from 4 to 5 percentabove LIBOR, but the banks charge market rates to their clients. It is not clear if this facility assists exporters, or is another form of credit. It is possiblethat some of the borrowers/exporterscould have raised money for their working capital from the banks without this facility. About US$- million out of total US$ 2.5 million has been disbursedto date, and only time will tell ifthis facility will increase exports compared to a traditional credit line to enterprises. EBRD Trade Facility was establishedto assist exporters and importers of Georgia, but to date almost all funds have been used for imports. The total amount of facility was US$8 million and currently more then 92 percent is utilized. The demand for this facility by participating banks hit its peak in 2001, but has since decreased. For import purposes, participating banks use the EBRD facility to confirm their LCs with international banks. But, given the high liquidity position of the participating Georgian banks, it is currently cheaper for them to deposit their own cash in international banks and use it as collateral for confirmation of LC. The deposit rates the banks receive from international banks range from 1.25 to 1.5 percent. Thus Georgian banks prefer to put these deposits as collateral and confirm LCs, insteadof paying 4 percent over LIBOR for the EBRD facility. For export purposes, the participating banks can use the EBRD facility to guarantee LCs from buyers of Georgian goods. But it seems that there is no demand from participating banks and Georgian exporters to use this guarantee as a collateral to raise pre-shipment working capital. loans. 5.25 Export Credit Agency. The Government is also considering the establishment o f an Export Credit Agency (ECA), that can provide specialized facilities to exporting companies such as pre-shipment insurance, short-term post-shipment insurance, medium and long-term post shipment insurance, pre- shipment guarantees. The banking sector and insurance sector in Georgia may not have the appetite or the ability to provide such facilities without charging significant premiums. Experience inother countries has demonstrated that ECAs can be successful, but there are many cases o f poorly performing institutions. Before the government proceeds with establishing such an entity, due assessment should be made o f demand for such an entity to ensure its sustainability over the medium to long term. Successful ECAs have few important factors incommon. 0 The management o f the entity is protected from political pressures but has support o f the government. 0 The right expertise is recruitedat usually internationally competitive compensation rates. 0 The operational procedures are designed to ensure adequate due diligence is done on each facility for each client. 0 The fee structure is adequate to provide for enough funds to cover operational cost as well as to accumulate additional reserve funds. 0 Adequate capital is secured for the institutions to ensure claims are paid on time, and losses likely to be incurred by ECA during the first years o f operations are covered. The required capital could be as highas US$3-4 million for countries like Georgia. ChauterS. Finance Supoort Services 50 0 Demand for export and import is high enough to justify establishment of ECA and to ensure satisfactory impact on exports and the overall economy. 0 ECAs do not compete with local financial institutions and distort the market; instead they work and collaboratewith local and internationalfinancial institutions. 0 Aggressive marketing is inplace. Conclusion 5.26 Despitethe recent progress in the Georgianbanking sector, it still lags significantly behindthose of other more advanced transition countries, including those of a similar size and starting point (Le., Balkanstates). 5.27 The macroeconomic and investment environments remain the most significant barriers to the growth of the banking and financial sector inGeorgia. While the government should focus on addressing these barriers, there are number of specific financial sector reforms that need to be undertaken inthe near to mid-termto further develop the financial sector, namely: Raising the minimum capital requirements to encourage the consolidation of the banking sector combined with effective exit strategy for weak banks. Strengthening of the registration process for movable collateral which could lead to additional lending. Improving proceduresandtransparency of collection on secured collateral. Introducing necessary legislationto support the establishment of credit bureaus. Enhancing the regulatory and supervision environment of the insurance sector, which has been growing very rapidly in the recent past. 5.28 As mentioned above, interest rate subsidies and loans to businesses through banks, with government taking all or part of the credit risk, can be ineffective and unsustainable. Credit line programs where commercial banks take the risk have shown to be more sustainablebut these programs are already operating in Georgiaand do not automatically leadto lower cost of lending. 5.29 The establishment of Export Credit Agency may be prematurefor Georgia, the government must be aware that such an entity is very expensiveto establish and run effectively and given the small size of the export potential in Georgiathis entity may not be able to generate enough incomefrom its transaction to survive. ChaDter 6. Apro-Food ExDorts 51 Chapter 6. Agro-Food Exports Introduction 6.1 Georgia has favorable conditions for the production of a variety of annual and perennial crops and agriculture has always been one ofthe most importantsectors inGeorgianeconomy. The agricultural sector presently accounts for 20 percent of GDP (down from 30 percent in 1990) and employs more than half of the country's labor force. Some 45 percent of household expenditures, on average, are accounted for by food and beverages. 6.2 Enormous structural changes have taken place in Georgian agriculture over the past decade. During the Soviet era, large farms using plantation-stylelabor producedmost basic crops for consumption and industry (grains, oilseeds, tea, and mainly fruits and vegetables). Meanwhile small householdplots produced much of the livestock products and family subsistence and some surplus for sale in the cities. Under the land reform program initiated in 1999, the large collective farms were dissolved and over one million small farms created with an average size of less than one hectare. Such household plots now account for the bulk ofnationalproduction of most cereals, fruits andvegetables. 6.3 The agricultural support services provided duringthe Soviet era were largely inappropriatefor the new agrarian structure. Lacking effective support and access to financial services, and in the face of a collapsing national infrastructure for irrigation and water drainage, a majority of the new smallholder farms have revertedto subsistence-orientedproduction. Recent surveys suggest that some 83 percent of Georgia's rural population are entirely dependent upontheir farms for subsistence and that they consume some 73 percent of their production. Auto-consumption now accounts for more than two-thirds of the total value of food consumed by rural household^^^. 6.4 Within the former Soviet Union, Georgia was a major producer and source for a broad array of foods. It accountedfor more than 10 percent ofthe total intra-Union trade inagricultural productsandthe recorded value of its food exports was virtually double that of its imports. During the Soviet era, Georgia's main exports were citrus and other fresh fruits, tea, wine and other alcoholic drinks, mineral water, and canned fruit and vegetables. Georgia imported mainly grains, meat and dairy products, and fodder from elsewhere inthe Union. 6.5 Since its independence, Georgia has experienced a substantial decline in the production of a broad array of its former `export' products, especially of fruit and tea. Georgia's per capita fruit production is now only about one-third of its level in 1990. Tea production inrecentyears was equivalent to only 5 percent ofthe output generally attainedinthe late 1980s. Livestock and poultry production also declined sharply, although in recent years there has been some recovery, especially in dairy production. Productionof cereals has been uneven, althoughit has generally beenhigher in recent years than recorded inthe early to mid-1990s. With an initially sharp decline inexports, Georgiabecame a large net importer of food and beverages inthe early to mid-1990s. Inrecent years, this gap has closeddue to a combination of reducedimportsandmodestly expanded exports. ' OBasedon OCS survey results. Figure 6.1. Georgia'sAgrolFood Imports and Exports 1998 1999 2000 2001 6.6 Table 6.1 provides an overview of recent developmentsamong Georgia's primaryagro-foodand beverage exports. Withthe exception of some recent expansion inwine exports, the overalltrends are not encouraging. Once large-scaleexports of fresh and processedfruit products and of tea have declined in recent years to very small quantities, although several firms are presently seeking to re-establish exports inthese sectorsandre-positionGeorgianproducts within CIS andWestern Europeanmarkets. Table 6.1: Agro-Foodmeverage Export Trends, 1997to 2001 1997 1998 1999 2000 2001 TOTAL 73.2 69.2 64.1 89.9 81.1 Wine 12.5 15.4 14.6 28.3 32.2 Mineral 20.7 8.2 3.O 12.8 15.2 Hazelnut 5.3 9.5 15.4 22.3 9.8 Tea 13.9 8.9 11.4 6.8 5.8 Citrus 5.2 5.6 1.9 2.5 1.6 Fruit 1.6 2.1 1.4 0.7 1.3 Spices 2.0 1.6 1.1 1.3 1.o Other 12.0 17.9 15.2 15.3 14.2 6.7 This chapter examines recent developments in and the internationalcompetitiveness of selected agro-food export industries and then identifies a series of cross-cutting strategic opportunities and challenges facing Georgian agribusiness. Brief case studies are provided of the wine, hazel nut, and processedfruit product industries. Wine Industry 6.8 Wine has been produced in Georgia since antiquity and is deeply embedded in the country's folklore and culture. It is also of considerable commercial importance. With exports valued at over US$32 million in 2001, wine is Georgia's third largest export, contributing 10 percent of total merchandise exports. There are over 60,000 ha planted throughout Georgia, and it is estimated that 30,000 farmers are involvedin grape production. Whilethe bulkof Georgian grape productionusedto be for commercial wine or spirit production, in recent years only about 15 percent of production is for Chaoter 6. Apro-Food Exoorts 53 commercial wineries, with the bulk of grapes either consumed, barteredfor basic foods, or convertedinto wine inbackyardor other tiny ~ineries.~' 6.9 The winemaking industry in Georgia is not large by international standards. In each of the past two years commercial wineries have crushed less than 20,000 M T of grapes, approximately one-third of which are red varieties and two-thirds are white varieties. Based on estimates of actual yields, one can estimate that about 4000 smallholder householdspresently supply to the commercial wineries. In recent years, the larger wineries have started to develop their own vineyards and may have provided 10 percent of total grape inputs in 2001. The trend of continued vertical integration in the industry is likely to accelerateinthe coming years. Wine makers are moving inthis direction because it allows them to better control quality and reduces raw productprocurementrisk. 6.10 In 2001, there were 40 vintners commercially producing wine in Georgia and another 66 companies involved in wine trading/exports. The five largest wineries process 52 percent of the grapes and the ten largest firms crushed 66 percent of the crop. It is estimated that about 2,000 people are employed in the nation's wineries on both a seasonal and full-time basis. A similar level of employment (i.e., about 2200 full-time equivalentjobs) is provided by commercial and smallholder farms producing grapes for commercialwineries.72 6.11 The CIS is by far Georgia's largest wine export market, accounting for 91 percent of wine exports. In 2001, Georgian exports to the CIS were valued at US$29 million, of which $24 million of product was shippedto Russia. Georgia's wine comparativeadvantage lies inthe fact that it can produce medium and high quality wines at competitive costs and that these wines can be shipped into CIS duty free, whereas non-CIS wines pay a 20 percent duty. Additionally, CIS consumers know Georgia as an origin of quality wines and have developed a taste preference for many of the grape varieties and wine types producedthere. GrapeSupply 6.12 Grape production in Georgia has declined sharply over the past decade. Production in recent years has fallen below 150,000 tons, compared with an average of 630,000 tons between 1986 and 1990 and 381,000 tons between 1991and 1995. The primary contributing factors to this decline have beenthe restructuring of the Georgian farm sector and the disruption of traditional market channels within the Former Soviet Union. Most of the small farmers who acquired land under the land reform have lacked capital, as well as the technical and management skills to produce high-quality grapes. Rather than sell the grapes to commercialwineries, farmers made wine at home. The resultantvolume of grapes used in commercial wine-making is presently less than 5 percent of 1990s levels (see Figure 6.2). This downward trend in grape output may have stabilized and some people in the industry feel that aggregate output will increase over the next several years. However, to date, there is no data to show that grape production has bottomedout yet. 6.13 In response to the difficulties in buying grapes and controlling quality from thousands of small farmers, some of the larger wineries have begunto buy and/or lease land from the government under 49 year contracts and startedto developtheir own vineyards. By employingthis vertical-integration strategy, larger firms are insolating themselves from supply risk. This strategy not only reduces raw product risk, 7' In2000, over the 210,000 tons ofgrapes produced, just under 35,000 tons was usedby commercial wineries. In 2001, only 19,011 tons out of the total grape production of 123,200 tons was usedby suchwineries. 72 Based on an estimated2,500 hectares for red varieties and 2000 hectares for white varieties, with an average of 125 man-days/year. Full-timeequivalentsare based on 260 working days. Chapter 6. Aaro-Food ExDorts 54 it also assures the firms will have a secure source of quality grapes necessary for premium/ high margin wines.73 Figure 6.2. Grapes Used in Wine 8 Spirits Production In Georgia, 1990 - 2002 I 450 I 400I *\ I \ I 350I \ I 4-+-Metric Tonsx 1000 f 300 :i250 F 200 150 100 50 0 1990 91 92 93 94 95 96 97 98 99 2000 01 02 Source: FA0 and GOG. 6.14 New investment is critical for the viability of commercial wine-making. The average age of vineyards in Georgia is estimated to be 30 years.74 In maturity terms, these are old vines. Normally, vines in California (using this as a best practicesexample) are replacedevery 25 years, but often growers will re-graft or replant them sooner (as varietal demand changes). Based on 25-year best-practices economic life, a wine-producing region should be re-planting 4 percent of its vineyards annually. Given the fact that most farmers in Georgia do not fertilize, irrigate or intensively manage their vineyards, the economic life of the grapes is probably significantly less than 25 years. This means a higher replant rate should be appliedto the Georgian industry. Actual replanting data are not available, yet it is surely at a rate far lower than is neededfor this industry. 6.15 There are five grape production zones inthe country, accordingto their unique climates and soils. The Kakhety region is the largest and most productive of the five regions, producing about 66 percent of the total crop. Some of the most popular white grape varieties planted in Kakhety are Rkatsiteli, and Mtsvano. The Kakhety red Saperapigrape is prized by winemakers and in 2002 had a farmgate price of US$SlO/ MT, well over the meanprice for white grapes of $350/ M T farmgate. Although these varieties are not well known inthe West, they are very familiar to wine drinkers in Russiaand other CIS countries. Inmany cases, CIS consumers prefer these varieties to their westerncounterparts, such as Merlots, Sirahs and Chardonnays. 6.16 The Saperavi, Rkatsiteli and other grape varieties produced in Georgia are considered to be reasonably good in terms of yield, quality and pathogen resistance. Nevertheless, Georgian farmers are not reaching productivity levels realized by other world production regions. The primary reason for the low yield is the low level of inputs used to grow the crop (including lack of fertilizer, crop-protection 73 One of the larger, foreignjoint venture wineries has an on-staff viticulture expert working with the firm's 35 contract growers and developing the company's 200 ha estate vineyards. Contract farming works in Georgia, but requires a significant financial commitment by the contracting company to supply the technical know-howto the client farmers. Firmsthat simply provide cashor inputsto farmersas advances on the crop are usually disappointed at harvestwhen they find that farmers do not honor these contracts. 74 Source:extrapolatedfrom: BaselineStudyon Viticultureand Wine Sector ofGeorgia, UNFAO, 2000 chemicals, and irrigation water), limited technical skills of the farmers and non-functional research and extension. Table 6.2: GrapeYield Comparison Mt/ha Measurable GeorgiaKakhety Georgia Kakhety California California SonomaCo. Sonoma Co. GrapeType Red White Red White Best Practices 7.0 9.0 13.0 16.2 Average Practices 2.5 5.O 9.8 12.2 Number and Size of Vintners 6.17 Compared to other wine producing regions of the world, Georgia's industry is in an underdeveloped state. Only five firms (about 12 percent oftotal producers) crush more than 1,000 MT o f grapes annually. One thousand tons of grapes yield approximately 840,000 bottles of wine. In the California wine industry, vintners producing more than 400,000 bottles annually typically produce at a point on the cost curve where they have achieved a reasonable level of efficiency in terms of per unit production costs. Once firms move to a production output level of less than 400,000 bottles, unit costs of output tend to increase. In Georgia, about 20 percent of the vintners are producing at levels over 400,000 bottles annually and nearly half o f the firms produce less than 200,000 bottles annually. However, the cost structures in California and Georgia are different and it is possible that some of the smaller Georgian firms can operate efficiently. Industrial Efjciency 6.18 Table 6.3 examines the differences intask level efficiency and sales per employee for three types of wineries. The foreignAoca1 company joint venture (JV) is 50 percent more efficient in utilizing its human capital as compared to the private-greenfield startup firm (which has been operating since 1991, but is still inthe process of acquiring and developingits fixed asset base). The foreign JV firm is nearly 3 times more effective in utilizing its human capital, as the former state-owned company now operating as an employee ownedjoint-stock company. The same trends that are present in the task level efficiency are also reflected in gross sales value per employee. The foreign JV firms estimated sales per employee is 37 percent higher than the locally owned private firms and more than 200 percent higher than the restructuredjoint stock company. Table 6.3: ComparativeEfficiencyin GeorgianWine Production Item RestructuredFormer State PrivateGreenfield Foreign-Georgian Owned Company Startup Firm JointVenture Task Level Efficiency, as BottlesEmployee 6,666 16,666 25,000 EstimatedUS$ Sales per Employee 16,166 38,300 52,500 Number of FullTime Employees 120 30 200 Bottles (750 ml) Produced 0.8 million 0.5 million 5.0 million 6.19 The explanations for these differences can be traced to several factors. Economies of scale is one of the main factors, as the foreignAoca1 JV produces more than six times the volume, as the other locally owned firms. However, it is unlikely that this accounts for all of the differences. The foreign JV also has a strong training program for all o f its employees, including management. It clearly links improved skill levels and increased knowledge to salary increases, thereby creatingan incentive to learn. Further,the JV firm has developed a close linkwith its grape suppliers so it can better manage its inputs, reducing losses and risk while correspondingly improving the quality of its inputs. This results in a higher quality finished product. 6.20 The foreign JV Company is better capitalized than the local firms, but it is operated as a profit center and once the initial capital investment is made, it can not simply phone the international partner and ask them to send money. Expansionof the firm takes place with locally generated capital. The final advantage that the foreign JV has is market knowledge. The JV majority shareholderparent company is an international company with global brands inthe wine and spirits markets. This knowledge and market linkage has allowed the foreign JV Company to ship its wine to mainstreaminternationalretailerssuch as Safeway, UK, as well as exploiting traditional markets inRussia and other CIS countries. In comparison, the locally owned firms depend heavily on the Russian markets with a small amount of sales entering niche markets in New York, Israel and other locations where high concentrations of CIS-expatriates reside. 6.21 Cost Structure: Medium cost wines exported from Georgia use mostly locally purchased inputs such as bottles, labels and caps. For such wines, it is estimatedthat grapes comprise 65 percent of the direct cost of manufacturing, while imported components (essentially the cork and some packaging materials) account for 6.5 percent of total costs. For premium wines, vintners almost exclusively use imported bottles, corks, labels and boxes. The cost of these imported materials typically makeup about half of the wines direct cost, while the other half of the direct cost is from domestically procuredgrapes, labor and services. Exporters report that they sell their medium priced wines at about US$4.15 per bottle at the Russianborder and premium wine sells at US$6.22 per bottle at the boarder. At this border price, the farmer receives 21 percent of export value for medium priced wines. Growers of premium wine grapes usually receive about 33 percentof border value. Markets 6.22 In 2001, Georgia exported wine to 25 countries worldwide; Russia accounted for 68 percent (nearly US$22 million) of all Russian exports. Georgia's second largest export market for wine was Ukraine (with 2001 exports valued at $3.6 million), followed by Kazakhstan (with $2.2 million of exports). In aggregate, Russia imported 256 million liters of wine in 2001. Nearly all of the wine consumed in Russia is imported by about 50 trading firms, which are based in Moscow and St. Petersburg. Only 1percentof wine exports were destinedto EUcountries. 6.23 The Russianmarket is dominatedby demand for redwines, which make up 71 percent of sales in Moscow and 64 percent o f sales outside of Moscow. White wines account for 25 percent of sales in Moscow and 33 percent outside Moscow. The Rose wine markets are estimated at 3 percent of sales in Moscow and about 4 percent outside Moscow. Low-cost wines (averaging US$2.55 per bottle) make up the bulk of the Russianwine market. The low-cost market faction is estimatedto be 85 percent of sales. Moderately prices (US$>2.55- 4.781bottle) wines make up about 10 percent of the market and premium wines (US$>4.78-13.69/ bottle) represent 5 percent of the national market share. The premium market fraction for Moscow and St. Petersburgis higher than the rest of Russia and is estimatedto be 15 percent of sales. Although the low-cost wine market dominates the Russianmarket, there is a growing demand for better quality wines. Growth in the premium wine market is linked to increasingincomes and a shift away from vodka towards beer, wine and other low-alcohol drinks." 75 Russianlabeling requirementschange often and without notice. One Georgian wine exporter reported that Russia had recently changed labeling standards three times in one 12-month period. Wine labels should contain the following information: the names o f the producer and importer, the legal address o f the exporter and importer, the origin and type of product, the date of production and expiry, storage requirements, content volume, and health warnings. Chauter 6. Aaro-Food Exuorts 57 6.24 Georgia is a supplier of medium priced and premium wines to Russia and it is in a unique position to take advantage of changing consumer demand trends by Russia for better quality wines.76 Figure 6.3 below demonstrates the 5-year import trends of wine shippedto Russia. Moldova is the largest supplier to Russia, but it tends to focus on the low-cost/ low quality market and thus does not compete directly with many of the Georgian exporters. Russian wine imports have recovered in recent years and are forecast to reach 300 million liters in 2002. Markettrends show that there is a shift away from low- end wine toward mid-priced and high-endwines. Figure 6.3. Russian Wine ImportTrends 500 400 300 200 100 0 1998 [ 1999 1 2000 1 2001 0Other-Foreign 68 65 43 14 24 0Other-CIS 87 50 17 38 96 Georgia 16 13 8 14 22 EllMoldova 247 136 120 125 136 I Source: USFA FAS. 6.25 The CIS will be Georgia's main market for the long-term. There may be scope to develop limited export marketselsewhere inEasternEurope(Le., Poland) as consumers there have traditionally consumed wines with similar characteristicsas those from Georgia. It will be difficult to sway consumers in the EU and North America away from their familiar varieties, but if Georgia wine makers can continue to improve productquality, there will be greater opportunities innon-CIS markets. Role of Government 6.26 There are a number of appellations in Georgiathat command a premium price. The Government needs to work with the GeorgianWine ProducersAssociation to create a mechanism that will insure that grapes and wines that are labeledfrom these appellationsreally are from these geographies. It is unlikely that the government can enforce this type of control by itself. It needs the leadership of the industry to help implementthe law and to self-police wine makers. 6.27 Inputs. Farmers and wineries complain that there is a serious problem with low quality farm chemicals being sold to farmers. Many of these compounds are thought to be diluted compounds or chemicals that have not been manufactured to international standards. Several international companies import chemicals into Georgia, but farmers are often looking for a deal and opt to buy the cheaper materials. Usually, they are disappointed when they discover the cheap material was ineffective. To prevent this, the government needs to improve its monitoring of ago-chemicals. It also needs to 76To take advantage of this market will require some upgrading of winery systems for quality assurance and food hygiene. In this regard, some companies have been upgradingtheir management systems, in some cases to obtain I S 0 9000 certification.The recent construction o f a EU accredited laboratory will also be o f assistance to the industry inmeetingand certifyingofficial and marketrequirementsfor safety and hygiene. encourage the internationalagro-chemicaldealers to start offering demonstrationand training programsto farmers. 6.28 Taxes. The wine exporters complain that the current VAT drawback system does not work. If wineries do not export all of their imported production inputs within six months, they must pay VAT on these goods. Other taxes needto be reviewedas well. For example, Georgia charges a 10 percenttax on advertising. This has the effect of reducing a firm's ability to grow its domestic market. The total tax burdenis high and administratively complex; the tax code needs to be simplified to improve compliance. 6.29 Fraud and Misrepresentation. Georgianvintners complain that low quality wines from Romania and Moldova are being labeledand sold as Georgianwine inthe Russianmarket. This has the combined effect of lowering the perceived quality of Georgianwine by the consumer, as well as reducing its price. Wine makers in Georgia are extremely concerned about this matter, and would like to see action taken againstthese counterfeitwines. It is highly unlikely that Russianinspectors will insure that wines labeled as Georgian are truly from that origin. This task will be the responsibility of the Georgian wine industry, supported by the Governmentof Georgia. Given the importance of this export inthe Georgian economy, it would be reasonable to expect the Government to ask its commercial attach& in countries where the counterfeit wine is being sold to identify these productsand draw them to the attentionof local authorities so they can be removedfrom store shelves.77 6.30 Corruption. Wine exporting firms report that corruption-generatedrents are often 32 percent of total shipping costs for loads shippedfrom Tbilisi to Moscow. One firm reportedthat it costs 4,700 US$ to ship 15,000 bottles by reefer truck from Tbilisi to Moscow (via Porti - Novorossiysk ferry, then by roadto Moscow). Ofthe total transport cost, corruption costs were estimatedto be US$1,500. Assuming that a medium-size winery could send 35 containers (about a half million bottles) a year to Moscow, the cost of corruption to the firm would be in the order of US$52,000. The corruption cost estimate was corroboratedwith other exporters and the costs appear fairly consistent. 6.31 Research There is weak linkage between viticulture and enology academics and the winegrowing industry in Georgia. This has resulted in a constriction in the flow of information from researchto application. In the Western model, agricultural academics would undertake applied research that is targeted to specific problems faced by the industry. In Georgia, this type of industry-driven research does not appear to be taking place. 6.32 The Government body, SAMTREST (State Industry Corporation for Viticulture and Winemaking), collects basic data on varieties, geographic distribution of production and market information. The data tends to be macro in nature, and has limited value for individual companies' market development activities. There is certainly a need for SAMTREST to improve the quality of its data, as well as its depth and breadth. However, with the severe budget limitations within the Government, it is unlikely that SAMTREST will be able to strengthenthe services it provides the industry without donor funding andtechnicalassistance. 6.33 Farm Size and GOGpolicy The Ministry of Agriculture supportsthe conceptthat farmers need to consolidateinto larger farming unitsto improve economiesof scale. This will requirethat some people will leavefarming and will needto find employment inother industries. This process will take decades to 77 One wine industry executive in Tbilisi said that this type of monitoring by the commercial attach6 would be impossibleto achieve, as the embassy staff would not see it intheir personalinterestto undertakethis type of work. Ifthis attitude is endemic amonggovernmentofficials, thewine industrywill be facedwiththe choiceofattempting to control counterfeitwines themselvesthroughtheir association, or simply ignoringthe problemand living with the results. Chapter 6. Aaro-Food Emorts 59 work through, as there needs to be a balance between non-farm job creation and the consolidation of farms into larger units. 6.34 Large winemakers have opted to vertically integrate, rather than try to work with small farmers. There is a saying inthe wine business that quality starts inthe vineyard. The future of the Georgian wine industry should be founded on providing premium wines to its traditional CIS markets, as well as introducing these premium wines to new markets inthe EU, US and other locations. Small farmers have a very difficult time producing grapes of the quality requiredto make premium wines. This fact is one of the key driving forces toward vertical integration of the industry in Georgia. Eventually, premium vintners will obtain grapes from their own vineyards and work with a handful of high-quality growers. Firms that target lower and mid-level quality wines will continue to work with small growers on a spot purchase basis. 6.35 Access to Land and Credit Winemakers report that there is no significant legal obstacle to obtaining land for vineyards. Properties can be purchased from private individuals or leased from the Government under 49-year contracts. Farmers and vintners expressed that the single largest obstacle to acquiring and developingvineyards was the availability of long-term debt capital. 6.36 The Government should be encouraged to privatize more land. Currently, approximately 1/3 of the country's croplandhas been privatized. Banks are unlikely to use properties that are leased from the Government as collateral on loans. Farmersneedto own land so that they can use this land as security on debt. By privatizing more land, the Government will strengthen the ability of the banking sector and farming sector to work together for their mutual benefit. 6.37 From a collateral and banking standpoint, it is important that Georgia's farm size increases. Banks are very reluctant to loan to farmers who have a small plot of land, particularly when their house shares the same property. Ifthe farmer defaults, the bank would have to repossessthe landand the house. Politically, this is probably impossible to do in rural Georgia. Banks will not start to lend to the agricultural sector untilthey can secure loans with properties that are not tied to the farmers' homes, and have a significant size (15 - 20 ha). Additionally, the market for land needs to mature so that banks are comfortable with the fact that a property canbe sold inthe event that a borrower defaults on a loan. Hazelnut Sector 6.38 Despite exhibiting a recent decline, hazelnuts remain Georgia's second largest agro-food product export in value terms. Export sales in 2001 were just under US$10 million, down from US$22 million the previous year. Georgia is a small, supplemental player in the world hazel nut market. Turkey dominates this market and had exports of more than US$486 million in 2001. World prices are heavily influenced by Turkish production and commercial strategies and sharp declines in these prices in recent years have adversely affected Georgiangrowers and exporters. 6.39 According to the GOG, between 1998 and 2001, Georgia's farmers produced on average 14,500 M T of hazelnuts annually (see Figure 6.4). Unoficial estimates by the Hazelnut Processors Association put the national output at over 28,000 MT, but this number cannot be confirmed. The majority of Georgia's hazelnuts are produced in the western part of the country. There are about 12,500 small hazelnut farmers and the income stream from hazelnuts is typically an important part of their household incomes. Approximately 20 percent of the Georgian crop is produced in the northeastern region of Abkhazia. The region is involved in an armed struggle for independence with Tbilisi and a large percentage of the hazelnuts from Abkhazia flow directly into the Russian market through informal channels. In2001, there were 33 legally registeredcompaniesexporting hazelnuts, but 5 firms dominated Chauter 6. Agro-Food Exuorts 60 the sector with an estimated 70 percent of exports. The processing and export businesses employ an estimated 1,200 people on a full-time and seasonalbasis. 6.40 While the industry is currently experiencingsevere pricing pressures, over the long term there are opportunitiesfor nut producersand exportersto add value to the crop. At the farm level, this can be done by improving quality primarily through better drying of the in-shellnuts, which will reduce spoilage, and increase nut size by improving crop nutrition. At the processing level, firms can add value by manufacturinga number of productssuch as slicedand dicednuts, and flour and oil. By developingthese products, the processors can divert low quality nuts away from the whole-nut market (where their value is low) and shift them into processesproductswhere their value can be increased. Production 6.41 There are a number of different hazelnutvarieties grown by Georgian farmers. About 90 percent of the hazelnut trees that grow in Georgia are classified as industrial varieties. Of this class of varieties, 70 percent are Anakliuri Futkurani, and 30 percent are made up of the Gulshishvela and Shveliskura varieties. The varieties used in Georgia are often less preferredby the European confectionary industry because the nuts have a pointed end. This point is sharp enough to pierce the wrapping paper of candy bars or other products in which whole nuts are used. This limits the market for some types of Georgian ha~elnuts.~' 6.42 Over the four-year period between 1998-2001, Georgian farmers produced an annual of 14,500 MT of in-shellhazelnuts. As seen in Figure 6.4, total production has fallen in the last two years. A primary factor is the serious decline in farm-gate prices which has led growers to use fewer inputs and thus obtain lower yields. Poor weather conditions, particularly in2001, also contributedto a lighter crop, as well as a reduction in kernel quality at the processing plants. Increasingly in Georgia, hazel nuts are producedwithout any in9uts other than the farmer's labor. This has led to lower yields, well below those incompetingcountries.7 F i g u r e 6 . 4 . H a z e l n u t I n - S h e l l P r o d u c t i o n O u t p u t I n G e o r g i a , 1 9 9 8 - 2 0 0 1 1 9 9 8 1 9 9 9 2 0 0 0 2 0 0 1 Source: GOGDept o f Statistics. 6.43 Table 6.4 examines the five-year farmgate price trends for hazelnuts produced in Georgia. As can be noted, there has been a consistent parallel fall inboth the U S dollar and GeorgianLari price for the commodity. An analysis ofthe farmgate and CIF price clearly shows that farmers are receiving a smaller 78A hazelnutorchard's economic lifespanis about 25 years. To ensure a sustainableproductionbase,the industry '' needsan aggregate re-plantrate o f4 percentannually. The governmentdoes notcompile statisticson replantingor new planting.Georgiashouldcarehlly monitor the re-plantratesto insurethat there will be sufficient tree opulations inthe future to support a healthy industry. Averageyields in Georgiaare estimatedat 1.16 MTper hectare, comparedwith 1.56 MT/ha.inTurkey and 1.5 MTha. inAzerbaijan. amount of the export value of hazelnuts over time. The share of the CIF price received by farmers has fallen from 41 percentin 1998 to 24 percentin2002. Table 6.4: HazelnutPriceHistory 1998 1999 2000 2001 2002 MeanYield Kernelpercento f Shelled 37% 36% 37% 32% FarmgatePriceGEL/MT 2100 2300 2000 1700 1000 FarmgatePriceUS$/MT 1433 1160 1022 821 455 CIF EUPriceUS$/MT 3500 3500 3200 2500 1900 US$Farmgateas percentof CIF Price 41% 33% 32% 33% 24% MeanGel: US$ ExchangeRate 1.465 1.982 1.956 2.070 2.200 6.44 There are several reasons for this trend of diminishing CIF value to farmers. In the external market, Turkey's over-production and high level of carryover inventorieshas flooded world markets with hazelnuts and driven down price. Within Georgia, the hazelnutsector is an oligopsony and producers are not organized. This allows the processor/exporters to squeeze the farmers on price when the kernel market softens. The farm-gate price is the only variable cost that they can reasonablyhope to influence as labor costs, energy costs, overheads, repair and maintenanceall tend to be more difficult to reduce when trying to maintain processor profitability. With the small number of buyers in the market, there is also price collusion. In the past, processors competed more for nuts at the farm-gate. Once international prices softened, processors realizedthat they would need to cooperate rather than compete in buying raw product. 6.45 Hazelnut production is centered in western Georgia's Imereti, Samegrelo and Guria regions and the processingis mainly in Tbilisi (eastern Georgia). This geographic layout means that the in-shellnuts must be collected in western Georgia, trucked to eastern Georgia for processing, then trucked back to western Georgiato be exportedthrough Black Sea ports. It is a very inefficient model, but one that seems to be usedby most processors. The only reason given for having the processors located in Tbilisi is that "this is where the owners want their businessto be located, near where they live". Table 6.5: ComparativeProductionCash Costsof Hazelnuts Item us (US$/ha) AZ GR Labor 219.51 125.00 92.59 Inputs 667.31 55.00 69.44 Total Costs 886.82 180.00 162.03 Yield MT/Ha 2.70 1s o 1.16 US$/MT 328.45 120.00 139.68 Source: Oregon State University Extension, AZ industry contacts andGeorgiaHazelnutProcessorsAssociation. ProcessingCapacity Large Medium Small PlantCapacityMT/HR 5.5 3.3 2.7 NumberofEmployees 185 100 75 TotalOutputMT/ 2,000 1,500 1,800 Gross Sales, US$ 4,000,000 3,000,000 3,600,000 OutputEmployeeMT 10.8 15.0 24.0 SalesEmployee, US$ 21,622 30,000 48,000 their exported product at $150 to $500 per MT lower than that of Turkey to attract international customers. Industry EfJiciency 6.47 Five locally owned firms process and export 70 percentof Georgia's hazelnuts. Although there is a significant difference in operating efficiency among the firms, in general, the five large exporters run well-managed businesses (by international standards). In addition to these large exporters, numerous small-scale processors and traders move the balance of the crop through official and unofficial channels. About 5 percent of the Georgian crop is exported to Turkey and is most likely re-exported from there labeledas Turkish nuts. 6.48 Table 6.6 examines the task level efficiency and sales per employee of 3 large exporters. The datatakes into account both full-timeand seasonal workers. The data shows that the firm with the largest theoretical capacity and actual volumes is not making the best use of its capital when measured in terms of task level efficiency or sales per employee. The largest capacity firm is operating at a task level efficiency (output per employee) ofjust 45 percentofthe more efficient smaller capacity company. From an international competitiveness perspective, the smaller capacity firm is on par with international industry norms. Hazelnut and almond" processing firms in the U S and the EU often add value by combining cracking, sorting and grading lines with other operations such as dicing, slicing, paste, flour and oil manufacturing. Usually lower quality nuts are used for these processed products, allowing value addition to productsthat would otherwise be sold at a discount. To date, no hazelnut processor inGeorgia has invested in value-addition beyond graded kernel production. However, members of the Georgian industry are beginning to discuss the formation of a partnership that would invest in value-added processingtechnology. Markets 6.49 Total hazelnut production in major producing countries is projectedto increase by 38 percent in MY 2001/02 to 843,800 MT. Total world supply has also increased due to Turkey's large levels of carryover stocks. Total exports inMY 2001/02 were expectedto reach 520,750 MT; this is up 12percent from the previous year. As a result of this increasedvolume, prices have dropped. The future price of hazelnuts on world markets will be strongly affected by the outcome of IMF-introduced reforms in Turkey to gradually phase out its hazelnut price support program. The price that Georgian exporters receive will also be closely linkedto the outcome of price reforms in Turkey, as well as the quality of the crop. 6.50 InMY 2001/02, Georgia sold at US$0.15 below Turkey. The greater price differential between Georgianand Turkish kernel is mainly due to rain, which fell on Georgia's production region in August. This kept the moisture level of the nuts high and without the availability of drying facilities in the growing region, the crop developed higher than normal defect levels. The cost to the export sector for the inadequatedrying facilities is estimatedto be about US$320,000 inMY 2001/02. 6.51 Georgia, Turkey and Azerbaijan are all looking at Russia for future market growth. As the Russianeconomy strengthens, demand for hazelnuts is increasing. Georgia has a competitive advantage over Turkey in the Russianmarket in that Turkey must pay a 20 percent duty on hazelnuts exported to Russiaand under the CIS Free-TradeAgreement, Georgiannutscan enter Russiaduty free. Industrysometimesuses almonds as a lower cost substitutefor hazelnuts. Chauter 6. Aaro-Food Exuorts 63 6.52 From the Georgian industry perspective,the primary concernindevelopingthe Russianmarket is not competition from Turkey, but rather the (+/-) 800 M T of hazelnuts exported from Abkhazia via unofficial channels. According to the industry, these low quality nuts are driving down the price of hazelnuts exported to Russia through Georgia's official commercial channels. This is one of the main concerns of the Georgian industry; but realistically, little can be done to curb unofficial exports from Abkhazia untilcivil order is restoredto the region. 6.53 Germany is the largest EUbuyer of hazelnuts. Germany alone accounts for about 50 percent of EU imports; however, German purchases slowed in 2001, making some producers look for alternative markets. China offers Georgian exporters opportunities in market development. China has increased its purchase of hazelnuts in recent years, as buyers there have beenpreparedto purchase lower quality nuts. In MY 2000/01, the US increased it sales to China by more than 75 percent over the previous year. Freight rates (20 foot container) from Tbilisi to Hong Kong are reportedly half the cost of freight rates plus corruption cost from Tbilisi to Moscow. Unlike shipments to Russia, once a Hong Kong bound container levels Georgia, corruption costs stop. TheRole of Government 6.54 The government can play an important role in providing an environment that will allow the Georgianhazelnut industry to reachits full potential. 6.55 Regulationson plant materials. The government can encourage the replanting of old orchards by reducing the barriers to importation of plant materials by eliminating duties on these products. The government requiresthat all new varieties be tested at research stations at least 2 years beforethey can be commercialized. These regulations impede the flow of new plant materials to growers and ultimately result in stuntingthe developmentof the industry. 6.56 Industry statistics. There is no reliable data source for ascertaining critical industry information such as number of farmers, mean plant populations, area pulled, area planted, bearing and non-bearing area, etc. Without these fundamental statistics provided on a regular basis, industry and government cannot effectively develop a long-term strategy for the industry, as they have no idea of the baseline situation. There is concern that the average Georgian hazelnut orchards are past their prime and the replant rates, which should be 4 percent to 5 percent to be sustainable, are not being met. If this is the case (which is very likely), then industry and government need to work together to encourage farmers to replaceold orchardsand maintain this practice. 6.57 Training: Exporters need a consistent supply of quality inputs (raw product) in order to remain competitive. A few of Georgia's more enlightened exporters in the wine and food-processing industries currently employ technical staff to work with their farmers/ suppliers. This type of industry-driven private sector extension system needs to be encouraged. The agriculture sector needs to improve its skill levels and knowledgebase; without this, export growth will be highly limited. The government does not have the resources to provide a remedy inthis area. The remedy will need to be deliveredby the industry and supported by donors and the government. The government needs to create an environment that will encourage industry to deliver technical assistance to growers; for example, through tax incentives for farmer training by input suppliers and/or developing tax incentives for in-house extension departments operatedby food processing/ exporting firms. 6.58 Research: With limited funds available, the government has no ongoing program in hazelnut research. Rather than duplicate work that has already been done in Turkey, the government should first look to Turkish sources for plant materials and information on improved cultural practices. In addition to Turkey, Georgia can utilize Italian plant material and production information to help strengthen its own ChaDter 6. Aaro-Food ExDorts 64 industry. Gettingthis information is only part ofthe problem. The most challengingaspect of increasing on-farm productivity is transferring the knowledge and technology from the researchers and technicians to the farmers. For these activities, researchers will need to link with input providers, processors, exporters and associations. 6.59 Standards and Quality. Hazelnut buyers and sellers carefully specify quality standards in sales contracts. The standards generally quantify physical characteristics of the nuts, including moisture, deformations, broken or damaged nuts, foreign material and pest infestations. Importers may require microbiological tests, with specific limits placed on moulds, salmonella, and enterobacteria. Often, importing countries will also check shipments on a random basis for contaminants such as aflatoxin(s), cadmium, mercury, lead and benzopyrene. Usually, chemical tests are conducted in the importing country. The physical characteristic testing is done in the country of origin, as well as in the receiving country to confirm product quality. 6.60 The UNDP Food Quality Laboratory, scheduled to open in Tbilisi in the second half of 2003, should be able to provide tests for the various physical, biological and chemical parameters required by hazelnut exporters. The certified lab will be able to provide exporters with a credible information source inthe eventthere is a quality dispute about a deliveredshipment. Processed HorticulturalProducts 6.61 Georgian fruitjuice exports were valued at 1.3 million US$ in 2001. The primary export product is 70-brix apple juice concentrate (AJC-about 6 times more concentrated than natural apple juice). In addition to concentrates, Georgia exports single strength juices, such as pomegranate juice, in small volumes. These single strength products target niche markets in Russia, Israel and the US, whereas AJC exports are sold to industrial re-processing markets in the EU and other locations. It is estimated that about 30,000 farmers supply Georgia's three AJC export firms with raw product. In addition, there are another 5-6 firms that buy fruit from farmers to process a wide variety o fjams, jellies, juices and other products. Total employment in the horticultural processing sector is estimated to be approximately 1,000 persons. CropProduction 6.62 A review of fruit productiontrends inGeorgia reveals one ofthe fundamental long-term problems facing the horticultural industry. Aging tree populations, poor orchard management, lack o f re-planting, and orchard destruction have all combined to result in a steady decline in production. If continued, this trendwill threaten existing agribusinessesthat dependon fruit as a raw productand limit the development o f new business in this sector. GOG Department o f Statistics long-term trends show that aggregate fruit production inGeorgia in2000 was 14 percent o f 1990 levels.*l 6.63 Tree fruit yields in Georgia are low. GOG statistics indicate that average yield for a fruit tree (in aggregate) is 4.7 MTha. AJC processors report that many apple growers achieve 10 MT/ha. These numbers are well below the potential yields for the crops. In comparison, apple farmers in the western *' It should be pointed out that the two AJC processors interviewed did not feel that raw product supply was currentlyaproblem. This year, they are buyingprocessinggrade apples at a meanprice of 25 US$ per MT, which is about half the cost that U S processorswould expect to pay in a bumper-crop year. Processorsin other CIS countries also felt comfortablewith their supply situation, only to be shockedwhen conditionschange. U S normally harvest over 40 MT/ha. The primary reasonyields are so low in Georgia's tree fruit sector is the lack of farming skills and low level of inputs.82 6.64 Apple acid levels are important, as they relate to consumer preferences in the final market the product is sold to and the AJC bulk selling price. Apple varieties and climate together determine the acid level o f the fruit. Poland and Ukraine are known worldwide for their high acid levels (3.5 to over 4 percent). This makes AJC from these counties very desirable to the European market. The American market prefers a lower acid level, usually around 2-3 percent. Georgian apples tend to be low in acid, which makes an AJC in the 2 percent -3 percent acid range. To improve acid levels and make Georgian AJC more valuable inthe EUmarket, farmers should be encouragedto plant early varieties. These apple varieties tend to be higher in acid but the trade-off is that they are lower in brix; this means that it takes more apples to make one ton o f concentrate. Industry EfJiciency 6.65 One o f the most notable observations in the Georgian processed food industry is the wide variation in operating efficiency among firms. A handful of companies have managed to combine good technology and contemporary management methods to create businesses that can easily compete inworld markets. There are also companies with antiquated technology and limited management and marketing skills that, in any region o f the world other than the CIS, would not survive for long. Table 6.9 examines three companies. Two are located in Georgia and one is located in California. All three produce bulk AJC; however the one firm labeled "Georgia Unspecialized AJC & Canning" also produces and sells US$92,000 (in 2001) of vegetables packed in hot-filled glass jars. The unspecialized firm makes 30 different hot fillproducts (each insmall volumes) inadditionto the 550 MT of AJC annually. Table 6.7: Apple Juice Concentrate Manufacturing Task LevelEfficiency& Sales per Employee Measurable GeorgiaUnspecialized Georgia US Specialized AJC & Canning Specialized AJC AJC ProcessingTechnology Soviet Italian German Employees (FT & Seasonal) 280 97 62 Total Output (MT o fAJCNear) 550 2000 3400 Sales, US$ (AJC & CannedProducts) 324,000 960,000 1.7 million Task LevelEfficiency (MT/Employee) 2.5 20.6 54.8 Salesper Employee, (US$/Employee) 1,157 9,900 27,400 6.66 The large difference in the efficiency of these firms can be traced back to a number of factors. First, the differences in processing technology; the unspecialized firm uses old Soviet equipment, the system lacks economies o f scale, is less energy efficient than standard systems used worldwide, producing a lower quality product (as a result o f mild-steelcontact surfaces and poorly designed matched evaporation systems for AJC manufacturing, etc.). It has a very inefficient layout and is inpoor condition in general, most likely resultingin more downtime and higher maintenance costs per unit of output. In contrast, the specialized firm uses a modern (built in 1991) Manizi processing line. The largest AJC processor inthe country has begun addressingthese concerns by creatinga new crop consulting/ agro-chemical supply company. The firm employs three hll-time crop consultants, who work with the farmers to identify pests and pathogens and help the farmers in developing strategies to remedy the problems. If there is an agro-chemical solution, they sell the farmer the neededmaterialand advisethem on the best applicationrates, timing and methods. The owners said that the firm operates at a low profit level, as the main goal of the company is to insure that there are sufficient apples produced in the region to supply the sister company - the AJC processing plant. Chauter 6. Aero-Food Exuorts 66 6.67 Technology is not the only factor that affects these firms' efficiency levels. A second major influence is overhead and asset utilization. The unspecializedfirm is located in a sprawling complex of rundown buildings, which is expensive to maintain and acts more as a liability than an asset. The unspecialized firm also inherited a large work force, which it has found difficult to rationalize. In contrast, the specialized firm is located in a compact, fairly well laid out complex, which is cost-effective to operate and maintain. Its workforce was smaller when it was privatized and over time, the firm has been ableto adjust its staff size to better reflect the business's real needs. 6.68 The third factor (and perhaps the most important) that contributes to the different levels of efficiency of these two firms is management. The specializedfirm is focusedon one core product and a small concentrated market. Its goal is to reduce manufacturing costs and maximize profits. The unspecializedfirm has to deal with manufacturingand selling 30 different products. This does not allow the management to focus resources and become efficient in any one product. The management is also encumbered with trying to keep a large number of people employed. Like the Soviet system, the unspecialized firm's primary goal seems to be job creation. The capitalistic concepts of reducing unit- manufacturing cost and maximizing profit appear to be a second level priority for the firm. 6.69 In commodity markets, the low cost producer wins. In actual cost terms, Georgia is a low cost producer of AJC. This is mainly the result of cheap apples, which is the single largest cost component in the manufacturing of AJC worldwide. However, the operating efficiency of Georgia's food processing industry remains a serious concern. Worldwide, many countries have problems with their fruit processing industry's capacity utilization. In Georgia, this is a problem in some plants but is not a universal constraint. For some firms operating in Georgia, capacity utilization constraints are actually constraints on working capital, as the high cost of credit makes it impossibleto afford to buy enough raw product to run plants efficiently. The debt is accumulated inthe short (90-day) harvest season, but the receivables may flow back to the firm over a 12 to 14 month period. This creates high debt service cost. Other than accessing lower cost credit lines, processors could partly alleviate the problem of plant under-utilization by looking for other fruits which can be processed in the AJC processing line, which will not conflict (time-wise) with the apple crop. Peaches, apricots and other stone fruit are the best fit for most AJC processors. Often these secondary products can be manufactured without interfering with the apple season. Markets 6.70 The world production of apple juice concentrate averages 620,000 M T annually. At current marketprice, which is near historical low levels, the aggregate world market value is US$300 million. In M Y 2002/03, Georgia is forecast to produce 3,300 M T of 70 brix AJC for export. This represents about 0.5 percent of world production. There is no domestic market for AJC in Georgia; all production is exported inbulk. EUdemandis flat, but demand for AJC inRussia has been increasingin recentyears as more domesticjuice producers(that blendandpack) enter the market. 6.71 Georgia, and other CIS concentrate processors occupy a unique niche in the world market; they supply crude concentrate to the EU re-processing industry. The majority of Georgian and other CIS concentrate exporters sell to Germany and other European countries where the crude AJC is filtered, blendedand soldto the international food industry. Georgiancrude AJC has a brown, cloudy appearance. The cloudiness is caused by the presence of a number of compounds including: pectin, starcheddextrin, polymers of the simple sugars such as arabinose, residual moulds, yeast, or bacteria and polyphenols/ tannins. These products are removedusing ultra-filtration or other more sophisticatedtechnology. Color is one of the main quality factors buyers look for. AJC can run from clear light honey in color to dark amber. After filtration, the AJC is blendedto achieve the proper acid balance, which differs by markets Chauter 6. Aaro-Food Exuorts 67 (EUpreferring high acid levels andNorthAmerica preferring low acid AJC). EUre-processorsprefer to buy crude AJC from the CIS, as it allows them the ability to control the final product's quality by fine- tuning color, clarity, and flavodchemistry to meet specificationsof individual buyers. 6.72 Georgia's largest AJC manufacturer has ultra-filtration equipment installed in its plant, but the buyers will not pay more for ultra-filtered product. The dark amber AJC, which is produced in Georgia, has a lower unit value than clear-light honey AJC (the product which results from ultra-filtration). There are several firms in Germany, Austria, Denmark, Switzerland and several inthe US, which specialize in re-manufacturing/ blending of AJC. It would be worth researchingto find out ifany of these firms would pay a premium for clear-light honey concentratefrom Georgia. 6.73 China is the largest producer of AJC in the world. Inthe 2001/02 season, the country produced 250,000 M T of concentrate. China's AJC industry growth can only be described as phenomenal. In 1991, government statistics showed that the country only produced 10,000 M T of AJC. By 1998, production rose to nearly 91,000 MT. About the same time, many of the AJC plants were privatized, and production skyrocketedto current levels. It is estimatedthat Chinahas atotal industry capacity to process 500,000 MT of AJC per year. 6.74 The main competitive advantage that China's AJC industry has over other world producers is the low cost of raw materials. Concentrateproducerstypically pay betweenUS$10- 50 /MT for raw apples. This compares to apple prices in Georgia (inthe current year) of US$25 - 50 /MT. Georgian apples tend to be slightly higher in acid, which gives them some advantage inthe market. Georgia's disadvantage is that processors' raw inputs to concentrate ratios are not particularly good at 10-1. In China and other parts of the world, processors are able to achieve concentrationratios inthe 8-1 range or less. The reason for this inefficiency is not totally clear, but may relate to low sugar levels in Georgian apples and/or the improper use (or lack of use) of processingaids (enzymes) that are utilized to increasejuice yields. On labor costs, China and Georgia are competitive. Factory workers at applejuice concentrateplants in rural China earn approximatelyUS$730/year. InGeorgia, the same worker would make about US$900/year. 6.75 A third factor that separates China and Georgiafrom other producers inthe world market is final product quality. Both countries tend to use low quality apples in their products. This is not uncommon worldwide, but the level of quality for industrial-grade apples utilized in many developing countries is below that of apples used indevelopedcountries. Part ofthis is the result of poor farming practicesinthe developing world, resulting in higher pathogen and insect problems in the crop. A second contributing factor is poor logistical and storage practices that tend to bruise the fruit and increase the rate of physiological breakdown. 6.76 China is an aggressive marketerof its food products. In 1999, it sold 2,512 M T ofAJC to Russia. In 2002, it expectedthat it would increase to 21,540 M T (over an 8-fold increase in four years). As the Russian economy grows, Georgia will need to improve its marketing and promotion activities to ensure that it will benefit from this growth, rather cede market growth to China. The Role of Government 6.77 The government can play a constructive role in creating a regulatory environment that will facilitate the private sector's ability to do business. Inparticular, the government needs to reduce barriers for new business startups and protect the agricultural resource base of the country by encouraging investmentat the farm level. Chapter 6. Aaro-Food Exports 68 6.78 Perennial Crop. Georgia's perennial crops (fruit trees, nuts and grapes) represent a major asset in value terms to the country. These crops are the raw product foundation on which much o f the sub-sector's economy rests. The perennial crop asset base needs to be maintained over time by regular re-planting. The government could create tax regulations (and other incentives) that would allow large commercial farmers to rapidly depreciate investments in new or re-planted orchards. 6.79 CertiJication of Plant Materials. Current regulations require that new plant materials be tested against standardvarieties. Before new plant materials are approved for use inGeorgia, they must perform equal to or better than the standard plant in 2 of 3 years o f testing (compared in terms o f yield and susceptibility to pests and pathogens). There are multiple problems with this regulation. The first issue involves technology transfer; seeds and other plant materials that are rapidly evolving. Plant breeders around the world are constantly commercializing new products. A farmer wants the best plant material available. The current regulations slow the transfer of this new technology to Georgian farmers and agribusiness. 6.80 A second concern is the cost o f entry for international seed companies into the Georgian market. Since the agricultural testing stations throughout the CIS operate on very small budgets, they ask seed companies to pay for the 2 to 3 years o f testing. Usually, they requirethat the testing be done at multiple sites throughout the country and costs often run into the hundreds o f thousands o f dollars. In some CIS countries, the seed companies complain that after investing their money and running three years of successful trials, corrupt government officials require a bribe before granting a license to sell the new genetic material. Given the costs and risks associated with this process, most seed companies will not seek to register its material in a small-market country like Georgia. This, in effect, prevents Georgian farmers from using improved plant materials. To remedy the problem, the government could simply allow any plant material that has been registered in a southern EU country (Greece, Italy, France or Spain) to be sold in Georgia. Or, it could adopt the US model, which requires no official testing before genetic material is sold. Strategic Orientation for Georgian Agribusiness 6.81 As illustratedthrough the above case studies and as evident from wider assessments of Georgian agriculture, there are considerable challenges inhibitingthe current performance and future prospects for Georgian agro-food exports. The country's agricultural sector is characterized by an increasingly fragile, decapitalized and fragmented agricultural production structure, severely deteriorating public research, veterinary health, and phytosanitary services, deteriorating rural infrastructure, and the virtual absence of rural/farmer organizations. Poor roads in some rural areas, non-competitive domestic rail services, frequent unofficial payments for the movement of raw materials and products along Georgian roads, and relatively high combined official and unofficial payments associated with the use o f Georgian ports all reduce earnings for Georgian farmers and agro-enterprises. 6.82 At the level o f emerging agribusinesses, there is still little awareness and application of internationalmanagement practices for quality assurance, food safety, or environmental protection. Many firms have little systematic information on the cost and quality profiles o f their major international competitors, or on the nature and dynamics of non-traditional markets. Working capital constraints are common throughout agro-industry, limiting raw material purchases and capacity utilization. Except for joint venture companies (which can tap into international sources of finance), the relatively high costs of finance deter investmentsin new technologies, capacity expansion, and quality management systems. 6.83 At present, Georgia's system o f standards and conformity certification lacks credibility among regulatory agencies and private buyers abroad. This has contributed to constrained access to certain Chauter 6. Aaro-Food Exuorts 69 markets, the duplication of testing abroad, and additional price discounts on Georgian products. There appears to be widespread problems in relation to imports and the production and sale of many food products inthe domestic market. While there is much identification of falsified productsand labels, there is little official actiontaken even though severaldifferent government productcontrol agencies are active. This exposes Georgian consumers to unnecessary health risks. Product and label falsification is also apparently a major problem in relation to the sale of Georgianwine and other products(including mineral water) within Russiaand other CIS countries, constrainingthe sales andjeopardizing quality reputationof legitimate Georgianproducts. 6.84 Looking forward, the strategic orientationfor Georgian agribusinessshould includethe following elements: 0 Building value rather than seeking to re-establish the country's position as a bulk commoditiessupplier; 0 Pursuing a dual market orientation, with primary attention on the CIS market, yet further exploring marketopportunities within the EU, EasternEurope, the Middle East, and Asia; 0 Further capitalizing on the recognition of the country and its particular brands and appellations within the CIS countries. This is most applicable inthe wine and mineral water markets; 0 Raising product quality and marketing services to re-position Georgian products beyond the `low cost-low price' end of their markets. This applies to the wine, tea, hazelnuts, and processedfruits andvegetables; 0 Capturing value from distinctive resources or circumstances, including further penetrating international markets for organic products, medicinal plants, and essentialoils; and 0 Pursuingselectedimport substitutionpossibilities by leveling the playing field and addressing widespread unrecordedand `tax free' agro-food imports. 6.85 Concerted action will be needed on a number of fronts in order for Georgian agribusiness to realize its potential during the coming years. Sustainedgrowth inagro-food exports is unlikely without a considerable strengthening of basic agricultural support services, together with the facilitation of smallholder outgrower arrangements and the commercial leasing of land. Through training and management assistance programs, an increasednumber of agro-enterprisescan be supported in adopting improved quality assurance and food safety systems and in gaining improved international market awareness and contacts. 6.86 Major efforts are neededto update and restructure Georgia's systems for standards, certification, and inspection. Georgia has made a commitment (through the WTO and its cooperation agreement with the EU) to move toward reliance upon voluntary standards, codes of practices, and private certification for most agro-food products. Assistance is neededto build awareness of these concepts-both within the public and private sectors-and in the technical design and implementation of such standards and procedures. On-going efforts to consolidatehestructure and increase the transparency of inspection and control services need to be supported. Through collective action by companies and through joint programs involving government and the private sector, efforts need to be intensified to remove falsified/adulteratedproducts from the domestic market and falsified Georgian products and labels from CIS markets. Chapter7. LightManufacturing Garments Industry 7.1 Textile and clothing productionin Georgia probablydates back to the days of the ancient "Silk Road" when Chinese merchants traded silk in the region. Duringthe Soviet periodGeorgia had several large apparel factories, employing in one case more than 1,200 workers, which suppliedvarious areas of the Soviet Union. Today the country is in a good competitivepositionto produce garments for the world market. Georgiahas adequate supplies of low-cost labor, with experienceingarments production. It is in good proximity to importantmarkets in the EU. While Asian countries must ship or airfreight garments to Europeanmarkets, Georgiacan sendthem faster andmore cheaply by truck. Georgia also is a member of WTO andhas GSP status inEUmarkets. Industry Characteristics 7.2 Size oflndustry. Official figures reportthat there are 223 garments firms operating inGeorgia of which21 are claimedto be exporters. However, interviewsfor this study couldfind only three significant exporters of apparel, all of which are privatized, joint stock companies. These three firms employ approximately 1000workers and their exports accountedfor about 98 percent o f total exports in 2001 in the category of "apparel and clothingaccessories, notknittedor crocheted" (see Table 7.1). Severalother exporters of specialty items are also active, in areas like wedding dressesexported to Russiaand the EU, butthe quantities ofthese exports are quitesmall. Table 7.1: Georgian Garments Exports 1999-2001 (000 US$) Destination 1999 2000 2001 Apparel K or C (a) CIS 48.4 82.2 39.2 EU 6.2 7.7 9.4 Other 46.3 0.1 112.8 Total 100.0 90.1 161.4 Apparel not K or C (b) CIS 20.8 218.2 11.8 EU 678.0 683.8 806.6 Other 16.1 13.6 77.8 Total 714.8 915.6 896.2 Total Apparel 815.7 1005.7 1057.6 Source: Statisticalyearbook of South Caucasus2002; (a) apparelknittedor crocheted; (b) apparel not knitted or crocheted. 7.3 All of the apparel exporters sell through the same German buyingagent, which works for large EU retailers like C&A, on a "cut-make-and-trim" (CMT) basis, whereby the German buyer supplies the fabric and accessories (including the packaging and labels) and the exporters use their labor and equipment to make up the garments. The clothing, which is currently mostly lady suits and blouses, is then pickedupby the Germanbuyer's trucks andtransportedto Germany each month. 7.4 Labor. Georgian Garments workers are paid on a piece rate basis. Inaddition, depending on the factory, there are bonusespaideach monthfor workersexceedingproductionquotas. Average pay ranges from 82 to 100 Lari per month (from which workers pay 20 percent income tax) plus 31percent social insurance. The U S dollar wage for a sewing machine operator averagedUS$54, rangingfrom US$48 to US$60. Firmscomplainedthat it was difficult to find workers at the low endofthe wage scale, but, given ChaDter 7. Liaht Manufacturinp 71 the pricesthey were getting for garments andthe productivity of the workers, ahigher wage could not be paid. All firms have labor unions, but they are not very powerful given the high unemployment. For example, the large producer in Kutaisi is one of the few operating employers in the area. The factory noted that in the beginning, after privatization, there were many strikes, but now there are few problems becausethere is no alternative work. 7.5 Technology. The technology in use in the three exporting factories is relatively up-to-date, machinery from Germany, Japan, and Italy. Two of the factories were among the last companies to benefit from large Soviet investments at the end of the 1980s. As in many of the older factories in Georgia, however, the existing plant and equipment was installedfor much larger volumes of output then are currently produced. For example, one factory has a modern "overhead moving system" for moving bundles of garments from one workstation to another as the production of a style progresses through the factory. The system installed was set up for productionruns of about 100,000 pieces on a style, which is more than six times the firm's total production ina month, let alone runs of a single style. Also, firms are currently operating in only about 50 to 60 percent of available production space. The German buyer agent generally provides new equipment when needed and then deducts a certain amount from each garment it buys untilmachine is paid off. Inone factory, the Germanbuyer extendeda US$300,000 loan for equipment (steamers, hemming machines, pocket machines) that was necessary to make styles its EU customers wanted. The German buyer has also has assisted firms with new approaches to quality control and other management innovations. Productivity 7.6 To take advantage of future export opportunities in the garments industry, Georgian companies will need to improve productivity. Georgia has a competitive advantage over many other exporting countries in the form of lower wages, but this will not be enough to sustain future export growth. As Table 7.2 indicates, the average wage of a garments worker in Georgia is about US$54 per month, less than half the wage paid to a machineoperator inChina's export processingzone, and about 60 percent of the wage paid inBulgaria, a rival exporter inEasternEurope. Only inWest African countries like Ghana does one find garments machineoperators with lower wages. Low wages are a considerable advantage in garments production, as labor costs are an important determinant of competitiveness. Even though labor costs generally only account for less than a quarter of the cost of producing an item of clothing, other inputs-such as fabric, thread, accessories-are usually accessible to all producers at roughly the same price, give or take some percentage for transportationcost. 7.7 However, competitiveness is ultimately determined by unit labor cost -- the ratio of wages to productivity. As Table 7.2 shows, output per worker in Georgian factories is only about 25 percent of that in China, 35 percent of India, and 50 percent of Bulgaria. Thus, while a Georgian worker gets paid only half the wage of a Chinese worker, she produces only one-quarter of the output. Georgia's low wages are not enoughto offset its even lower productivity, translating into significantly higher unit labor cost. The largestcompetitive gaps are with Chinaand India, which have unit labor cost 32 percent and 40 percentbelow Georgia's, respectively. 7.8 TaskLevel Efficiency. The task level efficiency in Georgian garments manufacturersis low. As table 7.2 indicates, the average Georgianmachine operator produces only 7 to 8 blousesper day, while an Indian operator makes 17per day and a Chinese worker 20. Some ofthis difference intask efficiency can be explained by differences in styles produced (some may be more complicated than others) or by differences in order sizes or length of production run (longer runs of a single item generally result in higher task efficiency). Georgia's order sizes are certainly smaller than inmany ofthe factories compared in Table 7.2. But the task efficiency gap is too large to be explained, in any substantial way, by such factors. Nor can one explain the observed task efficiency differences by differences in technology. Georgian factories have reasonably good, up-to-date equipment, comparable with most of the factories featured inthe table. In some cases there may be differences in availability of specializedmachinery for particular tasks, but this again would explain only a small part of the efficiency gap. It would appear that other factors such as worker motivation and management capability play a more important role in explaining the efficiency gap. Table 7.2: RelativeCompetitivenessof Georgia's Garments Industry Task Efficiency Output per Competitive worker . . Wage (# blousedday) UnitLabor Cost Gap (`percent) Country (US$/month) (US$/month) Georgia 54 7-8 250 0.22 India 110 17 724 0.15 -32 Ghana 45 10 228 0.20 -9 Bulgaria 95 13 525 0.18 -18 Mauritius 150 18 850 0.18 -18 China 125 20 1000 0.13 -40 Source: Interviewswith garmentsfactories invarious countries. (a) Basedon averagesfrom several factories ineach country producingwomen's blousesor similarly configuredmen's shirts; (b) Wage is the average gross monthly wage in US$;(c) No. of blouses or shirts a machine operator can produce in a normal work day; (d) value of gross output per worker in US$per month; (e) unit labor cost equals labor cost dividedby gross output. 7.9 Workers and managers in all the countries of the former Soviet Union have had a difficult time making the transition from the old system of central plans and quotas, where the accent was on meeting quantity targets, to the new system of market-orientedproduction, where the accent is on productivity and quality. This is certainly true of Georgia where worker mentality, in the words of one factory manager, "continues to be affected by old Soviet habits." Moreover, in the past 10 years political problems and privatization issues have created difficulties for the transition. Foreign buyersnote that Georgiangarment workers have reasonably good skills, as evidenced by the complexity and quality of the clothing they are making, but their work intensity is slow and it is difficult to get consistencythroughoutteams of workers. Lack of consistency is costly as poor quality is only picked up at the end of the production line. In addition, one buyer notes, "workers don't think about their work -- they just do it becausethey`re told to do it." Efficiency-basedpay incentives, such as piece rates, do appear to be motivating some increases in productivity, as task efficiency has more than doubled in the last five years in some factories from the very low base establishedat the end of the Soviet period. But a good deal of close foreign supervision has beenrequiredto maintainquality control. 7.10 Low task-level efficiency also reflects management problems. Buyers state that Georgian managers are not well trained and are often not fully engaged in the business. The German buyer operating in Georgia, for example, has three full-time technical agents in the field, located in Batumi, Kutaisi, and Tbilisi, assigned to each of the factories where its clothing is produced. It is also reported that the problemsGeorgianmanagers confront today are, inmany respects, the same problemsthey hadto deal with seven years ago when the factories began selling to the German buyer. It appears that technology transfer has not been progressingat a very rapid pace. Moreover, not having a fully engaged manager makes it difficult to adequatelymotivate workers in a highly competitive export business. These problems appear in many ways to be a legacy of the Soviet period, namely a lack of initiative and motivation, an indolent attitude toward the benefits that one can derive from improving one's own business, and a lack o f imagination with respect to what effort, innovation, and cooperation with the foreign buyer can accomplish. 7.11 Market Segment. Productivity and competitiveness are as much about the prices exporters can charge for their productsas they are about production efficiency. At present Georgian garments exporters operate in the lowest segment of the market - CMT production. Exporters get paid only for the labor ChaDter 7. Light Manufacturing 73 involved in cutting, sewing, and trimming the garment. Inthis segment, value added is limited and profit margins are slim. In fact, in Georgia's case, profit margins have been declining over the years. 1997, exporters have been squeezed by rising costs -- water costs have doubled, electricity has gone up Since fivefold, the government instituted an entrepreneur tax of 1 percent on turnover, and labor costs have risen 30 percent -- and puny product price increases of about 2 percentfrom buyers. 7.12 Improving competitive margins will require Georgian producers to move into new market segments where value added is higher. Garments firms in Georgia, however, have almost no marketing experience. As one manager noted "we have poor marketing, our educationwas driven ina different way and our practical experience is inappropriate." Firms do not have the funds for expensive marketing campaigns either or even trips abroad. In addition, Georgia has a reputation problem -- buyers do not want to go to Georgia right now becauseof stories about kidnapping and other criminal activities. Hence, there are very limited opportunitiesto come incontactwith new potential customersor to learnabout how to move into different segments of the market. Firms thought membership in WTO would attract customers, but that has not happened. Other constraints 7.13 Transportation Costs. A second problem area that reduces Georgia's competitiveness is transportationand the associated costs of dealing with trade support institutions like customs and police. Georgiangarments firms operate in isolation. There are no local supportingbusinesses upstream, making fabrics or thread, no machine producers, and no world-class ancillary companies producing accessories, labels, or packaging materials. Everything has to be imported. Having to produce without local supporting industries by itself raises costs, but things are made much worse by inefficiencies in the trade facilitation system. 7.14 Buyers with experience in Eastern Europe report that transport problems in Georgia are much worse than elsewhere. As one buyer noted, "EU freight forwarders don't want to go there [Georgia] -- too many delays and hassles from customs at a Adjara and stops along the roads by local police, everyone is looking for a bribe." Trucks are held up for four to five hours at the border, waiting for clearance and waiting for escorts, entering Georgia, and for two or three hours when leaving the country. Along the roadsthere are many checkpointswhere there are further delays. Firms claim that the unofficial fees they must pay today are almost equalto the official fees to transport goods to and from the country. For a 40- foot container official fees are said to be US$600, while all the unofficial payments for customs and police are about US$400. The German buyer has contracted with seven EU freight forwarders to deal with Georgia over the past seven years and six of them have quit. These extra costs of transport, hassles, and delays ultimately widen the competitiveness gap. In the Ukraine, for example, the same German buyer pays 15 percent more to exporters for the same clothing items because the cost of transport to Germany (official plus unofficial) is lower than it is from Georgia. 7.15 Energy. Power cuts reduce available working hours, and increase plant setup costs. Inaddition, when the power is turned back on there are often power surges that can damage machinery. Firms complain that for every eight hours of work there are one and one-half to two hours lost to power cuts. Cuts can occur throughout the day, which has a significant impact on worker task efficiency. Added to this, electricity costs have risen fivefoldsince 1997. Wood Processing Industry 7.16 Georgia has a good potential to develop its exports of wood products, given its considerable reserves of timber, notably beech, and good market opportunities for products made from its woods. In the past decade there has been a shift towards lighter timbers in the markets for home products, solid wood floors, and patio and garden products. According to the last three Cologne International Furniture Fairs, beech is one of the preferredtimbers. Also, Ikea, one of the world's leading furniture chains (with annual sales of Eu 10.5 billion), plans to open one store in every Russian city of over one million inhabitants and to source more products in the region, including Georgia. It is notable that some 70 percentof Ikea's raw materials are wood or wood fiber. 7.17 IfGeorgiawere to take advantage ofexisting market opportunities, it could raiseexports earning from wood ten-fold. For example, Georgia has 42 percent of the forest coverage of Romania, also a transition economy with a similar wood resourcebase, but only 5 percent of its exports. Ifthe Georgian furniture industry raised its development up to Romanian levels, it could hope for exports of about US$177million, ratherthan the US$22million it currently exports. Country Forest Forestin Beechand oak Softwoods Exports (sq. km.) . . Mountains (percent of (percent of (million dollars, (percent) timber total) timber total) 1999) Georgia 27,73 1 98 58 (4 25 22 (b) Romania 66,750 70 50 25 422 (c) - 2002; Total EconomicEvaluationof Georgian Forests, T. Arin and J. Siry, 2000. (a) Although Georgia is more mountainous, it has comparativelymore hardwoodthan Romania(which is more valuable than softwood) andthis hardwoodtends to be more prevalent at lower altitudesinGeorgia. (b) This figure allows for 15 percentundervaluingo fexports. (c) Romaniaplansthat its furniture exports will doubleto US$800 millionby 2010. 7.18 One of the reasons for Romania's higher wood export earnings is that it has moved up the value chain. Table 7.4 shows that Ghana exports timber products at prices ranging from US$239 to US$2,940/m3dependingon the degree of processing, while Romania's range from US$215 to US$1,250. Georgia, however, obtains only US$121/m3for its timber exports, which are generally sold inthe form of logs or in a semi-processedstate. Table 7.4: Value Added for Wood Products' Exports (FOB Ghana, 2000; Romania, 2002 US$ per m3) Air-dried Kiln Moldings Dowels Profile Flooring Layons Furniture lumber dried moldings parts lumber Ghana(tropical- Hardwood) 239 352 429 522 628 893 1,23 1 2,940 Romania (beech) 215 500 450 550 450 1,250 Source: ForestProductsInspectionDivision ExportPermitReport2000, Ghana; trade sources, Romania. 7.19 Prior to independence, some 85 percent of Georgia's timber requirements were met by imports (2.5 million m3per year). This importation has almost ceased, while illegal cutting of forest for fuel wood has increased. There is no reliable estimate of the size of the forest harvest. Estimates range from 619,000 m3in 2000, of which 7,000 m3of industrial timber was exported, up to 2.5 million m3in 1996, with 200,000 m3was exported in 199983.All sources agree that the volume of fuel wood far exceeds that of industrialwood. a3 p. 59, T. Arin and J. Siry. Industry Characteristics 7.20 Size and Structure of the Industry. The wood processingindustry has experienceda dramatic fall inproductionlevels since 1990and operates at low capacity. The privatisationofthe industry was started in 1994 and has now been completed. Information is scarce on the size and structure of the sector. Official data states that there are 201 wood firms, of which 56 are not working. Anecdotal information suggests (see Table 7.5) that there are some 20 large firms and 226 SMEs engaged in primary and secondary processing. Some 12 large firms undertaketertiary processingmaking, for example, furniture, doors and windows. 7.21 Georgia's wood processingindustry was the second largest in the former Soviet Union, after the Baltic countries, with 15,000 employees, but now the number of employees is saidto be 2,250. Table 7.5: Structure of the Wood Sector (number of firms) Type o fProcessing Large Mediumand Small Number o f Exporters PrimaryJSecondary 20 226 150 Tertiary 12 Unknown 4 Source: Georgiantax department database Challengesin Realizing Opportunities 7.22 Upstream Forestry policy. Georgia's 1999 forestry code provides a sound framework for a sustainable management of the forests,84but increased demand for wood (mostly for fuel) and lack of public funding for forest management have resulted in illegal and criminal practices in the sector. Temporary bans on final felling and export of logs have been ineffective. Policy objectives for the next eight years include eradicating illegal and criminal practices; improving the marketing and pricing of forest resources; legislating on forestry ownership rights; implementing modern programs for reforestation; and allocating lands for commercialuse and conservationpurposes. Activities such as these will be aided by the World Bank's credit for the GeorgiaForestsDevelopmentProject (2002-2008). 7.23 Access to Timber. Sawmills obtaintimber from logging firms and from their own licensed felling areas. Licenses are obtained through a tendering process, managed by the State Forestry Departmentg5 The cost of licenses varies according to the distance of the felling area from the existing road, and the logger has to put in a road from the existing one to the licensed area. Firms interviewed for this study reported obtaining licenses to fell areas of only 1 hectare. Formerly, firms were able to harvest in areas up to 25 hectares as the 1999 Forest Code allows, but the policy is now to allow tenders from smaller under-capitalizedfirms. This limits economies of scale in harvestingand processing. In addition, firms must bring timber from many small scatteredplots to a central location, which adds to the costs. One leading firm, with an installed capacity of 45,000 m3per year, reportedbeing able to process only 19,000 m3per year. Larger volumes, would allow the firm to sell beechto China at US$450/m3,but instead it sells at only US$180/m3to Turkish buyers, who consolidatesupplies and sell to China at the higher price. Another firm, requiring 24,000m3 of beech per year, obtains only 40 percent of the wood it needs and, thus, is forcedto seek timber inareas beyondthejurisdiction ofgovernmentandto process differenttypes of timber, reducing its efficiency, as different saw-blade settings, and kiln-drying schedules, are required 84See "Statement of the Government o f Georgia. Main Principles o f Government Policy for Georgia's Forest Sector Development in2002-2010", approved in May 2002. 85The departmentdelineatesthe areasto be tendered, marksthe trees that can be harvested,and monitorsthe practices o fthe loggingfirm. for each timber type. Also, logging firms note that once they have constructedroads to their felling areas, timber is stolenand illegally sold, becauseoftenthey cannot afford to police scattered felling areas.86 7.24 Stumpage Fees. Some industry experts claim that low stumpage fees are US$16/m3for good- quality beech stem when they could be US$37/m3, leading to low prices for logs and provides no incentive for firms to add value. 87 But, firms correctly note that with so much illegal logging, it is not possible to increase prices. A stumpage fee is levied on each stem harvested and is calculated by deducting logging costs from the export price of timber. Typically, the cost of obtaining and transporting timber to the sawmill amountsto US$44to 55 per m3(see Table 7.6). Table 7.6: TypicalCost of Access to Timber (US$ per m3) Cost ofmarkingtrees 2.10 License (amount depends on distanceto road) 10.50 - 21.00 Felling 10.00 Stumpage (based on a 3.0 m3stem) 5.00 Transport to sawmill 12.00 Cost of making road 4.00 Total 44.20 - 54.10 Source: Firm interviews. Access to Inputs and Equipment 7.25 Wood processing firms are paying higher prices for inputs, because of high transport costs and inability to get inputs and capital equipmentduty free. 7.26 Transport Costs. Most inputs are imported, generally from Turkey. Much of the furniture industry, as well as door producers, are heavily dependent on MDF panels to manufacturetheir products. According to Georgian firms, they pay more for MDF than their regional competitors because of high transport costs and small volumes. For example, Georgian firms pay US$37.50-47.00 for sheets of 18 mm MDF produced in Turkey, whereas Turkish manufacturers pay US$30. In Romania, firms buy Romanian-madeMDF for US$23.00 and elsewhere firms can obtainBrazilian-made MDF for US$19. 7.27 High transport costs can lock firms out of export markets, with transport costs accounting for up to half the total export price from Georgia. Firms trucking wood products from Tbilisi to Moscow pay US$2/km (US$3,500 per truck), whereas firms in Romania trucking to the UK pay US$1.4O/km. (US$3,050 per truck) over similar distances. The cost of shipping can reflect the small scale of the business in Georgia. For example, a container going to China may be transshippedinItaly and Germany before going to China and cost US$2,400 (40' container), and take up to 40 days in transit. Buyers generally consider the landed cost of products, paying exporters a lower price if the transport costs are high. 7.28 Taxes on Inputs and Equipment. Also, many wood industry production inputs are subject to 14 percent import duty. For example, important inputs like moisture-resistant glues made in Germany. Duties on such critical raw materials, raise costs and constrainefforts of firms to move into higher value add value products, and begin to export. Firms also have difficulty in offsetting the full cost of inputs against their profits when they pay taxes because of the informal and illegal VAT practices. Typically ~ 86 GHA estimate, Firmsbelieve that 80 percentofbusinesses inthe sector is illegal. " Metreveli,p. 22. Based on the differencebetweenthe market price of beechand its actual cost. firms obtain invoices for only one third to one quarter of what they actually pay for inputs.88Firms even fake factory fires in order to reconciletheir inventories with their invoices when it is time to pay taxes. 7.29 Differentials in import duties on machinery may introduce a bias in the choice of production technology. If firms import Russianmachinery, they pay 0.5 percent duty, but if they import EU or U S machinery they pay 14 percent duty. Duties on capital goods reduce the industry's ability to upgrade its technical capability, a crucial issue for Georgia's future development. Added to this, the differential duty between Russia and Western countries biases technology choice towards the purchase of Russian technology, which may not be the most appropriate. 7.30 Access to Finance. Several Georgian firms, which participated on study tours organized by CERMA, have not been able to acquire new equipment because of lack of financing. A saw-mill firm wanted to buy a machine costing US$200,000, so as to increase its sales from US$380,000 to US$800,000 per year, usingthe same volume oftimber. But, the firm could not get a loan for a period of over two months for which a collateral equivalent to the amount of the loan was required. A logging and saw-mill firm, did not have the collateral to get credit to buy French equipment which could increase harvestingtwenty-fold. One company did succeed inborrowing US$270,000, but only after spending 13 months seekingthe loan with two different banks and putting collateral worth more than twice the value of the loan. Another firm, which exports furniture, believes it can increase productivity five-fold in its edge veneering if it can buy a machine costing US$8,000, but it cannot. If it could borrow US$l,OOO to buy dust extraction equipment, it could bring its factory up to the government's required health standard. Insteadit pays a bribeofUS$10 per monthto healthand safety inspectorsto ignore violations. Productivity and Market Segment 7.3 1 Georgian exports consist of low value-added commodities, comprised almost entirely of round logs and semi-processed timber which sell for an average price of only US$121/m3 (see Table 7.7). Timber losses, in harvestingand sawing, add to the problem of low export values. For example, firms report that perhaps 20-40 percent of industrial timber is left in the forest because stems are cut in 5-6 m. lengths to suit transportation methods-leavingshort lengths inthe forest.8gPart of the problem is lack of adequate equipment. Logging firms report that they could increase their harvest 20 times, if they could use EU harvestingequipment. For every 1 m3exported about 2.10 m3is harvested. If these losses are taken into account, the effective price paid for timber in the forest is about US$57 per m3.90There are also losses in processing. Sawmills report, for example, that of the logs arriving at the sawmill, some 25 percentmay be export quality, 25 percent suitable for the domestic market, and 50 percent is waste. 7.32 Unit labor costs in the Georgian furniture industry are relatively high. As Table 7.8 shows, the unit labor cost in the average furniture Georgian firm is 0.30, compared with only 0.11 in the average Romanian furniture firm, while a typical Irish exporter has unit labor cost of about 0.20. Higher unit labor costs in Georgia appear to reflect both higher wage costs for skilled labor and lower output per worker. In Romania, operators of computer-numerically-controlled equipment are paid US$130 per '*Firms havethe greatest difficulty inunderstandingtax regulations. One ofthe best furniturefirms reportedthat its accountantspent 10 days per monthtryingto understandgovernmentlaws and regulations. U S sawmills can obtain US$3,500/m3for well-prepared short lengths o f oak, "Value Added Processing for the - Sawmill," G. Wengert, www.woodweb.com, 2001 As observedby T. Arin and J. Siry, p. 57: based on 15 percent loss between sawn timber and round wood logs, and on a 50 percent loss between exportable quality timber and the harvested quantity. Some of the loss between harvestingand exportableroundwood may be usedfor domesticconsumption, fie1wood, etc. month, compared with an average wage inGeorgiaofUS$l93, for a less technologically skilled ~orker,~' whereas the output (sales) per worker in Georgia is only half that of Romania. Even though Irishwages are 12times those in Georgia, the productivity of Irishworkers is 20 times higher, hence, their unit labor cost is lower. (m3> m3 Roundwood Harvested (harvestVola) Beech 184,332 22,198,036 120 192,505 385,O 10 58 Softwood(pine, spruce) 10,300 1,251,428 121 11,845 23,690 53 Other 5,425 683,750 126 6,085 12,170 56 Total 200,057 24,133,214 121 210,435 420,870 57 Table 7.8: ProductivityinInternationalFurniture Making Firms Machine operator Output per worker Unitlabor cost Productivity gap wage (US$/mo.) (US$ / mo.) (percent) Georgia 193 646 0.30 Romania(Firm A) 130 469 0.28 Romania(FirmB) 130 2,285 0.06 Romaniaaverage 130 1,225 0.11 -63 Ireland(Firm C) 2,333 11,759 0.20 -3 3 Source: Firm interviews. 7.33 The positive effect of batch size and of mechanizationcan be seen in firm D (see Table 7.9), the firm with the lowest unit labor cost, 0.18, makes modest batches of contract furniture and is the most mechanizedofthe firms interviewed for this study, while FirmF, the firm with the highestunit labor cost, (0.38), makes one-off pieces with modest mechanization. The wages paid by each of these firms are about the same, but output per worker in firm D is almost 70 percent higher. A similar pattern can be seen in Georgian Saw Mills. Table 7.9: Productivityin GeorgianFirms Wage (US$/mo.) Output (US$/mo. Unit Labor Rate Per worker) Furniture Making FirmD: contract furniture (modest batches) 200 1,126 0.18 Firm E: office furniture (small batches) 300 833 0.36 Firm F: doors andwindows (one offs) 250 667 0.38 Sawmills Firm G: large volume, highmechanization 90 1,852 0.05 FirmH: low volume, low mechanization 116 542 0.2 1 Source: FirmInterviews. Some Georgian firms believe that they can pay lower wages to skilled machine operators than to workers with handwork skills, e.g., Georgianfirms may pay workers who varnish productsUS$50 per month more than a skilled machinist, becauseo fthe use ofhazardouschemicals. ChaDter 7. Light Manufacturing 79 7.34 Prices. Sales per worker depends also on the price obtainedfor wood products, which inturn is a function of several factors-- design, quality, the market segment, and technical efficiency of production. The best Georgian firm realizesUS$1,020/ m3for dinning chairs, which is the lowest price/ m3 inTable 7.10. Right now the firm obtains 43 chairs per m3of timber, whereas inother factories inparts of Eastern Europe it is possible to make 90 or 100 chairs per m3. Georgian firms, as observed earlier, discard half their timber as off-cuts, while firms inmany other countries laminatetheir off-cuts, or waste products, to produce items like kitchen cutting boards for which they obtain up to US$2,227/m3. Some firms in Georgiaare aware of the potential of laminating wood to produce by-products, but lack capital to acquire the technology and lack market linkages. 7.35 Georgia obtains US$l20 for beech logs, while China pays US$416/m3 and Georgia gets US$128'* for semi-processed beech, while China pays up to US$711/m3 for the same commodity. Whereas Georgia obtains a 6 percent premium for semi-processed timber, there is a 71 percent premium available on China's wholesale markets, dependingonthe extent of processing. Table 7.10: PricesObtained for Wooden Products (US$ per m3) Best Georgian Mass-market Mid-market Ghanaian Bhutanese firm UKstore UKstore exporter wood-turners Product Chair Cutting Board CuttingBoard KeyRingHolder Bowl Retail price 4,123 11,136 FOB price (estimated) 1,020 1,375 2,227 27,000 3,500 Source: Firminterview; Argos catalogue, 2002; Habitatcatalogue, 2002-03; Thimpu street market, 2001. 7.36 Domestic Manufacturing. About 26 percent of industrial timber is consumed on the domestic market. While in 1990,60 percent ofthe timber used inthe wood processingindustry was convertedinto furniture, only a small amount of the furniture sold in Georgia is locally made. Much of the timber is used for construction, e.g., joists, doors and windows, and floorboards, with firms reportedly obtaining US$160 -240/m3. A Strategyfor the WoodIndustry 7.37 There are three main challenges for Georgian firms to take advantage of the considerable opportunitiesprovided by world markets: (a) government policy and access to timber; (b) development of marketing skills and (c) acquisition of technology by firms. These challenges are sequential. Firms must first be able to get access to predictableamountsoftimber of good quality. Only then they can undertake market research to identify products and buyers with potential in market segments that fit Georgia's capabilities. Lastly, they can balance the inputs available to them with the needs of the market and determine the appropriate technology needed to service market needs, as well as create appropriate enterprisestrategies and structures. 7.38 There is some urgency in addressing these challenges as markets are changing fast and Georgia cannot afford to lose the opportunities at hand. Three developments in particular are expectedto change the trade landscape in the future: (a) countries to the west of Georgiawill bejoining the EuropeanUnion inthe coming years; (b) an uncertaintrade regime with Russia; and (c) increasingdemand from Asia for logs and semi-processed timber. 92 Page 57, Ibid. T. Arin and J. Sir. ChaDter 7. Light Manufacturing 80 GovernmentPolicy: Access to Timber and Other Inputs 7.39 UpstreamForestry Policy. Firms needa predictable business environment to enable them to plan investments, transfer in new technologies, and develop marketing strategies. Frequent policy changes, such as temporary bans on harvesting or the export of logs, are damaging to firms' long-term relationshipswith buyers. 7.40 Elimination of Illegal Activities. Measures are needed to reduce illegal operations in the forests. Unless this is substantially achieved, the prices that legal firms can get for their products will be constrained, making it difficult for them to (a) pay license and/or stumpage fees and (b) invest in their businesses to enable value-addedproductsto be producedand marketed. 7.41 Size and Location of Licenses. Firms shouldbe permittedto bid on sufficiently large felling areas with long enough lease durations to allow them to invest optimally in the resource they have been allocated. Under the existing forest policy, firms incur the following costs in maintaining a felling lease: road construction; policing their felling area; setting up processingunits in the forest. All these costs are muchhigher when firms can only obtain leases on scattered tracts of forest for short durations. 7.42 Forestry Certijkation. In the future, access to important markets will depend on forest certification. Leading world markets for value-added products increasingly require products from example, Ikea targets "wood materials ... shall come from responsibly managed forests; sustainable forests, which conform to Forestry Stewardship Council (FSC), or equivalent criteria. For 93yyand B&Q, Europe's largest do it yourself chain, by the end of 1999 only sourced wooden products from FSC certified forests.94 Views about the sustainability of forest resources in Georgia range widely. Some believethat the forest is growing by 4 million m3per year; and hence, there are no sustainability concerns, even allowing for illegal harvesting. Others state that the harvest should be limited to 1 million m3a year to foster a healthy forest. 95 In any event, the key challenge for Georgiawill be the creation of areas of well-managed forest that can meet internationally acceptedstandards for sustainability. The government should begin introducing measures to certify forests by organizations such as the FSC. The prospect of certification would help attracting foreign investment and, in the longer term, assist manufacturers in penetratingexport markets. Unless Georgiaconforms to such standards it will be relegatedto selling into low-value segments. 7.43 Disseminating Information. Firms have difficulty getting information about the wood industry. Information about the sector, such as forestry laws and regulations, should be disseminated via the Internet, so firms are informed about their rights and responsibilities. Links on the website could enable firms to access information on markets, business associations, best production practices, etc. Laws and regulationsshould also be available inEnglish to better inform potential buyers and investors. 7.44 Taxes on Inputs and Equipment. Import duties on woodworking machinery and other such capital goods should be set at zero to give incentives to firms to bring in new equipment to improve productivity and quality and reduce waste andenergy use. 93 See Press Release 30 October 2000 ~www,ikean.com/about_ike~press_room/press~release_int.asp?pr_id=20 1> 94 Withthe exceptiono fgardenfurnitureand plywood. See