Georgia: Memorandum of Economic and Financial Policies for 2004

A. Introduction

1. This memorandum sets out the economic and financial policies of the Georgian government for 2004, which are aimed at sustained output growth and poverty reduction. These policies are the basis for a new three-year Fund-supported program under a PRGF arrangement.

2. The recent leadership change in our country provides a fresh opportunity to tackle corruption and governance issues, improve the efficiency, effectiveness and transparency of the government, and strengthen the country's macroeconomic fundamentals. This will be critical for achieving long-term economic growth and poverty reduction, as set out in the Economic Development and Poverty Reduction Program (EDPRP). In 2004, our program will focus on achieving the following objectives:

• To maintain a stable macroeconomic environment, supported by a prudent monetary policy and further fiscal consolidation;
  
• To raise tax revenue by accelerating administrative reforms in the tax and customs areas, as well as through tax policy measures;
  
  
• To make further improvements in budgetary expenditure management and to link the budgetary process more closely with the EDPRP;
  
  
• To conclude a new debt rescheduling agreement with the Paris Club and secure agreements with non-Paris Club bilateral creditors on comparable terms;
  
  
• To dramatically improve governance and reduce the scope for corrupt practices by implementing a phased reform of the public sector, focusing initially on the civil service and state property management;
  
  
• To accelerate other important structural reforms, particularly to rehabilitate the energy sector and improve the business climate; and
  
  
• To strengthen the financial system by promoting further banking sector consolidation and financial market deepening, building on earlier reforms to strengthen supervision, and by implementing new anti-money laundering legislation.

3. We discuss these objectives in more detail below. In addition, we have reached understandings with Fund staff on a set of macroeconomic targets and structural benchmarks (Tables 1 and 2) for 2004, which are specified in the attached Technical Memorandum of Understanding.

B. Past Economic Performance

4. Georgia made progress in implementing the economic program supported under the previous PRGF arrangement. Notable achievements include higher GDP growth than originally envisaged, maintaining low inflation, and introducing further reforms in the areas of tax policy and administration and the financial sector. However, progress was slow in some key areas, constrained in large part by weak governance and pervasive corruption. There was no sustained improvement in tax revenue collections, due to lax tax enforcement and tax code amendments that narrowed the tax base. Regional instability and a poor investment climate have undermined prospects for foreign investment. The situation in the energy sector remains serious and continues to pose a significant risk to macroeconomic stability and growth. Poverty remains widespread.

5. Real GDP grew by 8.6 percent in 2003, led by construction activities buoyed by the Baku-Tbilisi-Ceyhan oil pipeline, a recovery of farming from a bad harvest in 2002 and rehabilitation of certain industrial plants. End-period inflation rose from 5.4 percent during 2002 to 7 percent in 2003, driven in part by a sharp increase in wheat prices as a result of crop failures in the main CIS grain exporters. The 2003 target for tax revenue set under the previous IMF-supported program was missed by some 0.7 percent of GDP, especially because of a slackening in tax and customs administration. As a result, the stock of domestic expenditure arrears (accumulated since 1998) increased by GEL 123 million to 4.8 percent of GDP by year's end, instead of declining as programmed. The government deficit on a cash basis amounted to 1.3 percent of GDP in 2003 (compared with the indicative target of 1.6 percent), while the deficit on a commitment basis was 2.4 percent (versus the target of 1.3 percent). Monetary policy in 2003 was broadly in line with the program, assisted by continued remonetization of Georgia's economy. The NBG continued to float the lari, pursuing limited intervention to bolster reserves, and the lari remained broadly stable vis-à-vis the U.S. dollar in 2003. In real effective terms, however, the lari depreciated by 9 percent during the year, owing in part to the weakening of the dollar relative to other major currencies. In spite of active NBG intervention in the foreign exchange market, gross international official reserves fell slightly to 1.5 months of imports of non-pipeline goods and services, largely because of the inability to maintain the PRGF program on track and make the related IMF drawings.

6. Structural reforms in the fiscal area advanced in 2003, albeit with delays. The new Budget System Law passed in April 2003 provides a useful framework for improved public expenditure policy and management. The tax reform of August 2003 should simplify compliance and facilitate tax enforcement, aided by the strengthened investigative powers granted to the Ministry of Finance. Further revenue-neutral tax policy measures were introduced in December 2003 in order to ease the tax burden on small farmers, while offsetting the potential revenue loss to the central and local governments. These included (i) shifting collection of the land tax to local governments and giving them the legal option to raise the land tax rate on larger landholders; (ii) fully transferring the personal income and profit taxes to local governments (the State Tax Department will continue to collect them on their behalf); and (iii) introducing a new taxation regime for tobacco products. Moreover, various "nuisance taxes" that had been abolished in the August tax package were reintroduced in December to sustain the local government revenue base, although the longer term goal of the government is to phase out nuisance taxes in the context of a broader tax reform discussed below. Progress was made towards the establishment of a commitments control system by the treasury for all payments by state ministries and line agencies, and towards the establishment of a single treasury account, which will become fully effective April 1, 2004. The government program for 2004, outlined below, aims to build on these reforms.

7. In the energy sector, implementation of the action plan agreed with the donors in November 2002 was mixed. In May 2003, the electricity distribution utility outside Tbilisi (UDC) was brought under private management, but transfers from UDC to the wholesale electricity market continued to fall short of expectations throughout the year. The financial viability of the sector was also undercut by a court-ordered 11 percent reduction in power tariffs in effect since March 1, 2003. Bill collections from direct customers and budgetary organizations improved during the year, but the Q4 target for budgetary organizations was missed by a wide margin. In November 2003, agreement was reached on a modified action plan for the sector, including protection of power industry assets from trespassers seeking to avoid disconnection of non-paying customers and realistic budgeting to enable full payment of electricity bills by central and regional governments. However, progress in implementing that plan was mixed, and in February 2004 the energy sector stakeholders and donors proposed to strengthen this action plan by (i) forcefully disconnecting nonpaying customers; (ii) improving debt management in the sector, including to settle the sector's sizable legacy debt; and (iii) developing business plans to improve the performance of all major electricity distributors, including by improving their collection rates. Implementation of these measures is a key element of our economic reform strategy for 2004.

8. Financial sector reforms advanced in 2003 as the NBG secured regulatory changes to better target its banking supervisory authority. On-site inspections were made less predictable and more focused on problem banks. An anti-money laundering law was passed by parliament in early June 2003 and a Financial Monitoring Service was established under the NBG's auspices. Progress toward developing the market for government securities remained nonetheless limited.

9. The current account deficit including transfers widened to 8 percent of GDP in 2003 (from 6 percent in 2002), much of it covered by rising pipeline-related FDI. Because of slippages under the PRGF-supported program, which precluded the consolidation of 2003 principal maturities owed to the Paris Club, Georgia accumulated US$51 million in arrears to its bilateral creditors by end-December 2003, and a further building up of arrears of some US$12 million is now estimated during the first quarter of 2004. The financing assurances that we expect to receive from the Paris Club in the near future will pave the way for clearing these arrears. Georgia remained current on its interest obligations to them and on all obligations to multilateral creditors.

C. The Government Program

10. Our medium-term program features a rapid and decisive turnaround in governance, tax enforcement, and capacity building, and it also envisages a careful sequencing of reforms. Broadly consistent with the base case of the EDPRP, we assume 5 percent real GDP growth over 2004-06, slightly above the 1998-2003 average, though growth could well turn out to be faster if our efforts to improve the business climate and foster private investment bear fruit. Inflation is targeted to remain low as the NBG maintains prudent monetary policies. Efforts to strengthen governance and reduce corruption will be aimed at improving public sector operations, especially by creating a leaner, efficient, and accountable civil service and improving the management and accountability of SOEs. Tax enforcement will be strengthened by improving administration in the revenue-raising agencies, fighting corruption and smuggling, simplifying the tax system, and broadening the tax base. Progress on these fronts should allow us to achieve an increase in the tax revenue to GDP ratio of some 5-6 percentage points over the next five years. An increase of this magnitude, though relatively ambitious, appears to be feasible and necessary to secure fiscal sustainability and unwind domestic expenditure arrears. Progress in these areas will help us regain the confidence of donors and investors to secure higher aid flows and spur investment, both of which are critical for achieving the economic growth and poverty reduction goals laid out in the EDPRP. The new government has endorsed the EDPRP prepared by the previous administration and will update the poverty reduction program in the course of 2004 in consultation with stakeholders. A key objective of the EDPRP is to reduce the proportion of the population living below the official minimum subsistence levels, from 52 percent in 2002 to 20-25 percent by 2015. Other areas where we intend to make progress over the program period include strengthening the financial system and reducing its remaining vulnerabilities, and peacefully regaining full control over Georgian territory and normalizing relations with Russia, while continuing to integrate Georgia into the world economy.

11. The medium term macro-economic framework underpinning this three-year Fund-supported program includes projections for government revenue and expenditure that are somewhat higher than in the baseline scenario presented in the EDPRP. These projections are justified in the light of our intensified efforts to mobilize tax revenue and secure additional foreign aid, so as to make room for priority social and infrastructure spending. The improved medium-term outlook will be reflected in the EDPRP progress report to be prepared later this year.

12. Our economic program for 2004, more specifically, will focus on improving governance and the investment climate. Toward these ends, we will advance key aspects of the unfinished agenda for structural reform, underpinned by a continued prudent macroeconomic stance. As noted above, a high priority will be given to increasing government revenue to make room for higher spending on social programs and on infrastructure, as well as to initiate the phased reduction in the stock of domestic expenditure arrears. Another focus of our efforts will be to strengthen the performance of SOEs in an effort to avert fiscal pressures and improve resource allocation. We intend to take further steps to strengthen banking supervision in order to promote a sound financial sector and enhance financial intermediation that will facilitate investment and growth. Energy sector reform will be pursued to alleviate pressure on the budget and promote more reliable power supply. By refraining from commercial external borrowing and restructuring current obligations on bilateral debt, we aim to remove a significant obstacle to growth.

Macroeconomic prospects

13. We are confident that Georgia will achieve solid economic growth in 2004, supported by the construction of the Baku-Tbilisi-Ceyhan Oil Pipeline and sustained growth in our principal trading partners. The 2004 program targets a real GDP growth rate of 6 percent and inflation of around 5 percent. We anticipate a small gain in net foreign assets, which would keep gross reserve coverage at about 1½ months of non-pipeline imports.

Fiscal policy

14. The 2004 budget aims to increase tax revenue by at least 1.5 percent of GDP. The overall fiscal deficit will decline to 1.6 percent of GDP on a commitment basis and 2.6 percent on a cash basis, allowing for net repayments of expenditure arrears of 1.0 percent of GDP and thereby reducing the stock of arrears to 3.3 percent of GDP by end-2004. The increase in tax revenue will hinge on improving tax and customs administration, especially regarding excise and value added taxes and customs duties. In this regard, we have taken decisive measures to ensure the integrity and professionalism of tax and customs officials and will vigorously pursue cases of tax fraud and other abuses. We have created a financial police in the Ministry of Finance, while abolishing the economic crime units in the power ministries. Moreover, we are overhauling the Tax Department, and-without duplicating the functions of the Large Taxpayer Unit-we have created a new Excise Tax Inspectorate, which is now fully operational and incorporates the responsibilities of the Excise Stamp Service and the Excise Program Monitoring Bureau, as well as the excise collection functions of the Tax Department. Additional measures that will be taken to increase excise tax revenue include (a) targeting anti-smuggling efforts at access routes to major population centers; (b) intensifying surveillance over small-scale ("tea-kettle") oil refineries; and (c) introducing far-ranging improvements in the personnel management of the Tax and Customs Departments. In addition, the Ministry of Finance will prepare an effective customs reform and anti-smuggling strategy, in cooperation with other government agencies and donors. The new PRGF program includes a performance criterion on collections of fuel and cigarette excises, demonstrating our resolve to curb widespread evasion of these taxes.

15. To prepare for a deepening of reforms initiated in 2003, we will formulate a comprehensive review of tax policy in 2004, supported by donor technical assistance, for which we will seek parliamentary approval by end-2004. In this connection, we aim to broaden the tax base beginning with the 2005 budget, by dismantling exemptions (especially on the corporate income tax and VAT), while eliminating nuisance taxes to simplify the tax regime. Discussions are continuing toward a normalization of revenue transfers from Adjara to the central government.

16. Non-tax revenue will rise significantly from 2005 onward, in the form of transit fees for oil transported through the Baku-Tbilisi-Ceyhan Oil Pipeline. In-kind transit fees from the South Caucasus Pipeline (SCP) are expected to start in 2006. In 2004, we will develop plans for a mechanism for transparent reporting of these revenues, and for monetizing the in-kind SCP fees.

17. The new Budget Systems Law abolished the system of protected items starting with the 2004 budget, thereby fostering greater operating flexibility and discouraging accumulation of new expenditure arrears. In 2004, we will introduce a number of amendments to further enhance the law's effectiveness, including (a) aligning it with recent constitutional amendments; (b) upgrading its status to that of an organic law; (c) revising the budget preparation calendar to allow more time for negotiations between the Ministry of Finance and spending agencies on the agencies' budget allocations; and (d) strengthening the treasury's exclusive control over the treasury single account. Regarding the accumulated stock of domestic expenditure arrears, we have effectively stopped the build-up of these arrears and plan to reduce them by some GEL 90 million (1.0 percent of GDP) in 2004, focusing initially on settling arrears on wages and pensions. Subsequent to auditing the stock of all expenditure arrears, we will develop a plan to settle them before the expiration of the PRGF-supported program. This plan will be incorporated in the Medium-Term Expenditure Framework, which will include sufficient budgetary appropriations for this purpose. We will also audit the registers of pensioners and internally displaced persons (IDPs), to make sure that payments are made only to those who are entitled to receive a state pension and/or refugee allowance. In 2004, all revenue transit accounts at the banking system will be closed as an interim step to the establishment of a single treasury account by end-June 2004, and full commitment control for all payments by the treasury for state ministries and line agencies will be established. Cash and debt management will be improved by preparing realistic monthly projections for cash and spending and by providing financial markets with timely information on projected treasury bill auctions.

18. We will transfer a number of functions currently in the domain of budgetary organizations to legal entities of public law (LEPLs), with a view to improving the focus of budgetary organizations on their core activities. The exact list of functions to be transferred to LEPLs will be determined in the course of 2004, in close consultation with Fund staff. To safeguard the transparency and accountability in the use of budget resources, all transfers to LEPLs will go through line ministries as program financing to those entities, with each line ministry being legally responsible for ensuring that funds are used properly. In addition, all LEPLs will be held to high transparency standards and will be obliged to fully disclose all their revenues and expenditures as well as to report them in a timely manner to the Ministry of Finance.

19. Efforts to improve the governance, efficiency and transparency of key state-owned enterprises (SOEs) are an important element of our 2004 reform agenda. At present, the government does not exert sufficient control over these enterprises and their financial reports are neither reliable nor systematic. As a result, many large SOEs are not subject to hard budget constraints and systematically evade payment of taxes and dividends to the budget. In 2003, the Ministry of State Property Management was dissolved, and its tasks were transferred to the Ministry of Economy, which has assumed responsibility for privatization. A new Enterprise Management Agency (EMA) now oversees the management of SOEs by appointing supervisory boards and preparing enterprises for privatization. Although no major privatizations are now envisaged to take place in 2004, besides the sale of the Agrobusiness Bank, the EMA is reviewing procedures for subsequent privatizations (possibly including medium- and large-scale SOEs) during the program period. We view improved transparency and accountability of SOEs as an effective tool for better performance. Toward that end, the 2002 accounts of three major companies (Georgian Railways, Poti Port, and Madneuli Mining Company) are being audited by reputable international experts, selected in July 2003 through a competitive bidding process. The audit reports will be certified by end-July 2004 and published within one month of their completion. Based on the experience gained in 2003, we plan to broaden the coverage of international audits to all ten SOEs with a turnover exceeding GEL 10 million (US$5 million), starting in 2004 with the state telecommunications company (Elektrokavshiri) and the Tbilisi Airport Authority. These companies will be expected to publish the audit results and maintain high auditing standards henceforth. Our ultimate goal is to improve the monitoring of financial accounts of the major parastatals, so as to allow for a broadening of the coverage of the fiscal accounts over the medium term.

Energy sector and other structural reforms

20. The 2004 reform program will continue to focus on improving financial performance and governance of the energy system, which are fundamental from the fiscal and resource allocation standpoints. A 16-month business plan for the power sector through the winter of 2004/05 is being developed in consultation with donors and key sector participants to address the more urgent problems in the sector. The centerpiece of that plan is to secure a further sustained increase in collection rates in the sector. Moreover, a longer-term strategy will be formulated to rehabilitate and upgrade the sector's infrastructure and mobilize the corresponding investment resources, currently estimated at US$375 million for the power and gas sectors over the next several years. Within this comprehensive framework, and while political discussions continue to regain full Georgian sovereignty over the breakaway regions, the government will also address the problems created by the electricity that is consumed but not paid for by Abkhazia. Progress in the design and implementation of energy sector reform will be a principal topic covered during the first review under the program, as discussed below. The review will assess, inter alia, progress in improving bill collection rates, implementing the strategy to address energy sector legacy debt, and securing domestic and external resources to rehabilitate power and gas infrastructure. Privatization of electricity distribution in Tbilisi has contributed to higher collection rates and more reliable power supply in the capital; however, in the rest of the country, collection rates are low, and electricity supply has not improved. In April 2002, most municipally owned distribution companies outside Tbilisi were consolidated into a single, state owned United Distribution Company (UDC), which was put under private management contract in May 2003. Virtually all power distribution, transmission and dispatch, as well as part of the country's generation capacity has now been brought under private management contract. Combined with strong support for policies to cut off non-paying consumers of electricity and further work to extend the metering of customers, this should result in an increase in cash collections for electricity consumption for direct customers of the wholesale electricity market to 90 percent, and for budgetary organizations to 97 percent on average in 2004 (including 100 percent of billing in the third and fourth quarters of the year). In addition, the UDC's collection rate is targeted to increase to an average of 25 percent of billing in 2004. We will closely monitor the collection performance of the other distribution companies (Adjara and Kakheti) and will withdraw the licenses from small distributors that currently operate within the territory of the main electricity distribution companies. Tbilgazi's collection system has been moved to banks, to boost the collection rate to 32 percent on average in 2004. We aim to further increase UDC's and Tbilgazi's collection rates during the remainder of the program period, following the completion of ongoing metering programs. In 2004, the government will fully reassert the autonomy of the Georgian National Energy Regulatory Committee (GNERC) in conducting its regulatory activities, including formulation of energy tariff policy and licensing of energy sector utilities. Moreover, a comprehensive review of the electricity tariff methodology will be initiated by end-June 2004 with donor assistance.

21. Achieving tangible and substantial improvement in governance by reforming the public sector is an important objective of our 2004 economic reform program. Toward that end, the constitutional reform passed in February 2004 has created the position of Prime Minister, abolished all state departments and subordinated them directly to the respective line ministries, and institutionalized the notion of collective responsibility of ministers. We will thoroughly revise the mandates of the remaining 15 ministries, their structures, internal procedures and process, as well as coordination and reporting mechanisms. These reforms should help to enhance the effectiveness of government. State procurement will be strengthened by announcing all public tenders on the website of the State Procurement Agency.

22. Civil service reform will be pursued with the aim of creating a competent, motivated and well-remunerated yet affordable civil service, thereby improving the efficiency of government structures and reducing incentives to engage in corrupt practices. To achieve this, we will develop in the second half of 2004 a comprehensive and carefully costed civil service reform strategy that will (i) develop merit-based recruitment, remuneration and suspension mechanisms, (ii) revise the current grading system, (iii) provide for professional development, and (iv) introduce and enforce disciplinary and ethic codes. Donors have agreed to provide technical and financial support for this effort. A number of ministries have already started to reduce staff through self-financing retrenchments, with a corresponding envisaged increase in salaries to remaining personnel (after clearing wage arrears and effecting severance payments). We also plan to effect payment of government salaries by direct deposit, replacing the current cash payments system, as another aspect of our efforts to improve public sector efficiency and reduce the scope for corruption.

23. By simplifying the tax regime and strengthening governance as discussed above, the business climate should improve significantly and conditions should be created for small and medium-sized enterprises (SMEs) to flourish. Supporting measures in that direction will include (i) creating an investment and trade development agency with donor support that would serve as a "one-stop shop" for investors; (ii) appointing a business ombudsman in the Ministry of Economy; and (iii) strengthening microfinance institutions.

Monetary and financial sector policies

24. The monetary program for 2004 remains focused on maintaining inflation in the 5 percent range and strengthening the foreign reserve position of the NBG. It envisages reserve money growth of 14 percent and broad money growth of 19 percent, assuming that recent trends in remonetization continue. The lari's floating exchange rate regime will be maintained. The NBG has enhanced its monetary policy tools by reviving and expanding the lari interbank market in 2003 in the form of a redesigned credit auction that better fulfills the needs of banks; credit auctions are now held several times a week. Access to a portion of required reserves as collateral for the credit auction has been made automatic. We anticipate that this expansion in the availability of secure, liquid, lari-denominated assets, along with a gradual improvement in the business climate and the introduction of differential reserve requirements in 2003, will stem and possibly reverse the trend toward dollarization over the medium term. Our goal is to further improve the functioning of interbank and treasury bill markets, in particular through the development of a primary dealer system in 2004. We recognize that these measures may mitigate dollarization marginally, and that a more substantial reversal of this phenomenon depends on gradual, continued improvement in the economic fundamentals and investor confidence.

25. Besides continuing our efforts to increase financial sector transparency, we are developing a strategy for further banking sector consolidation in 2004 and already introduced a phased increase in minimum capital requirements. With regard to banking supervision, we have begun (i) regular stress testing of the banking system in line with the IMF's Monetary and Financial Systems Department (MFD) recommendations; (ii) implementing the principles and procedures of the NBG's analytical framework for bank resolution; and (iii) utilizing predictable and progressively stronger supervision measures for banks in distress (i.e., those rated as CAMEL three, four or five according to internationally-accepted supervisory criteria). Additionally, the government will propose necessary changes in legislation to provide the NBG with the legal authority to disqualify auditors from performing bank audits and require them to disclose violations of law, regulations, or significant misrepresentation of financial data to the NBG. Following Georgia's ratification of the Strasbourg Convention Number 141 on "Laundering, Search, Seizure and Confiscation of the Proceeds from Crime," thereby binding Georgia to full compliance with the requirements contained therein, the authorities are now proceeding to bring the Georgian legislation and enabling regulations on AML into full compliance with the international agreement, in consultation with the IMF's Legal Department.

External policies

26. The end of the Paris Club consolidation period in 2002 resulted in 2003 in a sharp increase in Georgia's external debt service due and in the accumulation of external arrears noted above. To clear these arrears and achieve medium term external viability, we intend to request a rescheduling of 2003 arrears and eligible 2004-06 maturities (i.e., bilateral pre-cutoff obligations, excluding those rescheduled under the 2001 arrangement), with comparable treatment by non-Paris Club bilaterals. We will also continue negotiations with Turkmenistan to reach a formal agreement on the rescheduling of pre-2001 arrears, as well as 2001 and 2002 principal maturities. In this connection, we have reviewed the implications for Georgia of the Paris Club's new Evian approach. The latest Debt Sustainability Analysis, which has been updated in advance of a request for a new arrangement, suggests that absent a concessional restructuring, Georgia would continue to face a heavy debt burden. We will pursue prudent external debt management and will not contract or guarantee any non-concessional loans during the program period.

27. Georgia will continue to maintain a liberal foreign trade regime. In December 2002, parliament passed legislation increasing the level and the dispersion of import duties, taking advantage of the margins provided at the time of Georgia's accession to the WTO. The number of tariff bands was increased from 3 to 22 and the maximum tax rate was increased from 12 percent to 30 percent. While the increase in average protection-evidenced by a one percentage point rise in the weighted average tariff to 11.3 percent-is modest, tariff dispersion has increased substantially. In keeping with Georgia's outward-looking growth strategy, we will phase out the protective measures introduced in late 2002, with a view to reducing the level and dispersion of import tariffs, thereby reducing rent-seeking opportunities, by end-2004. More generally, and in conjunction with the comprehensive tax policy assessment to be conducted this year as noted above, we will review the scope for eventually adopting a low uniform import tariff (accompanied by introduction of a duty-drawback system and improvements in the VAT refund mechanism for exporters). Given the anti-smuggling efforts mentioned earlier, we believe it should be possible to liberalize the trade regime while simultaneously raising duty collections, improving resource allocation, and reducing the anti-export bias of the trade regime.

D. Program Monitoring

28. Progress in implementing the program will be monitored through quantitative performance criteria and indicative targets set forth in the attached Table 1, as well as structural performance criteria and benchmarks as listed in Table 2. Semiannual performance criteria will be monitored under two reviews. Completion of the first review, scheduled for October 2004, will require observance of the performance criteria for end-June 2004, as shown in Tables 1 and 2. The review would focus on progress in improving governance, securing fiscal consolidation, and launching or implementing reforms in the energy sector and the civil service. Key governance-related elements of conditionality for this review will be (i) progress on implementation of our customs reform strategy; (ii) development and implementation of a comprehensive, 16-month emergency plan to restore the viability of the electricity sector, featuring inter alia a move of collection systems for payments to electricity distributors in major towns outside Tbilisi to banks or service centers; (iii) the strengthening of the supervisory boards of Madneuli mining and Elektrokavshiri; and (iv) publication of the audits of the 2002 accounts of Poti Port, Georgian Railways, and Madneuli Mining Company. The second review, scheduled to be completed by April 2005, will assess developments in the areas mentioned above and gauge program performance on the basis of end-December 2004 quantitative performance criteria and indicative targets. Key governance-related elements of conditionality for this review will include reversal of the changes in import tariffs introduced in December 2002 and initiation of additional audits of two key SOEs.

Georgia: Technical Memorandum of Understanding (TMU)

May 12, 2004

1. This memorandum sets out the understandings between the Georgian authorities and the IMF staff regarding the definitions of quantitative and structural performance criteria and indicative targets, as well as respective reporting requirements for the arrangement supported under the Poverty Reduction and Growth Facility (PRGF). These performance criteria and targets are reported in Tables 1 and 2 of the Memorandum of Economic and Financial Policies (MEFP), attached to the Letter dated April 22, 2004.

2. The quantitative performance criteria (ceilings and floors) and indicative targets listed in Table 1, Sections 1 and 2, of the MEFP are defined as cumulative changes from end-December 2003. The program allows for an automatic adjustment to the cash deficit target in case of deviations of external project financing from expectations, subject to a cap on the upward adjustment.

Quantitative Performance Criteria, Indicative Targets, and Continuous Performance Criteria: Definitions and Reporting Standards

A. Definition of the General Government and the Public Sector

3. The general government is defined as the central government, local government, and extrabudgetary funds. The public sector consists of the general government and the National Bank of Georgia (NBG).

B. Floor on Tax Revenues

4. Definition: Tax revenues are defined as total tax collections by the central government, local governments, and extrabudgetary funds.

5. Supporting material: The Ministry of Finance (Treasury) will provide data showing a detailed breakdown of tax revenues paid into the NBG revenue account(s) on a monthly basis within two weeks of the end of each month. The local budget department in the Ministry of Finance will provide additional information on revenue collections of local governments.

C. Floor on Revenues from Tobacco and Petroleum Products

6. Definition: This target is defined as the total of (1) customs duties, excise duties, and VAT collected by the State Tax Department and the State Customs Department on the domestic production, sales and imports of petroleum products; (2) the fixed tax collected on production, sales, and imports of tobacco products until July 1, 2004; and (3) the fixed tax and VAT collected on production, sales and imports of tobacco products afterwards.

7. Supporting material: The Ministry of Finance will provide data with a breakdown into the main categories of products on a monthly basis within two weeks of the end of each month.

D. Ceiling on Domestic Expenditure Arrears

8. Definition: Domestic expenditure arrears are defined as arrears incurred by the general government on expenditure items, excluding external debt service payments. The measurement of central government expenditure arrears will be based on the following principles: (a) goods and services have been received; (b) they have been certified to conform to the order of the contract; (c) the bill for payment has been received; and (d) the due-for-payment date has passed and the bill has remained unpaid beyond the normal or agreed period of credit. Extrabudgetary funds will start using the same method from June 2004 onwards. Until then, the net change in arrears will be estimated as the difference between actual cash spending and the monthly cash limits issued prior to the beginning of the month. Expenditure arrears of local governments are also estimated as the difference between actual cash spending and the monthly cash limits issued prior to the beginning of the month.

9. Supporting material: The Ministry of Finance (Treasury) will provide monthly data, with a detailed breakdown by economic and organizational category, on cash spending and commitments made by the central government, and/or cash limits issued to the spending units. Information on cash limits and spending commitments will be provided within two weeks from the beginning of each month. Information on cash spending will be provided within four weeks of the end of each month. The local budget department in the Ministry of Finance will provide information on monthly spending by the local budgets, and the extrabudgetary funds will provide information, through the Ministry of Finance, on their monthly expenditures.

E. Ceiling on the Cash Deficit of the General Government

10. Definition: The cash deficit of the general government will be measured from the financing side, and will be defined as equal to the total financing (domestic and external, plus privatization proceeds) received by the general government.¹ Privatization receipts consist of all gross proceeds received by the central and local governments. Domestic financing consists of all bank and non-bank financing to the general government. External financing is defined as the total of disbursements, macroeconomic support, net change in external arrears, minus amortization. Disbursements include all project financing (capital expenditure and net lending) and balance of payments support (excluding grants) received by the budget. Amortization includes all external debt-related payments of principal; amortization to external creditors via third parties is accounted for at the time and in the amount of payment by the budget to the third party, rather than at the time of recognition of amortization by the external creditor.

11. Adjustment clauses: The ceiling will be adjusted to reflect cumulative deviations from program assumptions on external project financing for capital expenditure or net lending. The ceiling at the end of a quarter will be adjusted upward (downward) by the full amount of the cumulative excess (shortfall) of external project financing. There will be a cap on cumulative upward adjustment of GEL 100 million for calendar year 2004.

12. Supporting material: Data on privatization receipts will be provided by the Ministry of Finance (Treasury) on a monthly basis within two weeks of the end of each month. The data will be consistent with the revenue account(s) in the NBG. Data on domestic bank and non-bank financing will be provided by the NBG. A table on external project financing will be provided monthly by the Ministry of Finance (specifying project by creditor) within two weeks of the end of each month.

F. Ceiling on Net Credit of the Banking System to the General Government

13. Definition: Net credit of the banking system to the general government includes net credit to the general government from the NBG and the deposit money banks. Credit to the government includes all loans to the general government and all treasury bills issued by the general government held by the banking system. Net credit to the government is defined as credit to the government less deposits of the general government in the banking system.

14. Supporting material: The NBG will provide the monetary survey on a monthly basis within three weeks of the end of each month. The NBG will also provide information on the activities of the treasury bill market.

G. Ceiling on Net Domestic Assets of the NBG

15. Definition: Net domestic assets of the NBG are defined as the difference between net foreign assets and reserve money. Net domestic assets are defined as the sum of net claims on the government (the sum of loans and treasury bills purchased by the NBG, less deposits of the government with the NBG), claims on banks, claims on the rest of the economy, and other items net (comprising the NBG capital accounts, net unclassified assets, counterpart funds and exchange rate revaluation).

16. Supporting material: The NBG will provide its balance sheet, which includes data on its net domestic assets, on a monthly basis within one week of the end of each month.

H. Floor on Net International Reserves of the NBG

17. Definition: Net international reserves (NIR) of the NBG in U.S. dollars are defined as foreign assets minus foreign liabilities of the NBG, using program assumptions on bilateral exchange rates (GEL 2.15 lari per U.S. dollar, US$1.49 per SDR, US$1.27 per euro, and a gold price of US$425.00 per ounce). Gross reserves of the NBG are defined as liquid, convertible currency claims of the NBG on nonresidents that are readily available. Pledged or otherwise encumbered assets, including but not limited to assets used as collateral (or guarantee for third party external liabilities) are excluded from reserve assets. Reserve liabilities include the use of Fund resources and any other liabilities of the NBG.

18. Supporting material: Data on net international reserves and data on net foreign-currency non-project financing will be provided in a table on the NBG's foreign exchange flows (which includes details of inflows, outflows, and net international reserves) on a monthly basis within two weeks following the end of the month.

I. Ceiling on Contracting or Guaranteeing of New Non-Concessional Medium- and Long-Term External Debt by the Public Sector (with Original Maturity of One Year or More)

19. Definition: Non-concessional external loans are defined as loans from lenders other than the IMF with a grant element of less than 35 percent of the value of the loan. The grant element is to be calculated by using currency-specific discount rates reported by the OECD (CIRRs).² For maturities of less than 15 years, the grant element will be calculated based on six-month averages of commercial interest rates. For maturities longer than 15 years, the grant element will be calculated based on 10-year averages. This performance criterion applies not only to debt as defined in point No. 9 of the IMF's Guidelines on Performance Criteria with Respect to Foreign Debt (Decision No. 12274-(00/85) August 24, 2000) but also to commitments contracted or guaranteed for which value has not been received.³ Previously contracted non-concessional external debt that has been rescheduled will be excluded from the definition of "new debt" for the purposes of this performance criterion.

20. Supporting material: Details of all new commitments and government guarantees for external borrowing, with detailed explanations, will be provided by the Ministry of Finance on a monthly basis within two weeks of the end of each month.

J. Ceiling on Contracting or Guaranteeing Short-Term External Debt by the Public Sector (With Original Maturity of Less than one Year)

21. Definition: This performance criterion applies to debt as defined in point No. 9 of the IMF's Guidelines on Performance Criteria with Respect to Foreign Debt (Decision No. 12274-(00/85) August 24, 2000), see footnote for Section H, as well as to commitments contracted or guaranteed for which value has not been received.

22. Supporting material: Details of all new commitments and government guarantees for external borrowing, with detailed explanations to be provided by the Ministry of Finance on a monthly basis within two weeks of the end of each month.

K. Non-Accumulation of External Arrears

23. Definition: During the period of the arrangement, the general government and the NBG will not accumulate any new external payment arrears. Official arrears on external debt service obligations include any non-payment of interest and/or principal in full and on time falling due to all creditors, including the Fund, the World Bank, and other official creditors.

24. Supporting material: Details of official arrears accumulated on interest and principal payments to creditors will be reported within one week from the date of the missed payment.

L. Indicative Target for Reserve Money

25. Definition: Reserve money is defined as currency in circulation and required reserves of deposit money banks and balances on banks' correspondent accounts at the NBG.

26. Supporting material: The NBG balance sheet is to be transmitted on a monthly basis, within two weeks of the end of the month.

M. Target for Electricity Cash Collection Rate from Direct Customers of the Georgian Wholesale Electricity Market (GWEM)

27. Definition: The cash collection rate is defined as the ratio of all cash payments received in each month to the lari amount billed in the previous month. "Cash offset" payments—direct cash payments from Direct Customers of the GWEM to power generators, bypassing the GWEM—will be included in the cash collection rate if the payment took place with prior GWEM approval and was motivated by the impossibility of paying the GWEM at that time, due to the fact that the GWEM's bank accounts were frozen. Direct customers of the GWEM are defined as all customers receiving electricity through the GWEM excluding the electricity distribution companies. For comparability purposes, the data will separately include the delivered, billed and collected amounts from all transactions originated from direct contracts concluded after February 1, 2002 by any current or former member of the Wholesale Electricity Market. Quarterly collection rates in each quarter are calculated by taking quarterly collections in the current quarter divided by billings in the last month of the previous quarter and the first two months of the current quarter.

28. Supporting material: The Ministry of Energy will provide both aggregated data on electricity delivery, billing and collection amounts as well as a breakdown into payments by all individual customers of the GWEM and individual transactions based on direct contracts described in the definition above. The total payments received from each customer of the GWEM as well as payments originating from the direct contracts will be broken down into cash, cash offset and offset payments. Subsidies paid in cash by donors to the GWEM should be included in the cash component of payments. Monthly data will be reported within three weeks of the end of each month.

N. Target for Electricity Cash Collection Rate from the General Government

29. Definition: The cash collection rate is defined as the ratio of all cash payments received by electricity distribution companies in each month to the lari amount billed in the previous month. Quarterly collection rates in each quarter are calculated by taking quarterly collections in the current quarter divided by billings in the last month of the previous quarter and the first two months of the current quarter.

30. Supporting material: The Ministry of Energy will provide data on electricity delivery, billing and total collection amounts (separate data for local and central budgetary organizations). This data will be reported for each electricity distribution company and as an aggregate. Monthly data will be reported, within three weeks of the end of each month.

O. Target for Cash Collection Rate of the United Distribution Company (UDC)

31. Definition: the cash collection rate is defined as the ratio of all cash payments by customers to UDC each month to the lari amount billed in the previous month. Transfers by international donors to help needy individuals pay their bills (such as transfers under the Georgian Winter Heat Assistance Program) are not included in cash payments. Quarterly collection rates in each quarter are calculated by taking quarterly collections in the current quarter divided by billings in the last month of the previous quarter and the first two months of the current quarter.

32. Supporting material: The Ministry of Energy will provide data on UDC's billing and received payments on a monthly basis, within three weeks of the end of each month.

P. Target for Gas Cash Collection Rate of Tbilgazi

33. Definition: the cash collection rate will be defined as the ratio of all cash payments by customers to Tbilgazi each month to the lari amount billed in the previous month. Quarterly collection rates in each quarter are calculated by taking quarterly collections in the current quarter divided by billings in the last month of the previous quarter and the first two months of the current quarter.

34. Supporting material: The Ministry of Energy will provide data on Tbilgazi's billing and received payments on a monthly basis, within three weeks of the end of each month.