July 12, 1999

Dear Mr. Camdessus:

Since the approval of the third annual arrangement under the ESAF in July 1998, the challenges with the implementation of our economic program were exacerbated by adverse domestic developments, and by the emergence of the Russian crisis in mid-August 1998. These developments have affected our external position and, in particular, our fiscal position, resulting in insufficiently buoyant tax revenues and significant increases in expenditure arrears. We have strengthened the program significantly in response. We attach the Supplementary Statement of Economic and Financial Policies (SSEFP) which details our macroeconomic objectives and the policies we intend to implement in order to achieve them.

We are requesting waivers for the nonobservance of quantitative performance criteria at end-October 1998 on the floor on net international reserves (overall and in convertible currencies), on the floor on tax revenues and on the floor on cigarette tax revenues (Table 1 attached to the SSEFP). We have since stopped intervening in the foreign exchange market, strengthened our reserve position, and taken measures to improve tax revenue collections.

We are also requesting waivers for the nonobservance of structural performance criteria at end-October 1998 on the introduction of excise stamps on all cigarettes, on the expansion of the large taxpayer unit (LTU) to cover 50 percent of revenues, on the enactment of the law on urban and industrial land privatization, and on the expansion of the treasury system to cover all but a few government accounts (Table 3 attached to the SSEFP). Excise stamps on cigarettes are now in place; the coverage of the LTU is estimated to have reached 50 percent of total revenues as of June 1999; the law on urban land and industrial privatization was enacted in November 1998; and the planned expansion of the treasury system was achieved in November 1998.

The policies set out in the Supplementary Statement of Economic and Financial Policies should be adequate to address the aforementioned difficulties and achieve the objectives of our program. If necessary, the government and the National Bank of Georgia stand ready to take additional measures that may become appropriate during the program period. We will continue to consult with the Fund from time to time at our initiative or at the request of the Managing Director.

We also request an augmentation in the amount of the arrangement of SDR 5.55 million to help alleviate the impact of the crisis in Russia on our balance of payments. Thus, together with the remaining undisbursed amount, we are requesting completion of the review of the third annual arrangement under the ESAF with a disbursement equivalent to SDR 33.3 million (30 percent of old quota).

Following the expiration of the current ESAF, we would request continued Fund support of our economic program through a successor ESAF arrangement.

Attachment: Supplementary Statement of Economic and Financial Policies

1.  Since the approval of the third annual ESAF arrangement, the Georgian government has continued the task initiated in 1994 of building a market economy with the aim of generating sustained economic growth, low inflation, and making progress toward external viability. During this period, however, the challenges with the implementation of the reform program were exacerbated by adverse domestic developments, and the emergence of the Russian crisis in mid-August 1998. Forging public consensus toward an appropriate policy response to the major external shock facing the economy and the underlying pressures stemming from a weak fiscal stance has been a difficult task for the government, as it required taking difficult decisions, inter alia, in the fiscal, monetary, and exchange rate policy fronts. Nonetheless, the Georgian government has now developed an economic program for 1999, described in paragraphs 12 to 45 below, which in the view of the government will help reduce domestic and external imbalances, and bring the economy back to a non-inflationary growth path. The economic program aims also at making progress in fighting corruption, increasing accountability of public bodies, and boosting good governance. In the government's view, the 1999 economic program merits the continued support of the International Monetary Fund through a completion of the mid-term review under the third annual ESAF arrangement.

2.  Core to the 1999 program is an improvement in the public finances through increased revenue mobilization and the continuation of structural reform. Increased tax collections will be critical in reducing public sector dissavings, allowing the general government to cover its current expenditure needs on a timely basis, and providing support to the exchange rate. Higher tax collections will also allow a sharp reduction of government expenditure arrears, including the elimination of arrears on wages, pensions, and social transfers, which increased substantially in 1998. The registered increase in core expenditure arrears (on wages, pensions and social transfers) in 1998 hurt mainly the poorest segments of the Georgian population which are heavily dependent on this source of income.

3.  An acceleration in the pace of structural reform in 1999 will be critical for reducing government intervention in the economy and allowing the development of private sector entrepreneurship in areas which until now have been reserved for the state only. Reform in the energy sector will be a crucial ingredient for promoting economic growth. In addition, judicial and civil service reform will be instrumental in fighting corruption and promoting good governance.

4.  Inflation and growth trends during the first six to eight months of 1998 were favorable. Real GDP grew at an annual rate of 6 percent during the first half of 1998, and cumulative inflation between end-December 1997 and end-August 1998 was 0.5 percent. Exports also continued to grow. Monetary developments were also favorable, with money demand growing broadly in line with projections under the ESAF-supported program. Against this positive background, however, public finances remained weak. Overall tax revenue grew in nominal terms by about 22 percent compared with the first half of 1997, but it was 10 percent below the end-June 1998 program target. Also, expenditure arrears did not decline as programmed and the share of core expenditure arrears (wages, pensions, and social transfers) in total expenditure arrears increased between end-1997 and end-August 1998.¹

5.  Georgia's overall macroeconomic and financial position deteriorated sharply with the emergence of the Russian crisis in mid-August 1998. The trade balance and the payments system between Georgia and Russia were hit immediately by the turmoil in Russia. In addition, the transit of goods to Russia via Georgia substantially diminished. Estimates of the State Department of Statistics indicate that Georgia's annual growth rate of real GDP fell to about 1-2 percent during the second half of 1998, compared with developments earlier in the year. At the same time, the monthly rate of inflation in December reached a high of 12.1 percent compared with a monthly average rate of 0.1 percent during the first eleven months of 1998. In the event, the 12-month inflation rate at end-December 1998 reached 10.6 percent compared with a rate of 7.3 percent at end-1997. Money demand and market sentiment regarding the level of the nominal exchange rate also changed as a result of the sizeable external shock hitting the economy and a further deterioration of the public finances (as described below in paragraph 6). Broad money fell in nominal terms by lari 75 million (a 19 percent decline) between end-August and end-October 1998 and the velocity of money reached 22.9 in September, compared with program estimates of 20. Although the NBG tightened monetary policy² in response to the deteriorating financial conditions, these measures, however, were insufficient to eliminate excess demand pressures in the foreign exchange market and the NBG intervened heavily to prevent a depreciation of the nominal exchange rate. In September alone, the central bank sold US$25 million in the exchange market, bringing the level of reserves down to an equivalent of 4 weeks of imports, while allowing a gradual depreciation of the exchange rate from lari 1.35 per U.S. dollar at end-August to lari 1.367 at end-September 1998. Intervention during October-November 1998 totaled US$29 million, with gross reserves falling to US$64 million (equivalent to three weeks of imports) and the exchange rate reaching lari 1.73 per U.S. dollar by December 4, 1998.

6.  Cumulative fiscal results through end-1998 were most worrisome for us. First, the overall government deficit (on a cash basis) reached lari 246 million (about 3.4 percent of GDP)³, compared with a program target of lari 232 million (2.9 percent of programmed GDP). Tax revenue was 22 percent below the program target, while government expenditure arrears (mainly on wages, pensions, and social transfers) reached lari 140 million (equivalent to roughly 2 percent of GDP) against a program objective of complete elimination of all arrears outstanding at end-1998. After years of considerable and steady improvement, the ratio of tax revenue to GDP increased only marginally to 8.9 percent of GDP in 1998, reflecting a major budgetary crisis which started before the advent of the Russian crisis. Moreover, the ratio of general government tax revenue to current expenditure fell to 64.5 percent, a very low level by all standards and clearly not sustainable. Another financial problem which emerged in 1998 was the need for the budget to recapitalize the NBG as a result of the financial losses stemming from the depreciation of the lari and the deterioration of the gross international reserves position in 1998.

7.  In light of widening budgetary and exchange rate crises, we implemented a number of policies in December 1998 to address both internal and external imbalances and bring the ESAF-supported program back on track. First, on December 7, 1998, the NBG stopped intervening in the foreign exchange market in order to allow the nominal exchange rate to move freely to a new equilibrium. Second, a number of Tax Code amendments⁴ entered into effect in December. In some cases, like the increased taxation of wheat and flour, the tax amendments speeded-up the timetable originally agreed in the context of the third annual ESAF arrangement. Third, on the structural front, the government concluded the privatization of Telasi. Finally, the NBG acted effectively to prevent a banking sector crisis following the decision to stop intervening in the foreign exchange rate market. Memoranda of understanding (MOUs) were signed with 8 out of 12 major domestic banks with a view to improve their liquidity position through regular liquidity assessments (updated every 10 days) reviewing the potential impact to borrowers and the vulnerability of banks to deposit withdrawals.⁵

8.  Inflation for the first five months of 1999 amounted to 9.9 percent on account of the large injection of liquidity (reserve money grew by 25 percent in December 1998 alone) stemming from significant foreign inflows, including the proceeds from the privatization of Telasi, and the rapid utilization of these funds by the government. In addition, the increase in prices reflected the pass through of the lari depreciation. Prices in the economy have now adjusted to the change in the exchange rate which occurred in the latter part of 1998. Indeed, except for the increase in cigarette prices owing to the effective implementation of excise stamps, the consumer price index in April would have increased only slightly. The implementation of tight monetary policies, combined with increased mobilization of tax revenue in more recent months in the context of a staff-monitored program (Table 2), has stabilized the exchange rate of the lari in the range of lari 2.0-2.2 per U.S. dollar. Economic activity, however, has remained depressed, reflecting the impact that the Russian crisis has had on business confidence, the trade balance, and lower remittances. Compared with the first quarter of 1998, real GDP increased by 1.2 percent in the first quarter of 1999. The decline in industrial output and stagnation in agriculture were offset by growth in construction, transport, and telecommunications. In addition, net exports have partially recovered in recent months.

9.  Georgia took a major step in its attempt to normalize relations with one of its major external creditors in late December 1998. On December 18, 1998, Georgia made a cash payment of US$21.84 million to Turkmenistan to cover one fourth of the principal due in 1998 and settle payment arrears on gas imports which took place in 1995. To demonstrate their "best efforts," the Georgian authorities executed the payment in advance of the rescheduling negotiations. Thereafter, on December 25, 1998, the authorities met with their Turkmen counterparts in Ashgabat and conducted preliminary debt-rescheduling discussions. Discussions in Ashgabat were constructive, with both parties exchanging their views on a possible debt settlement arrangement.

10.  As noted above, performance under the ESAF-supported program during 1998 was below expectations; a number of quantitative and structural performance criteria were not observed for end-October 1998 (Tables 1 and 3). The net international reserves (NIR) performance criteria on convertible and non-convertible currencies (adjusted for shortfalls in balance of payments support) were missed by about US$35.5 million reflecting the gross reserves losses incurred in September and October. The performance criteria on overall tax collections and collections from taxes on cigarettes were also not observed as a result of lags in tax administration and weak enforcement of various new taxes introduced in the context of the current ESAF-supported program (particularly taxes on imported gasoline and presumptive income of small businesses). While the computerization of all regional treasuries and the central treasury and the establishment of an arrears monitoring unit within the central treasury proceeded broadly on schedule⁶, various structural performance criteria were not observed by end-October 1998. These performance criteria were: (i) the introduction of excise stamps on all cigarettes sold in Georgia, which was rescheduled for April 1, 1999, and resulted in a significant tax revenue shortfall in 1998; (ii) the expansion of the coverage of the Tax Inspectorate of Georgia's (TIG) Large Taxpayer Unit (LTU) to include taxpayers accounting for at least 50 percent of total revenues, which was subsequently [met] at end-June 1999; (iii) the enactment of the law on urban and industrial land privatization, which was signed by the President on November 12, 1998; and (iv) the expansion of the treasury system in the Ministry of Finance to cover all central government revenue and expenditure accounts, excluding higher education, and the accounts of the special funds, excluding Pension Fund accounts outside Tbilisi. This last condition was however met in early November 1998 with the issue of the Joint Order of the Ministry of Finance and the Ministry of Social Security, Labor, and Employment (#300/173 of November 10, 1998) bringing the bank accounts of the Tbilisi Pension Fund offices under the umbrella of the treasury system. Overall, 8 out of a total of 18 quantitative and structural performance criteria were not observed as of end-October 1998.

11.  Performance against various financial and structural benchmarks included in the program was also mixed (Table 3). While the end-October 1998 quantitative benchmark for reserve money was met, the benchmark on health expenditure was not observed and domestic expenditure arrears increased by about lari 50 million instead of declining by lari 65 million, as envisaged under the program. In addition, various structural benchmarks included in the program were not observed as of end-October 1998. The benchmark on the reduction of tax arrears to 15 percent of annual tax revenue of the general government was missed. Instead, tax arrears increased by about lari 95 million between end-May 1998 and end-September 1998, reaching 35 percent of 1998 tax revenue of the general government. The programmed introduction of commitment accounting of the treasury system did not happen, although some pilot projects were initiated in tandem with the computerization of the regional treasury offices. Definite progress toward the introduction of commitment accounting will need to await projected improvements in the existing computer system used by the regional treasuries. The law on the simplification of licensing requirements was not approved. Finally, the structural benchmark on the compilation of budget statistics according to GFS methodology was missed: the draft 1999 budget submitted to parliament departed from the GFS methodology in a number of ways. Among the structural benchmarks which were successfully met as of end-October 1998, it is worth mentioning the efforts by the NBG to strengthen prudential requirements regarding commercial banks' insider lending and undertakings by the Ministry of Finance to extend the treasury management to local budgets. On the latter, district level treasury units have been established in all 61 rayons for servicing local budgetary institutions and thousands of budgetary and extrabudgetary bank accounts are being consolidated into treasury accounts in specific agency banks.

12.  As noted in paragraphs 7 and 8, starting in December 1998, and more forcefully during the first part of 1999, financial policies were reassessed with a view to correct the underlying domestic and external imbalances registered in 1998 and bring the ESAF-supported program back on track. The thrust of the program consists of a coordinated policy action in the fiscal and monetary fronts to achieve low inflation and sustained economic growth. In addition, the pace of structural reform will be accelerated to catch-up with program objectives originally targeted for 1998 and go beyond them. The economic program includes quantitative indicative targets for end-June, end-September, and end-December 1999 (Table 2).

13.  For 1999, the program's main macroeconomic objectives are: (i) an annual growth rate conservatively projected at 2 percent, with a distinct possibility that growth may be higher on account of more favorable climatic conditions which would positively impact agriculture and power generation; (ii) an inflation rate of 13 percent (end-period); and (iii) a gross official reserves target of US$213 million by year-end, equivalent to 2.5 months of estimated imports. Key to achieving the macroeconomic objectives will be a continuation of prudent monetary policy and a reduction in the general government overall fiscal deficit (on a commitment basis) from an estimated 4.3 percent of GDP in 1998 to 1.8 percent in 1999. In the view of the Georgian authorities, the reduction of the overall fiscal deficit is a necessary condition for a recovery in private sector investment and savings, as well as the stability of the exchange rate. Moreover, the projected increase in Georgia's official debt service obligations over the next ten years heightens the urgency of a successful fiscal adjustment which should give a large boost of confidence to international investors and guarantee the sustainability of Georgia's external debt position over the medium term.

14.  To gain credibility and strengthen the program's initial conditions, a number of policies have been implemented in the recent past as prior actions for Executive Board consideration of Georgia's mid-term review under the third annual ESAF arrangement. These policies include, inter alia, (i) a satisfactory track record through end-June 1999; (ii) the introduction of excise stamps on all cigarettes sold by April 1, 1999; (iii) the expansion of the coverage of the LTU to include taxpayers accounting for at least 50 percent of TIG's tax revenue by end-June 1999, in line with the recommendations of the Fund's Fiscal Affairs Department (FAD); (iv) making the VAT and excise regime for imported and domestically produced alcoholic beverages identical; (v) initiating legal actions against the 10 largest delinquent taxpayers with a view to reduce the outstanding stock of tax arrears and demonstrating the government's commitment to take action against delinquent taxpayers and to enhance compliance; (vi) adoption of a set of fiscal measures (described in paragraph 18) which would bring the budget back in line with the program's overall macroeconomic objectives in view of the shortfall in tax revenue; (vii) a law on licensing, approved by parliament in May, aimed at simplifying existing licensing requirements and reducing the number of economic activities requiring government permits to operate in Georgia; (viii) the issuance by the National Bank of Georgia of a directive to commercial banks to comply with the increase in the minimum capital requirement of lari 2 million by June 30, 1999, consistent with the phased increase of reaching the objective of lari 5 million minimum capital requirement by the end of 2000; (ix) revoking licenses and starting liquidation procedures of all banks with CAMEL 5 ratings and limiting the activities of all CAMEL 4 rated banks and placing them under temporary administration or closing them as appropriate in accordance with the Supervisory Action Framework of the NBG;⁷ and (x) measures aimed at further strengthening the taxation of cigarettes (see paragraph 19). We intend to convene an extraordinary session of parliament in the next week or so to repeal the current export tax on scrap metal in line with the understandings reached at the time of the IMF Executive Board approval of the third annual ESAF arrangement

15.  The fiscal action plan for 1999 targets a more rigorous enforcement of the Tax Code, and a forceful implementation of the government's policy commitments under the current ESAF arrangement. Numerous tax exemptions introduced in early 1998 have now been removed (see paragraph 7 above) and no new ones will be considered. In addition, the planned reduction of government expenditure arrears has been recorded in the 1999 budget as a separate line item to underline the government's commitment to cancel these obligations. Finally, the fiscal plan envisages replacing the current expenditure management system with a revised control framework which would limit central government expenditure strictly to the cash inflows available. For the cash available in any month, priority would be given to meeting wage, pensions, interest payments, and social expenditures. In line with the economic program's price and output objectives, regional governments will continue to be required to balance their budgets in 1999 (i.e., local authorities will not be accorded powers to issue domestic or external debt).

16.  As noted in paragraph 13, the program's fiscal objectives are to reduce the overall fiscal deficit (on a commitment basis) to 1.8 percent of GDP in 1999, while improving the revenue raising capacity and the buoyancy of the tax system including customs, and strengthening expenditure and budgetary control. Total revenue and grants are targeted to increase from 10.9 percent of GDP in 1998 to 11.5 percent in 1999, largely on account of the rigorous enforcement of the tax amendments enacted in December 1998 (see paragraph 7 above), the measures implemented in June 1999 (see paragraph 18), and improved tax administration, including a significant increase in the role of the LTU in collecting taxes and in taxpayers' compliance with the law. On account of the reduction in expenditure arrears, the overall fiscal deficit on a cash basis will decline from 3.4 percent of GDP in 1998 to 3.0 percent of GDP in 1999. Non-interest current government expenditure (on a commitment basis) will decline from 12.2 percent of GDP in 1998 to 9.7 percent in 1999. Domestic financing of the 1999 fiscal deficit is targeted at 0.3 percent of GDP, including a sharp reduction in NBG net domestic financing of the budget (from lari 110 million in 1998 to lari 15.5 million⁸ in 1999). Net external financing will mainly reflect disbursements under the World Bank Structural Adjustment Credits and project financing and onlending, net of amortization payments to bilateral and multilateral creditors and reduction in external arrears. Privatization receipts are assumed at lari 70 million in 1999.⁹

17.  Paramount for achieving the 1999 overall tax revenue targets will be: (i) a strict implementation of current tax legislation, including, in particular, increased tax collections on cigarettes and petroleum products, and the expansion of the LTU; (ii) eliminating the practice of ad hoc tax rebates; (iii) the government meeting all of its financial obligations on a timely basis to prevent any expenditure arrears and to break the vicious circle of overdue obligations vis-_-vis taxpayers; (iv) the hiring of a well-respected international firm to assist in the management of the customs administration, which will reduce reported corruption in this area;¹⁰ and (v) the enforcement of legislation requiring state-owned enterprises to submit dividends due to the state budget. In this regard, in 1999, Georgia International Oil Company (GIOC) will transfer its profit to the budget, including the profits from the oil transit fees. The government is aware that revenue forgone in 1998 on account of tax exemptions and weak tax enforcement was very large and could comfortably finance a major increase of the current level of social spending in Georgia, if collected. Overall tax revenue and cigarette tax collections, in addition to petroleum taxation, will be quantitative indicative targets under the program.

18.  In view of the shortfall in collection revenue in the earlier part of the year, the following fiscal measures totaling lari 88 million (1 percent of annual GDP) have been adopted in order to realize the 1999 fiscal targets: (i) a strengthening of tax collections on petroleum products to generate additional lari 26 million¹¹; (ii) a continuation of administrative improvements in collecting cigarette taxes which would generate an additional lari 18 million; (iii) hiring a pre-shipment import inspection firm to generate additional revenue of lari 15 million in the fourth quarter; (iv) increasing the VAT on all vehicle sales (new and used) from 5 percent to the standard rate of 20 percent effective August 1, 1999 (yield of lari 4 million); (v) reducing transfers to Adjara by lari 9.5 million since Adjara has failed to remit collected customs duty to Tbilisi; and (vi) reducing government expenditure commitments by lari 16 million in order to eliminate the remaining estimated budgetary gap. At the forthcoming extraordinary session of parliament, we intend to propose an airport departure tax of lari 40 for all passengers traveling abroad which would yield nearly 3 million in 1999. In order to undertake such sequestration in a transparent manner, following approval by the government of the expenditure cuts, the Finance Committee in parliament will convene to discuss the need to reduce government spending. All members of parliament and the press crops will be invited to attend this parliamentary committee session. In addition, the extrabudgetary invalids account has been eliminated and normal, transparent budgetary procedures are now followed for spending on invalids.

19.  The system for taxing cigarettes continues to be strengthened. First, brands of cigarettes have been reclassified, effective July 1, 1999, from the current four-way classification of high/low quality to an filtered/unfiltered classification, so as to facilitate WTO accession. In addition, tax rates on cigarettes will be increased by January 1, 2000. At present, the tax rates on domestically produced cigarettes are 15 tetri per pack plus VAT of 20 percent for filtered cigarettes and 5 tetri per pack plus VAT of 20 percent for unfiltered cigarettes. For imported cigarettes, a specific tax is currently imposed (in lieu of excises and VAT) at a rate of 25 tetri per pack for filtered and 19 tetri per pack for unfiltered cigarettes. In the event of a large substitution of consumption towards domestically produced cigarettes later in the year, taxes on domestically produced cigarettes will be increased within one month, so as to prevent any loss in the programmed tax revenue collection from cigarettes. By no later than January 1, 2000, a specific tax rate (in lieu of excises and VAT)¹² will be imposed on all cigarettes and the tax rates will be consolidated (whether they are domestically produced or imported) and increased to at least 40 tetri per pack for filtered and 30 tetri per pack for unfiltered cigarettes. Finally, we are considering imposing an import tariff on cigarettes, but any such tariff would not exceed the maximum rate of 12 percent.

20.  Efforts to reduce the outstanding stock of tax arrears will be reinforced in 1999. To this end, the program calls for the establishment of quick legal actions which could be taken to force delinquent enterprises to agree on a schedule to eliminate overdue tax liabilities to the budget while remaining current on taxes due or initiate bankruptcy procedures. In the government's view, taxpayers need to be convinced that penalties for non-fulfillment of their financial obligations to the state will be enforced. As noted above, legal actions against the 10 largest tax evaders have already been initiated and are progressing on schedule. Write-offs of tax arrears will occur only in the event that an enterprise is closed and its assets are insufficient to cover all tax arrears. Quantitative benchmarks for the reduction of tax arrears are set in the following table:

21.  The 1999 program will continue to reform the tax and customs administration. To this end, it will target (i) the computerization of tax declaration forms for profits, income, and excise taxes by end-July 1999; (ii) a continuation of the functional reorganization of the TIG, and closing the Tbilisi central office, bringing the 10 Tbilisi Regional Tax Inspectorates under the full direction of headquarters, and reducing the number of Tbilisi regional offices to no more than three by year-end 1999; and (iii) the issuance of tax identification numbers (TINs) for all individuals, with an objective of completion by end-1999. In developing the LTU, the Georgian authorities will ensure that the unit has adequate staffing for conducting tax collections, and well-trained auditors, and that it functions as a full-service tax office where the large taxpayers file their returns, have their tax liabilities controlled and collected, and receive the information and support to understand and discharge the tax consequences of their business undertakings. With the LTU having reached the program target of 50 percent of TIG's overall tax revenues, the Head of the TIG and the Minister of Finance will closely monitor whether the transfer of large taxpayers from the local taxpayer units to the LTU is consistent with the technical assistance recommendations from FAD.

22.  Despite the envisaged increase in tax revenue collections in 1999, the level of expenditure in the 1999 budget would have to remain tight and utmost efforts would need to be made to prioritize spending and strengthen budgetary control. Accordingly, the program will seek to: (i) reduce domestic expenditure arrears outstanding in end-December 1999 by lari 110 million including all wage, pension, and social expenditure arrears, with the remainder of arrears paid in early 2000; the 1999 program does not envisage the accumulation of new arrears; (ii) reduce the number of budgetary positions in line with the recommendations from the ongoing civil service reform project financed by the World Bank; and (iii) target the general government's wage bill at lari 188 million in 1999. An increase in wages and pension will only be considered once all of the aforementioned arrears have been eliminated and tax revenues turn out to be larger than programmed. We would note that domestic interest expenditures in the fiscal accounts incorporate lari 10.5 million for interest payments related to the recapitalization of the NBG. Also, the figures for 1999 include lari 24.3 million in targeted expenditure as agreed with the World Bank staff in the context of the Energy Sector Adjustment Credit (ESAC). In addition, the government will set aside resources to begin clearing its arrears to international organizations for missed payments of membership dues and begin reviewing Georgia's current membership in the various international institutions with a view to reduce participation to just the most important, given the limited budgetary position. The government will also take firm steps to ensure that Sakenergo and other state-owned enterprises which have received government guarantees for external obligations in the past will meet their debt service obligations on a timely basis.¹⁴

23.  As noted above, the fiscal plan aims at replacing the present system of central government expenditure control with a revised framework which would limit spending (cash outflows) strictly to cash inflows available. Accordingly, during the program period, the Ministry of Finance will set monthly cash limits for each line ministry/spending units in terms of a prioritized list of expenditure items. In order for such a system to operate effectively, a Presidential Decree was issued and parliamentary legislation was passed which discontinues the practice of tax offsets effective July 20, 1999. We view this as a fundamental component of our expenditure control program. At the same time, the Ministry will continue to work on the development of a treasury system as the basis for better public expenditure management over the medium term. In developing the new expenditure control framework, the government will be guided by the recommendations from the Fund's Fiscal Affairs Department.¹⁵ In this regard, the entire amount of pensions, social allowances, and other government payments to individuals will be paid directly to such individuals, without any portion being transferred directly to the energy or other companies.

24.  The government's social policies will continue to protect the poor through an improved targeting of the social safety net. To this end, expenditures on health and education total 20.3 percent total budgetary appropriations in 1999, in line with understandings reached with the World Bank. In addition, the elimination of all expenditure arrears and putting into place expenditure control mechanisms to prevent new arrears and ensure timely payment of all government obligations will greatly benefit the poorer segments of society.

25.  The government will seek to collect the credit that was extended to certain enterprises through on lending of a loan from the Turkish Eximbank. The Georgian government has drawn-up a complete list of delinquent debtors, and will seek full settlement of all outstanding balances. Moreover, the government will collect at least lari 10 million in repayment of outstanding state credits. Neither the government, nor the NBG, will provide any guarantees on domestic debt during the program period.

26.  Monetary and exchange rate policies in 1999 will be geared toward achieving low inflation and securing the stability of the exchange rate. The NBG will also step up its efforts to increase the efficiency of its indirect monetary instruments and accelerate banking sector reform.

27.  The program projects a reduction in NBG net financing of the general government deficit from lari 110 million in 1998 to about lari 15.5 million¹⁶ in 1999. This reduction in net domestic financing takes into account the expected disbursements from the World Bank's ESAC and SAC, as well as privatization receipts.¹⁷ Velocity at end-1999 is programmed to increase by 2 percent relative to its end-1998 level reflecting the large increase in money at end-1998. The money multiplier is projected to increase slightly during 1999 with respect to 1998 on account of enhanced financial intermediation in the second half of the year. Consistent with these targets, quarterly indicative benchmarks through end-December 1999 for changes in net domestic assets of the NBG, the banking system's net claims on the general government, total domestic borrowing requirements of the general government, as well as the floor on net international reserves have been specified (Table 2). To instill greater payments discipline, the 1999 program will retain the automatic adjustor on net credit to government for any shortfalls in interest payments due by the government to the NBG.

28.  As regards the conduct of monetary policy and the development of indirect monetary instruments, the program objectives are fivefold. First, bring the interbank credit auction and market for bank credit back into operation (undertaken as of January 1999) with a view to reviving financial intermediation. To this end, the MOUs signed with major domestic banks in December 1998 (paragraph 7 above) will need to be reviewed on a regular basis to assess for which of these banks the limits on new lending, deposit taking, and normal off-balance sheet activity could be relaxed. Second, amend the securities law in order to align the legislation on the secondary market for treasury bills with the recommendations of the Fund's Monetary and Exchange Affairs Department (MAE); i.e. making the TICEX the venue for this market. Third, limit bank-to-bank liquidity lending. To the extent that liquidity support is needed on a system-wide basis, the NBG will provide needed financing through intervention in the interbank credit market, rather than through bank-by-bank liquidity loans, which should be reserved for unusual pressures arising on a particular bank which is solvent. Fourth, revisit various issues regarding reserve requirement regulations in line with the recommendations of MAE. In particular, following further technical assistance from MAE, we will introduce reserve averaging by the end of the year. All commercial banks, including Agrobank, met the minimum legal reserve requirements and transferred these resources to the NBG by May 1, 1999. Starting in April 1999, the remuneration of required reserves applies to both local currency and foreign currency deposits, with the interest rate being set at the projected annual inflation for the year. The NBG, in consultation with MAE, will review the possibility for a switch to maintaining required reserves on foreign currencies deposits in foreign exchange. Fifth, increase commercial banks' minimum capital requirements to lari 2 million by June 30, 1999, in line with the already established timetable to increase these requirements up to lari 5 million by December 31, 2000. Finally, in 1999, the NBG has agreed to reschedule 1994 government debt to the central bank (totaling some lari 18.4 million) falling due in June 1999.¹⁸

29.  In view of the low level on international reserves and uncertainties about the equilibrium exchange rate, the 1999 program will have a floating exchange regime. The NBG will not intervene to defend the exchange rate but may purchase foreign exchange in order to replenish its reserves. The ultimate objective would be to achieve by 2004 a three months import reserves coverage for the NBG in preparation for the event that a change in the exchange regime is decided sometime in the future. Should net international reserves increase considerably over the levels envisaged under the program, the NBG could allow the lari to appreciate in consultation with Fund staff. In letting the exchange rate appreciate, however, the NBG would be mindful so as not to appreciate the rate significantly too quickly, as this could lead to excessive swings in the nominal exchange rate given Georgia's rather thin foreign exchange market. In addition, the NBG will analyze performance in the tradeable goods sector and the overall growth prospects in assessing the appropriateness of the exchange rate. The official exchange rate will continue to be set daily in line with the exchange rate determined in the TICEX so as to retain a margin of less than one percent from the market rate.

30.  The program will also target a further strengthening of the banking system and a deepening of financial reform. Tasks in this area are in two broad categories: bank supervision and bank licensing requirements. As regards bank supervision, the NBG has (i) required banks' annual external audits by international auditors as mandated by the banking law as of February 1, 1999; (ii) amended banks' reporting forms to allow disclosure of foreign exchange and lari past due credits; (iii) implemented the Supervisory Action Framework for monitoring of banks in financial distress starting end-January 1999. In addition, the NBG will: (i) issue necessary regulations tightening loan loss provisions by end-June 1999; (ii) for those banks that fail to meet the minimum capital requirement and are challenging the NBG's directive through the courts, the NBG will require tighter loan classification and provisioning requirements by end-June 1999; (iii) review rules for permissible foreign exchange open positions to align them with international practices while requiring that off-balance sheet items be included in the calculation of the net position, no later than end-June 1999. On licensing, the NBG will develop a plan for encouraging effective mergers of the smaller banks. Also, no later than end-May 1999, it will review current liquidation procedures for commercial banks with a view to speed-up the process and protect depositors in line with MAE recommendations. The NBG, however, would avoid issuing a blanket guarantee of bank deposits and, instead, ensure that equity investors bear the appropriate risk and costs in the event of financial mismanagement of banks. Moreover, to monitor the soundness of the banking system, the NBG will continue to carry on regular on- and off-site examinations of all certified banks in 1999, remove the license of banks which persistently fail to comply with prudential regulations, and expedite the liquidation process of banks whose licenses have been withdrawn. The development, dissemination, and implementation of International Accounting Standards (IAS) for domestic commercial banks will remain an important objective for the NBG in 1999. In this regard, the monetary authorities have established December 31, 2000 as the target date for full conversion of all banks to IAS. The NBG's licensing and banking supervision departments were merged in March 1999.

31.  We will seek further repayment of all outstanding guarantees (including penalty fees) issued by the NBG to date and the NBG will not provide any guarantees for imports.

32.  The program's objectives regarding Georgia's exchange and trade systems are fourfold. First, the NBG will refrain from trying to control and/or limit financial transactions in U.S. dollars by foreign exchange bureaus, except for standard prudential regulations. Second, the NBG will ensure that payments and transfers to the banking system for all current international transactions remain free and will avoid taking any action which might be viewed as an exchange restriction under Article VIII. The monetary authorities are aware that a deviation of more than 2 percent between the official and market exchange rates resulting from official action could be considered a multiple currency practice and it would be in violation of Article VIII of the Fund's Articles of Agreement. Finally, a certificate is required for exporting logs, but only for record keeping purposes. Since no restrictions are involved, the procedures for the exporting of logs is consistent with our application to accede to the WTO. In order to protect the forest, all commercial cutting of trees is forbidden throughout Georgia. Thus only trees with sanitary cuts can be processed domestically and eventually exported. In order to protect the environment, the same policy to prevent deforestation will be used for all entrepreneurs, regardless of the ultimate destination of the logs; in other words, trade policy will not be used.

33.  In view of Georgia's large external debt burden and its limited capacity to service its debt, the government will refrain from contracting or guaranteeing new external debt with a maturity of five years or less and will strictly limit the contracting or guaranteeing of long-term debt on non-concessional terms over the program period. The government will continue to ensure that the Debt Department of the Ministry of Finance obtains all relevant data on public and publicly-guaranteed external obligations from all branches of the government and the NBG. The Ministry of Finance will continue to be responsible for approval of any new external borrowing contracted or guaranteed by the government, and will, inter alia, ensure that such borrowing complies with the program's ceiling. In-kind debt service payments will be avoided during the duration of the program. The Ministry of Finance will ensure that such borrowing complies with the program's ceilings with respect to the accumulation of external arrears on official debt as specified in Table 2.

34.  For 1999, Georgia will continue to pay US$8 million each quarter into the special account at the Netherlands Bank to cover interest payments to bilateral creditors. Georgia will continue to seek a rescheduling of its debt to Turkmenistan, consistent with its payments capacity, and will remain current on interest payments. On the basis of satisfactory progress in the negotiations for rescheduling, Georgia stands ready to make a cash payment of a similar magnitude of the one made in 1998 (see paragraph 9 above) to demonstrate its continuing "good faith" in conducting negotiations. Starting this autumn, in consultation with the IMF, we will begin exploring the possibility of a second round of debt-rescheduling operations with all other bilateral creditors as the grace periods expire in 2000 and our payments capacity has regrettably not strengthened sufficiently to permit full payment of maturities falling due. We will however commence making principal payments in order to gradually diminish our debt burden and demonstrate to our creditors our willingness to service our debt.

35.  Progress with structural reform will be a key element of the 1999 program. The government's agenda in this area includes a number of measures to deepen land and enterprise privatization, and accelerate energy, judicial, and civil service reform.

36.  Regarding urban and industrial land privatization, the State Land Management Department will take the necessary measures to accelerate in Tbilisi and other regions in the country: (i) the registration of land plots; and (ii) the issue of land ownership certificates in favor of those enterprises which have made the required payments to buy the land. According to the law on non-agricultural land privatization, enacted on November 23, 1998, all existing privatized enterprises should either buy or lease (up to 99 years) their land plots within 1-2 years. We expect that the revenue generated for the sale of these land plots will yield lari 10-15 million in 1999.

37.  State enterprise privatization will proceed on a two-prong path in 1999. On the one hand, privatization of large-scale enterprises will be accelerated, with work toward the privatization of Georgia's Telecom, the ports, and key state enterprises in the electricity generation sector being at the core of this program. On the other hand, the government will aim at completing the privatization of all medium-size state enterprises, in coordination with the World Bank.

38.  The 1999 structural reform program aims at making further progress regarding the reform of Georgia's civil service. During 1998, a census of general government sector employees was conducted by the State Chancellery and a medium-term program targeting a sizeable reduction in the size of the government was drafted in coordination with the World Bank. Initially, this will result in a net reduction of some 70,000 employees from the public sector payroll in 1999. For 1999, the State Chancellery will also review the activities of four ministries (Education, Health, Telecommunications and Post, and Transport) with a view to streamline the organization, functions, and manpower needs of these government institutions.

39.  In the sphere of energy sector restructuring, the successful privatization of Telasi will be followed by other sales of electricity generation and distribution companies in 1999/2000. Although the privatization of state gas distribution companies was temporarily suspended, the privatization process will resume in 1999 once the necessary regulatory framework for privatizing enterprises in this sector is finalized by the government. Electricity tariffs will also be adjusted during 1999 in line with understandings with the World Bank under the energy sector structural adjustment credit.

40.  In 1999, significant judicial reform will be targeted in order to provide greater fairness in procedures and court decisions. To date, qualification exams for judges have been offered four times and the Law on Common Courts has been amended to allow the removal of judges who failed or did not take these exams in 1998. Technical assistance and training for judges has been and will continue to be provided under the World Bank SATAC program in 1999. In addition, a Judicial Training Center offering seminars open to mass media was established in 1998 and will continue to operate in 1999 to improve the dissemination of legal information to the judicial system and the public in general. The planned review and compilation of the many laws and regulations adopted since Georgia regained independence in 1992 was conducted in 1998.

41.  In line with the understanding reached with the Fund under the third annual ESAF arrangement, we have taken several important steps toward improving the compilation of national accounts statistics. In particular, besides the implementation of some organizational changes recommended by the Fund, the State Department of Statistics (SDS) has improved its data sources and estimation methods regarding for assessing the informal sector. Preliminary estimates of nominal GDP figures show that historical data might have been overstated, and downwards revisions of nominal GDP figures in the order of 25 percent are necessary to accurately reflect size of the overall Georgian economy. During 1999, the government will continue to work with the Fund and other IFIs to compile better historical and current estimates of the value of final goods and services produced in the economy.

42.  The government remains committed to improve the quality of government finance (GFS) and balance of payments statistics in 1999. Much progress was already achieved in 1998 toward the establishment of report forms used by various levels of government, including the general government, according to the GFS classification methodology.

43.  Regarding balance of payments statistics (BOP), the SDS objectives for 1999 are to continue to cooperate with the Customs Department regarding the compilation of trade data, and to continue to upgrade the coverage of the business register. The target for end-1999 will be the timely publication of official BOP statistics. Also, the SDS will remain in charge of compiling the quarterly survey of foreign direct investment, which has become a leading indicator for the government of the confidence that the international community places on the government's reform efforts. The NBG will continue to monitor external borrowing by domestic financial intermediaries and regularly update the Fund staff on developments in this area throughout the duration of the program.

44.  We are committed to improving our fulfillment of reporting requirements specified under the third annual ESAF arrangement. In particular, we will provide the Fund staff with monthly reports of: (i) monthly tax collections by the LTU and summary data showing the efforts towards achieving the expansion of the coverage of the LTU to include taxpayers accounting for at least 44 percent of TIG's tax revenue by end-April 1999 and 50 percent by end-June 1999, in line with the recommendations from FAD; (ii) monthly general government revenues, including a breakdown for taxes on cigarettes and petroleum products; (iii) monthly computerized reports of expenditures pre-approved by the Ministry of Finance according to GFS and functional classification; and (iv) monthly data on the evolution of government expenditure arrears and tax arrears.

45.  Progress with the implementation of the program will be monitored on the basis of targets detailed in the attached Table 2.

This memorandum provides a guide to calculating the adjustors for program targets in the event that net disbursements of balance of payments support and U.S. dollar-denominated privatisation receipts differ from those assumed under the program for the period May to December 1999.

Scope of adjustors

Adjustors apply to the following program targets:

• ceiling on net credit of the banking system to the general government
• ceiling on net domestic assets (NDA) of the National Bank of Georgia (NBG).
• ceiling on total domestic borrowing of the general government
• floor on total net international reserves (NIR) of the NBG
• floor on NIR in convertible currencies of the NBG.

Net disbursement of balance of payments lending and dollar-denominated privatisation receipts

Under the program, the net disbursements of balance of payments lending and dollar-denominated privatisation receipts are shown in Table 2 of the Supplementary Statement of Economic and Financial Policies.

Under the program, it is assumed that a payment of US$25 million to Turkmenistan would take place in September 1999, in order to demonstrate "good faith" in conducting rescheduling negotiations.

Calculation of adjustors

In the event that cumulative net disbursements of balance of payments support and dollar denominated privatisation receipts differ from those assumed under the program, the following adjustments to program targets are made:

• ceilings on net credit of the banking system to the general government, on NDA of the NBG and on total domestic borrowing of the general government

In the event of a shortfall in cumulative net disbursements of balance of payments of support¹ relative to assumptions under the program, the program ceilings will be increased in an amount equivalent to 10 percent of the shortfall. In the event of an excess in cumulative net disbursements of balance of payments of support² relative to assumptions under the program, the program ceilings will be decreased by the full amount of the of the excess.

In the event of a shortfall in dollar denominated cumulative privatisation receipts relative to assumptions under the program there will be no adjustment of the program ceilings.

In the event of an excess of dollar denominated cumulative privatisation receipts relative to assumptions under the program ceilings will be decreased in an amount equivalent to 50 percent of the cumulative excess.

• floors on total NIR of the NBG and on NIR in convertible currencies of the NBG.

The NBG is pursuing a policy of non-intervention in the foreign exchange market. Therefore any shortfall (excess) in cumulative net disbursements of balance of payments support and dollar denominated privatisation receipts is reflected in an equal decrease (increase) of the cumulative floor targeted under the program.

Examples

1. In the event of a shortfall of US$10 million in balance of payments of support relative to program assumptions the following adjustors would apply:

• The ceilings on net credit of the banking system to the general government, on NDA of the NBG and on total domestic borrowing of the general government would increase by US$1 million, i.e. 10 percent of the shortfall.

• The floors on total NIR of the NBG and on NIR in convertible currencies of the NBG would decrease by US$10 million.

2. In the event of an excess of US$10 million of dollar denominated privatisation receipts relative to program assumptions the following adjustors would apply:

• The ceilings on net credit of the banking system to the general government, on NDA of the NBG and on total domestic borrowing of the general government would decrease by US$5 million, i.e. 50 percent of the excess.

• The floors on total NIR of the NBG and on NIR in convertible currencies of the NBG would increase by US$10 million.