CHARTING GEORGIA’S FUTURE Competitive, Connected, Capable © 2022 International Bank for Reconstruction and Development / The World Bank 1818 H Street NW, Washington, DC 20433 Telephone: 202-473-1000; Internet: www.worldbank.org Some rights reserved 1 2 3 4 23 22 21 20 This work is a product of the staff of The World Bank with external contributions. The findings, interpretations, and conclusions expressed in this work do not necessarily reflect the views of The World Bank, its Board of Executive directors, or the governments they represent. The World Bank does not guarantee the accuracy of the data included in this work. The boundaries, colors, denominations, and other information shown on any map in this work do not imply any judgment on the part of The World Bank concerning the legal status of any territory or the endorsement or acceptance of such boundaries. 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Design: Florencia Micheltorena. Table of contents Executive Summary: Charting Georgia’s future 4 Navigating global trends to ensure another successful decade 6 Looking back at the last decade in Georgia 7 An agenda for a competitive, connected, and capable Georgia 13 Priorities for a Competitive, Connected and Capable Georgia 20 Bibliography 22 Overview: Charting Georgia’s future 24 Key messages 25 Navigating global trends to ensure another successful decade 32 Synopsis 38 Chapter 1: Understanding Georgia’s growth 39 Chapter 2: Spatial transformation 48 Georgia’s spatial transformation is proceeding in parallel to its structural transformation 49 Chapter 3: Firm Performance 56 Chapter 4: Connecting Georgia 61 Chapter 5: Labor Market and Skills 67 Bibliography 74 2 CHARTING GEORGIA’S FUTURE Abbreviations and acronyms AA Association Agreement MoESCS Ministry of Education, Science, Culture and AEO Authorized Economic Operator Sports ALMP Active labor Market Policies MoLHSA Ministry of Labor, Health and Social Affairs ARDA Agriculture and Rural Development MRO Maintenance, Repair and Overhaul Agency NBG National Bank of Georgia CAC Central Asia and Caucasus NDC Nationally Determined Contributions CAGR Compound Annual Growth Rate NEET Not in Education, Employment, Or Training CAP Common Agriculture Policy NJC Net job creation CBAM Carbon Border Adjustment Mechanism NTFC National Trade Facilitation Committee CEM Country Economic Memorandum NTL Night-Time Lights CIS Commonwealth of Independent States NTM Non-Tariff Measures CRS Credit Reporting System OECD Organization for Economic Cooperation CSA Climate Smart Agriculture and Development CTC Caucasus Transport Corridor PEFA Public Expenditure and Financial DCFTA Deep and Comprehensive Free Accountability Trade Area PISA Programme for International Student EaEU Eurasian Economic Union Assessment ECA Europe and Central Asia RCA Revealed Comparative Advantage EMDE Emerging Market and Developing RDI Research and Development Institution Economy RIA Regulatory Impact Assessment EU European Union RS Revenue Services EV Electric Vehicle RTA Regional Trade Agreement EXPY Income Content Of Exports R&D Research and development HHI Herfindahl-Hirschman Index SARAS Service for Accounting, Reporting and FDI Foreign Direct Investment Auditing Supervision FTA Free Trade Agreement SESA State Employment Support Agency GDP Gross Domestic Product SME Small and Medium-Size Enterprises GITA Georgia Innovation and Technology SOE State-Owned Enterprise Agency SPS Sanitary and Phyto-Sanitary GNCA Georgian National Competition Agency STR Student Teach Ratio GVC Global Value Chain STRI Services Trade Restrictiveness Index HCI Human Capital Index TBT Technical Barriers to Trade ICT Information and Communication TEAW Tertiary Educated Agriculture Worker Technologies TFP Total Factor Productivity IEMP Index of Export Market Penetration TIMSS Trends in International Mathematics IMF International Monetary Fund and Science Study ISP Internet Service Provider TSA Targeted Social Assistance JCR Job Creation Rate UMIC Upper Middle-Income Country JDR Job Destruction Rate UN United Nations LFP Labor Force Participation VAT Value added tax LFS Labor Force Survey VET Vocational Education and Training MNC Multinational company WBES World Bank Enterprise Survey MoEPA Ministry of Environment Protection and WDI World Development Indicators Agriculture WGI Worldwide Governance Indicators COMPETITIVE, CONNECTED, CAPABLE 3 Acknowledgements This CEM was prepared by a team led by Evgenij Najdov, Mariam Dolidze and Arvind Nair under the skillful guidance of Sandeep Mahajan, Practice Manager for Macroeconomics, Trade and Investment, and Sebastian Molineus, Country Director for Georgia. Chapter 1 was prepared by Evgenij Najdov, with contributions from Arvind Nair, Mariam Dolidze, Patrick Alexander Kirby, Siddhartha Raja, Kathrin Plangemann, Constantin Rusu, Leonardo Iacovone, Matias Belacin, Aira Htenas, Jan Nijhoff, Joern Huenteler, Rhedon Begolli and Filip Jolevski. Chapter 2 was authored by Tom Farole, Ellen Hamilton, Nino Lazariia, and Giuseppe Rossitti with inputs from Liang Cai, Tengiz Gogotishvili, Aira Htenas, Audrey Sachs, Taras Seryy and Evgenij Najdov. Chapter 3 was produced by Leonardo Iacovone and Matias Belacin, based on background papers “Aggregate Productivity, Misallocation and Firm-Level Sources of Growth: An Analysis of Georgian Private Sector from a Micro Perspective” and “Markups, Profits and Competition: Firm-Level Evidence from Georgian Sectors” by Umut Kilinc and with additional inputs from Ifeyinwa Onugha, Karina Baba, Haocong Ren, Natalia Tsivadze, Graciela Murciego, Cesar Borja Galan Santos, Alan Fuchs, Natsuko Nozaki, Maria Fernanda Gonzales Icaza, Shu Yu, Srdjan Svircev, and Filip Jolevski. Chapter 4. was prepared by Michele Ruta, Luis Blancas, Victor Aragones, Violane Konar-Leacy, Ankur Huria, Jim Williams, Amali Rajapaksa and Evgenij Najdov. Chapter 5. was prepared by Maddalena Honorati and Isil Oral Savonitto, with inputs from Karina Margarita Acevedo Gonzalez, Jose Martin Moreno Vigo, Katia Marina Herrera Sosa, Alan Fuchs, Natsuko Nozaki, Maria Fernanda Gonzales Icaza, Filip Jolevski and Evgenij Najdov. Executive Summary EXECUTIVE SUMMARY 5 G eorgia oversaw a successful economic exports. European integration is the cornerstone of this expansion in the last decade, ambitious outlook. Building on the 2014 Association notwithstanding COVID. Underpinned Agreement (AA) with the EU, Georgia has been by a sound macroeconomic framework, approximating its institutions and policies with those of an attractive business environment and improving the EU and in March 2022 submitted a formal application governance, real GDP per capita grew by 5.2 percent for EU membership. on average during 2010-2019. This made Georgia one of the fastest growing economies in the Europe and Despite the country’s strong foundations for Central Asia (ECA) region. Georgia moved to upper- growth, continued success in the next decade is not middle income country (UMIC) status and the poverty guaranteed. Under a business-as-usual scenario, rate (measured at the national poverty line) declined to potential GDP per capita growth could slow from 4-5 19.5 percent from 37.3 percent at the start of the decade. percent currently to 3.5 percent in 2030 and to 1.9 The COVID-19 pandemic disrupted these trends, but it percent by 2050. Some constraints are already binding: also demonstrated the growing maturity of Georgia’s investments may need to moderate to stabilize debt economic institutions. While GDP contracted by 6.8 accumulation, skills are an acute problem for firm percent in 2020, the government’s large and timely growth and the population is aging. Other constraints pandemic response kept the increase in the poverty rate will become increasingly more binding. The economy’s to only 1.8 percentage points (pp) and facilitated one of ongoing structural transformation from agriculture to the fastest recoveries in the region in 2021, with output services (and to a lesser degree industry) is delivering expanding by 10.4 percent. Still, the pandemic’s impact gains, but its potency will gradually diminish. Moreover, on employment, income and human capital is likely to Georgian firms have not improved their efficiency, which persist for some time. has meant that, despite strong GDP growth, creation of good jobs was underwhelming keeping many Georgians Georgia’s future aspirations are equally ambitious, unemployed. Among those who are employed, many anchored in the objective for closer integration with are engaged in unproductive agriculture. The Georgians the European Union (EU). The government’s 10-year that transitioned out of agriculture are doing only slightly economic plan envisages GDP growth rates of around better, as a large number are either self-employed or 5 percent per annum until 2030 and halving of the engaged in low-wage jobs. Finally, Georgia faces an poverty rate to below 11 percent. Georgia intends to uncertain global environment that is rapidly changing. further open markets and invest in connectivity to boost The February 2022 invasion of Ukraine by Russia is the 6 CHARTING GEORGIA’S FUTURE third large shock to affect the Georgian economy in less growth and aging populations across advanced than four years, following the unilateral ban on flights economies and China, lower global investment, and from Russia in 2019 and the COVID-19 pandemic during slowing TFP growth lowered global potential growth2 2020 and 2021. to 2.2 percent by 2019, below its 3.3 percent average in the first decade of the 2000s. Under pre-pandemic This Country Economic Memorandum (CEM) trends, global potential growth was already expected aims to inform the policies that could offset these to slow by 0.4 pp over the next decade (World Bank, headwinds. To sustain productivity growth, Georgia 2021). The pandemic deepened the slowdown by an needs to facilitate its structural transformation and the additional 0.3 pp and the war in Ukraine will exacerbate corresponding spatial adjustment (Chapters 1 and 2). this slowdown. This will translate into lower external Furthermore, growth will increasingly need to come demand, remittances, and capital inflows for countries from improvements in total factor productivity (TFP) like Georgia. Slowing global potential growth coincided in Georgia’s firms (Chapter 3) and advancement in with the largest, fastest, and most broad-based increase their ability to exploit opportunities in external markets in global debt in five decades. With about one-half (Chapter 4). Finally, more active and better-skilled of more than 500 episodes of rapid sovereign and/ labor (Chapter 5) can help offset existing demographic or corporate debt accumulation in emerging markets trends and augment productivity. Progress in these and developing economies (EMDEs) since 1970 being areas, supported by higher savings, will make Georgia’s associated with financial crises (Kose, Nagle, Ohnsorge, economy more competitive, connected, and capable, & Sugawara, 2021), the recent build up in debt is a help sustain robust GDP growth over the long-term and concern. At the same time, slowing global value chain turn Georgia’s aspirations into reality. (GVCs) expansion is limiting the integration opportunities. This is also due to new technologies, which, combined with changing globalization patterns, have brought Navigating global trends to ensure the feasibility of manufacturing-led development into another successful decade question for developing countries (Hallward-Driemeier & Nayyar, 2018). On the other hand, technologies also From the COVID pandemic to the war in Ukraine, the open opportunities for firms to expand their customer world and Georgia are experiencing more uncertainty base and to scale up operations. The pandemic clearly and accelerating disruption. The Russian invasion of demonstrated this, as technology helped many firms and Ukraine is taking place close to the Georgian borders households mitigate its economic disruptions. Finally, and is affecting investor sentiments. This means that climate change could push between 68 and 132 million Georgia’s policy makers face the challenge of driving people worldwide into poverty within the decade (World a post-COVID recovery amid disruptions from the war Bank, 2020f). Global efforts in climate change mitigation in Ukraine, while also grappling with the global trends and adaptation will reduce demand for fossil fuels and of falling potential growth, rising debt, strains in global increase demand for the metals and minerals required value chains (GVCs), disruptive technologies, and for renewable energy generation. The war in Ukraine climate change.1 These trends had been taking shape for has also underscored the need to accelerate the energy a while, but the combination of the pandemic and the transition and enhance energy security. war has caused them to accelerate, while also increasing uncertainty. A more capable, competitive and connected Georgia will be better placed to navigate these trends. Higher As a small open economy looking to integrate with savings can mitigate risks from lower global growth, but the global economy, Georgia must carefully navigate so can diversification. The CEM highlights potential for these trends by being prepared for the risks and on the Georgia to increase exports, including in regions where lookout for emerging opportunities. Falling population growth is expected to remain robust. The expected 1  This is not an exhaustive list of all challenges, but some that have the potential to be disruptive and re-shape the next decade. 2  Potential output is the level of output an economy can sustain at full capacity utilization and full employment. It is a function of labor, the capital stock, and total factor productivity, which is itself determined by technology and factor allocation efficiency. EXECUTIVE SUMMARY 7 reshaping of GVCs, as companies attempt to increase a slump in the early years, recovered as structural the reliability of supply chains, is an opportunity for transformation picked up pace. Still, savings remained Georgia to better integrate in GVCs, while greater lower than investments, firm-level productivity did not tradability of services offers opportunities for countries improve, skills became an even more acute problem for like Georgia to increase and diversify exports. And businesses, and trade integration was underwhelming. while Georgia’s unfavorable demographic trends will Consequently, the economy continued to perform less drag down its own potential growth, building up skills well in the creation of well-paying jobs. and activating the labor force can offset some of their impact. An agenda that will target digital skills, address The pandemic dealt a blow to the economy, but a gaps in access and quality of internet and facilitate robust response limited the scarring and assisted the technology adoption can ensure that most Georgians recovery. A large and timely policy response limited the benefit from digital transformation. Georgia’s debt pandemic’s impact on living conditions and facilitated levels are sustainable under most plausible scenarios; one of the strongest recoveries in ECA in 2021, with still, rebuilding buffers, developing domestic capital output expanding by 10.4 percent. However, the markets and de-dollarization can lower risks from a unemployment rate remains above pre-COVID levels, shift in market sentiments in response to surging global while a pick-up in inflation has eroded income gains. debt. Making agriculture climate-smart, increasing energy efficiency, improving connectivity, and adopting A persistent investment - savings gap resulted in a modern mining sector policy framework can help higher external debt. Investment levels, at 27 percent Georgia adapt to climate change, meet its Nationally of GDP on average during 2015-2019, exceeded most Determined Contributions (NDCs) and benefit from the peers (Figure 1). Investment activity took a hit during energy transition. COVID and has not yet recovered, with the investment rate falling to 22 percent of GDP in 2021. And while savings increased from around 10 percent of GDP in Looking back at the last decade in 2010 to 20 percent of GDP just prior to COVID-19, they Georgia have plummeted since to around 12 percent of GDP (Figure 2). A relatively disciplined fiscal policy kept public When the World Bank produced the previous Georgia sector savings positive prior to the pandemic, though growth reports in 2013 and 2014, Georgia was adding state-owned enterprises (SOEs) will lower the reforming and growing rapidly, but had limited success savings. The household sector was the main driver of in creating jobs and faced growing imbalances. GDP the improvement in savings (prior to the pandemic); growth had averaged above 6 percent in the decade however, Georgian households save less than following the 2003 Rose Revolution, as the private households in aspirational peers.3 A corporate sector sector responded to the far-reaching reforms. However, that posted relatively low profits and registered losses in progress in unemployment and poverty reduction was five years between 2010-2020 didn’t contribute much more modest, strong domestic demand pushed down to savings. The mirror image of the investment - savings national savings, and firm-level productivity was largely gap is a current account deficit that averaged around stagnant. 10 percent of GDP over the last decade, though with a marked improvement prior to the pandemic. This, Since 2014, and until the COVID-19 pandemic, combined with a volatile exchange rate of the lari, kept Georgia’s economy continued to perform strongly, the gross external debt of Georgia above 100 percent of addressing many constraints, even as some persisted GDP since 2015. and new ones emerged. GDP growth remained robust, investment moderated but remained relatively Debt levels are sustainable under most plausible high, savings improved, and TFP, after going through scenarios; however, balance sheets are stretched and 3  According to Geostat, households’ savings (income less consumption expenses) reached 10 percent of income only in more recent years and averaged less than 5 percent between 2010-2020. Eurostat / OECD data put these averages at 8 percent in Czech Republic and Hungary, 10 percent in Chile, and 6 percent in Russia. 8 CHARTING GEORGIA’S FUTURE Figure 1. Gross capital formation Figure 2. Gross national savings In percent of GDP 40 40 30 30 20 20 10 10 0 0 2010 2011 2012 2013 2014 2015 2016 2017 2018 2019 2020 2010 2011 2012 2013 2014 2015 2016 2017 2018 2019 2020 GEO ECA UMIC GEO ECA UMIC Source: World Development Indicators. exposed to risk due to large foreign currency exposure. is more reliant on services for value-added, but less for Georgia’s public debt, at around 50 percent of GDP, employment. Manufacturing is where the structural is below the EMDE average but contingent liabilities transformation is least visible; its contribution to GDP are sizeable. The leverage ratio (liabilities / equity remains around 10 percent, and below what would be and reserves) of the corporate sector increased from expected given the income level. While the move away around one in 2013 to 1.4 by 20204, and corporate debt from agriculture contributed almost half of the growth exceeded 50 percent of GDP in 2020. By the end of 2020, in GDP per capita over the last decade (Figure 3), the bank loans were 60 percent of households’ disposable large share of labor still engaged in agriculture (around income, up from 31 percent in 2013.5 A large share of a fifth of employment) and the significant difference debt is denominated in foreign currency (50 percent of in the output per worker in agriculture and the rest of all loans from banks, 80 percent of government debt), the economy (Figure 4) suggests that the potential of increasing vulnerability to lari depreciation. structural transformation is not exhausted. The economy is benefiting from structural Georgia’s spatial transformation is transformation, but the process remains proceeding in parallel incomplete The spatial corollary of the structural transformation Georgia is structurally transforming and becoming has meant greater concentration in the largest cities more productive, and the process is still ongoing. and substantial regional disparities in output per The share of agriculture in GDP has declined to around capita. Following a period of de-urbanization in the 7-8 percent of GDP in recent years, similar to peers. 1990s due to civil strife and the difficult economic Employment in agriculture peaked later than in peers but transition, Georgia started to re-urbanize in the 2000s has been falling relatively fast recently. Still, at around 19 and has since been one of the faster urbanizing percent (based on the new methodology; close to 40 countries in ECA during this period. Still, most secondary percent under the old6), it remains above peers. Services cities have smaller populations compared to the start are the largest sector; compared to other UMICs, Georgia of the century, and a large share of the population still 4  Geostat, Financial Soundness Indicators on Non-Financial Corporations. 5  NBG, Financial Soundness Indicators for client sectors. Still, debt service deteriorated only slightly. 6  In 2020, GEOSTAT introduced changes to the labor market indicators which consider individuals working in households as employed only if more than half of their produce was sold in the market. This affects many Georgians engaged in subsistence agriculture and who were previously considered self-employed. For more details, see Box 1 in Chapter 1. EXECUTIVE SUMMARY 9 Figure 3. Labor productivity decomposition Figure 4. Di erences in value added per worker 6 40.000 % Yearly Contribution to Inter-sectoral, Services 5 Inter-sectoral, Industry lari per person 4 30.000 3 Growth Inter-sectoral, Agriculture 2 20.000 1 Within, Services 0 Within, Industry 10.000 -1 Within, Agriculture -2 0 2010-2019 Agriculture Industry Services Total=4.5% 2010 2019 Source: World Bank sta based on Geostat data. Source: World Bank sta based on Geostat data. Figure 5. Variation in regional GDP per capita Figure 6. Nightlights intensity, by raster 2018 or latest year 2016 0.6 0.5 0.4 0.3 0.2 0.1 0.0 SWE FIN GRC ESP AUT PRT BEL NOR ITA NLD DNK FRA IRL DEU GBR CZE SVK SVN MLT LTH HRV EST ROU POL BGR HUN LVA ALB SRB MKD GEO Source: Eurostat; various national statistics agencies (Western Source: Global Human Settlements Index; OpenStreetMaps. Balkans); Geostat. Note: Data presented at NUTS-3 level for EU and Western Balkans and at regional level for Georgia. lives in rural areas. Variation in regional GDP per capita Structural change delivered productivity in Georgia is above that of most peers in the EU and the gains, but the corporate sector is not Western Balkans, though it is not excessive (Figure 5). becoming more productive The pattern of leading and lagging regions is matched by patterns in investment and business demography. Capital accumulation and structural change drove Outside of the more vibrant Tbilisi and Batumi, other Georgia’s growth between 2010-2019; however, cities have limited economic clout, and there is an firm-level TFP performance has been weak. Capital absence of non-agricultural economic activity outside accumulation explained 2 pp of the 4.6 percent GDP of cities (Figure 6). The limited pull from urban areas growth during 2010-2019 (Figure 7). Overall TFP growth and constraints to labor mobility explain why a large accounted for one third of output growth (1.5 pp of GDP part of the population remains in agriculture, where per annum) and, demonstrating Georgia’s structural productivity is hampered by small plots, limited skills, change, was largely driven by the movement of labor weak land markets and fragmented supply chains. from agriculture to services and industry. However, 10 CHARTING GEORGIA’S FUTURE Figure 7. Growth accounting results appears to be explained by the existence of larger firms that dominate employment but not productivity, and productive startups that fail to scale up after their initial 6 5 growth spurt. Growth of less productive firms suggests 4 weak competitive pressures in markets, while factors 54% 46% 33% 14% like informality and limited export orientation could be 3 31% 10% 13% 9% 14% affecting the scale up of small firms. 2 8% 85% 1 28% 43% 44% -2% Only a few Georgian firms innovate, due to limited 0 -31% -1 investments and a nascent innovation ecosystem. -2 Irrespective of the unit of measure, the gap in R&D 2010-2013 2014-2016 2017-2019 2010-2019 investment between Georgia and aspirational peers is large. Firms’ investments in ICT are limited to basic digital TFP HC / labor Labor Capital stock services, and in the absence of complementary labor Source: World Bank sta based on Geostat data. skills, even these investments do not always translate into higher productivity. In addition, the innovation ecosystem is nascent, with limited incentives for research among a relatively large sample of non-agriculture and development institutions (RDIs) to orient research firms, TFP in 2019 was actually 6.7 percent below its towards commercialization and a relatively low stock of 2007 level, when estimated using firm data.7 Despite engineers and scientists. As a result, only 7 percent of an improving employment rate during this period, the firms introduced new or significantly improved goods shrinking labor force meant that the contribution of or services.8 the stock of labor was negligible (0.6 pp, or 14 percent), while small gains in the human capital per labor added Management practices in Georgian firms lag peers. around 10 percent of the observed GDP growth (0.4 Better management is positively associated with pp). performance. However, the average Georgian firm is family-managed and performs poorly on key Weak firm-level TFP performance is likely driven management aspects, such as performance monitoring by limited upgrading of firm capabilities, as well and dealing with production disruptions (Table 1). In as remaining economy-wide constraints. Among addition, many entrepreneurs appear to be “pushed” into the firms in the sample, the construction sector economic activity due to lack of other opportunities, become more productive, but TFP in manufacturing rather than being “pulled” by profits, independence, or declined slightly and plummeted in services (Figure autonomy (Kuriakose, 2013), and they may also lack the 8). Decomposing firm-level TFP trends shows that needed entrepreneurial skills. Together, these factors manufacturing and construction firms became result in one of the lowest rates of firm survival in Europe. more productive (i.e., reported positive “within-firm” component); but firms in services did not, indicative A sizeable, though declining, informal economy may of limited innovation or weak management. Further, be limiting growth of businesses. Various measures resources appear to be allocated towards more provide different results for the size of Georgia’s productive firms (i.e., positive “between / covariance” informal sector (Figure 9), though they all point to its component) only in construction; in manufacturing and decline in line with improvements in governance and services, the correlation between market shares and the regulatory framework. Still, where informality is TFP levels is negative. Such weak allocative efficiency more present, it also presents a bigger obstacle for 7  Caution is advised in interpreting the firm-level data to be representative of the entire economy. The initial sample of firms was from Geostat’s Business Statistics survey, which covers most larger companies and a sample of smaller companies in manufacturing, construction, and some services sectors. Further entries were lost due to insufficient data to compute TFP. Most of the lost entries were for smaller and newer companies, which could be more productive. See Chapter 3 for details. 8  Geostat, Innovation activities of enterprises (2016-2020). EXECUTIVE SUMMARY 11 Figure 8. Productivity growth decomposition, by sectors (2010-2019 average, 3-year di erencing) Manufacturing Construction and Services Textiles, Wearing Apparel & Leather prod. Construction Mach., Equip., Elec., Inst., Medic. Land, Water & Air Transport Non−metallic products Hotels & Restaurants Wood & Paper Retail Trade Chemicals, Rubber & Plastics Wholesale Trade Food, Beverages & Tobaco Publishing & Printing Supporting & Aux. Transport act. Basic & Fabricated Metals Sales and Repair of Vehicles .05 -.15 -.10 -.05 0 .15 .20 .25 .30 -.15 -.10 -.05 0 .05 .15 .20 .25 .30 Within Covariance Exit Entry Within Covariance Exit Entry Source: World Bank sta calculations based on GeoStat. Note: Average TFP annual growth calculated at the two-digit level of NACE Rev. 3. Annual averages are arithmetic averages. Aggregate employment is the average 2007-2019. Table 1. Management score in Georgian and comparator countries firms On a scale from 0 to 1 (higher scores are better), for firms with 50-5,000 employees Questions Georgia Bulgaria Poland Romania Serbia What happens when a problem arises? 0.663 0.879 0.904 0.873 0.894 # of key performance indicators (KPI) 0.293 0.556 0.590 0.523 0.572 Time frame of operational targets 0.617 0.592 0.677 0.607 0.607 Criteria for non-managers’ promotion 0.821 0.820 0.829 0.840 0.915 Source: World Bank staff calculations based on Enterprise Survey (2019). firms. In 2019, 13 percent of firms identified competition Weak competitive pressures could explain growth of from the informal sector as a major concern.9 A less productive firms. More firms operate in markets particular feature of informality in Georgia is that while with fewer competitors in Georgia compared to peers, most businesses are formal, their operations may be confirming business perceptions that markets are underreported. Around a fifth of medium-size firms in concentrated. Still, firm-level data points to increased Georgia are not fully compliant with their VAT liabilities, competitive pressures in product markets in recent while bunching of firms just below the VAT registration years – average markups have declined, with evidence threshold may suggest that firms aim to appear small by that this has been driven by TFP rather than market underreporting their income (World Bank, 2021) and not share. However, competition may continue to be growing to their full potential. Related to this, unreliable weaker in some sectors. For example, a few sectors are financial information is a key reason for loan rejections, characterized by higher dispersion in markups, while contributing to access to finance being one of the also having higher levels of markups. Further, in services, biggest obstacles reported by businesses. a small number of firms appear to be driving markups. 9  World Bank Georgia Enterprise Survey 2019. 12 CHARTING GEORGIA’S FUTURE Figure 9. Informality and development: Is Georgia an outlier? Output informality Labor informality Perceived informality MIMIC-based informal activity 100 100 7 WEF index (reversed order) (percent of employment) 80 80 6 Self-employment (percent of GDP) Georgia Georgia 5 60 60 4 40 40 3 20 20 2 Georgia 0 0 1 4 6 8 10 12 4 6 8 10 12 4 6 8 10 12 Ln(GDP per capita) Ln(GDP per capita) Ln(GDP per capita) AE EMDE AE EMDE AE EMDE Source: (Yu, 2020). Note: AE: Advanced Economies; EMDE: Emerging markets and developing economies. Georgia’s labor force made a very modest reflects challenges throughout the education system. contribution to growth Too few kids attend early childhood education and, as a result, enter the general education system unprepared The relatively high unemployment and low to learn. The general education system fails to instill participation rates mean that around 30 percent of good foundational skills, which is further compounded the labor force is not actively contributing to the by the weak quality and relevance of VET and tertiary economy. Economic reforms delivered growth and education. Finally, an underdeveloped labor market poverty reduction; however, net job creation has not information and employment services keep information kept pace with economic growth (Posadas, Makovec, asymmetries high and labor mobility low. Jaef, Gruen, & Ajwad, 2018), as robust job creation in manufacturing and industry was offset by shrinking Georgia is integrating, but only in a few, agriculture employment. Consequently, Georgia’s low value-added sectors, and connectivity unemployment rate at around 19 percent, while remains a challenge declining, is high (Figure 10). The quality of jobs is an equally big problem, with most job creation taking place Integration has underpinned Georgia’s growth story, in traditional and low-productivity sectors, thus keeping but in a narrow way. Trade expanded briskly in the wages low. Participation in the labor market, at around decade prior to COVID-19, and in 2019, Georgia’s trade 50 percent is low and declining, reflecting social norms in goods and services exceeded the expected level for and limited support services. its income. The country has also increasingly been able to position itself as a hub for the region, with re-exports Skills gaps and mismatches limit the potential of the gaining a greater share of trade. However, while Georgia labor force. On the one hand, most jobs require basic now exports more products to more markets, its export skills, while most workers have secondary education basket remains relatively unsophisticated and with limited and above. This pushes out those with lower education value-added. The opportunities provided by the opening (for example, 16 percent of workers with upper of markets have not fully materialized, with Georgia secondary education work in elementary occupations) exploiting only 4.2 percent of the market potential of and keeps returns to education low for workers. On the its exports structure. Large and integrated companies other hand, the few high-skilled jobs that are created benefited from the free trade arrangements, but there frequently remain unfilled because a higher education are only few such firms in Georgia. In fact, very few level doesn’t always equate to skills. The skills gap firms export, and export relationships don’t survive long. EXECUTIVE SUMMARY 13 Figure 10. Labor market indicators: Georgia vs comparators (2019, in percent) 70 20 60 15 in percent in percent 50 10 40 5 30 0 HRV GEO* UKR EU-27 ARM CZE ALB GEO EST CZE EST HRV EU-27 UKR ALB GEO GEO* ARM Source: ILO and Geostat for Georgia according to new methodology. Note: * refers to Georgia using new methodology. In the EU-27, the new standards would not substantially a ect labor indicators as own-account workers only represent 9.9 percent of total workers. Georgia’s GVC participation has been low and declining, An agenda for a competitive, due in part to its inability to attract the multinationals that typically form the backbone of GVCs. Services generate connected, and capable Georgia 70 percent of the exports value-added, exceeding most In a more uncertain and challenging world, the peers. However, apart from tourism and transport, there key objective for Georgia is to sustain pre-COVID have been relatively few services on Georgia’s export list, growth rates and to improve the quality of growth and most exported services are low-skilled and do not to allow people to access better-paying jobs. Under add value to other sectors. a business-as-usual scenario, potential growth will slow to below two percent by 2050 as gains from Georgia occupies a strategic location, serving as structural transformation are exhausted and push TFP a logistics gateway for the Caucasus region and growth down to global averages10, macroeconomic potentially Central Asia, yet its connectivity is lower constraints and increased uncertainty limit investment compared to peers. The country’s attractiveness is and demographics takes a toll. But these headwinds restrained by higher transport and logistics costs and can be offset. Restoring investment and higher savings, unpredictable delays, as simplified regulations and a facilitating the ongoing structural transformation, modern customs administration have been outweighed promoting a more active and better-skilled labor by perceptions of low quality of transport infrastructure force and unlocking firm productivity growth can still (especially in multimodal transport), high costs of deliver growth rates of around 4-4.5 percent over the infrastructure use and an underdeveloped logistics long-term. To achieve this, Georgia should, in many industry. Limited cooperation among stakeholders and ways, do what it was doing before: continue prudent with neighbors adds to the delays and unpredictability. economic management, improve governance, and The logistics disruptions during the COVID-19 recovery invest in infrastructure. However, the remaining agenda and the impact of the Russian invasion of Ukraine are is considerable: to make businesses more competitive putting existing transport arrangements to the test. so that they can create more and better jobs; foster a Importantly, the November 2020 tripartite Peace more capable and mobile workforce; and promote Statement by Armenia, Azerbaijan and the Russian the country’s connectivity. The EU accession process, Federation could lead to eventual opening of corridors after it is approved and formally launched, has the that are now closed, which may mean growing potential to serve as an anchor for some of the more competition for Georgia’s transit role. 10  The average TFP growth rate during 2000-2019 for a sample of 118 countries for which information is available in the Penn World Table (version 10.0) was 0.6 percent. For UMICs it was 0.7 percent. 14 CHARTING GEORGIA’S FUTURE demanding institutional reforms that are needed, while well-appraised public investment projects, better linking also providing Georgia with an opportunity to more spending to outcomes, adopting cost-recovery tariffs in closely integrate and converge in income levels with regulated sectors and reforming management of SOEs aspirational peers. (i.e., implementing the new corporate governance code for SOEs, improved performance monitoring, etc.) can Figure 11. Long-term growth produce considerable savings, while improving service In percent delivery. In addition, as off-budget activities are likely to become more important as Georgia starts to rely more 6.0% on complex private-public engagements in service delivery, so will the need to monitor fiscal risks of these 4.0% activities. 2.0% Household savings need to increase. Growth and job creation will increase savings; however, saving rates need to considerably exceed pre-pandemic levels. The 0.0% pension reform is helping to drive savings accumulation, 2023 2025 2027 2029 2031 2033 2035 2037 2039 2041 2043 2045 2047 2049 and additional savings could be mobilized through instruments such as unemployment and disability Baseline Scenario insurance or life insurance products. Improving the Source: WB. public’s financial literacy, especially regarding decisions Note: In the baseline TFP declines to 0.5 percent by 2040, with longer-term implications (i.e., education and human capital declines by 0.01 percent annual, labor market participation stays constant; under Scenario, TFP declines to health), can also help. Finally, maintaining financial 1.5 percent by 2040, labor force participation and human sector stability and supplementary tax policy measures capital increase to high-income levels. (such as taxation of second homes or unused land) may help channel investment in jewelry and real estate into Restoring investment and increasing savings financial sector savings. Savings should increase to maintain strong investment Facilitating the structural and spatial rates. Georgia’s development needs are substantial, transformation which elevates the importance of reversing the recent decline in investment levels. To avoid debt levels Large differences in output per worker and persistence increasing further, investments will need to be matched of a high share of the labor force in agriculture suggest by higher savings by the government and by households that the potential for structural transformation is not and a more profitable corporate sector. Georgia’s aging fully exploited. Labor in manufacturing and services demographics further strengthens the case for higher produces around seven times more output compared savings, with evidence that higher old age dependency to agriculture. Given the large share of the labor force11 negatively impacts the private saving rate (Loayza, still engaged in agriculture, further shifting of labor from Schmiddt-Hebbel, & Serven, 2000). agriculture will be productivity-enhancing. Importantly, agriculture needs to become more productive, so that In the public sector, buffers need to be restored while the remaining farmers can have better livelihoods. In management of fiscal risks should be improved. addition, to incentivize the move from agriculture, Georgia’s fiscal rule is robust and will see a gradual the rest of the economy will also need to increase restoration of fiscal buffers, though, given the strong productivity to sustain the wage differential. recovery from the pandemic, a faster adjustment could be considered. Unwinding of COVID-19 mitigation measures To create the most opportunities, growth should be can provide some savings. Improved prioritization of efficient, and its spatial consequences adequately 11  Slightly below 40 percent of total employment based on the old methodology, which is comparable to more countries. The new methodology puts employment in agriculture at 19 percent of total employment. EXECUTIVE SUMMARY 15 managed. This requires a framework that allows markets structural constraints that limit their development to identify growth opportunities and people and capital potential. Effective policies for these areas are likely to to move to be able to capture those opportunities. This be those that enhance equality of opportunity, with a starts with building up endowments across the board, focus on human capital. Agricultural transformation, such as human capital and institutions, as well as policies along with niche sectoral development based on that target market, government and coordination territorial endowments (natural resources, tourism) can failures that limit opportunities or hinder mobility. also offer opportunities. Place-based investments can be transformational for some areas; however, these are unlikely to work if While density and market access may define a region’s distortions are not removed, the opportunities are not potential, to grow regions need sufficient endowments, there and interventions are not properly appraised and including human capital and local institutions. A coordinated. Such a growth strategy will have important nation-wide effort to increase skills (Chapter 5) will spatial consequences: less, but more productive jobs facilitate labor mobility and benefit lagging regions. in the rural economy, more jobs in the urban economy Spatially targeted efforts can help in areas with potential (mostly in Tbilisi, but also in some of Georgia’s secondary (i.e., training on tourism-relevant skills or climate smart cities), but also some areas with limited potential to agriculture). And while it is recognized that quality support sustainable economic activities. Though these of local administration is associated with regional regions may continue to lag in terms of per capita economic outcomes (Rodriguez-Pose and Ketterer, output, redistributive fiscal policies, equal access to 2016), local governments in Georgia, despite some opportunities and migration can help equalize per capita progress, remain weak. Building capacity, coupled consumption. Notably, urbanization will deliver the with more autonomy and capacity to raise revenues productivity dividends only if it is adequately managed can ensure local governments can better support local to ensure that cities are better connected, planned and development. livable. Figure 12. Mapping Georgian municipalities Regional development policy should build on these by density and connectivity principles complemented with a clear understanding 2019 of the regional context. Labor and capital mobility are critical for effective regional development policies (McCulloch & Yellen, 1977). However, locations also differ in their starting points and structural conditions, which determine their viability. While a variety of factors impact sub-national productivity, urbanization and economic density, as well as market access and local transport connectivity, stand out as robust variables across methodologies. Bringing together density and market connectivity can help differentiate policy priorities for various regions of Georgia. For example, about 53 percent of Georgia’s population (but only eight municipalities) resides in densely populated, centrally located (well-connected) regions which are Source: Authors. not lagging (Figure 12) and which could benefit from properly appraised, place-based interventions directed Facilitating Georgia’s structural and spatial towards improving connectivity, urban planning and transformation will require addressing the structural providing affordable and safe housing. By contrast, factors that limit opportunities and cause frictions in another 27 percent of the population (and 60 out of factor markets, as well as building up of endowments. 76 municipalities) reside in sparsely populated and Lack of density and connectivity, disconnected and peripherally located regions. These areas face substantial stagnant rural areas, inefficient land markets and lack 16 CHARTING GEORGIA’S FUTURE of affordable housing, weak human capital, as well city to excel in its role as the main hub for Georgia’s as limited capacity of local institutions are slowing people and markets. the pace of Georgia’s adjustment. Accelerating the transformation will require investments in building Making the most of the available human up endowments (human capital, basic services and capital institutions), complemented with a focus on three broad priorities: A more active and skilled labor force can support growth. More and better jobs are needed to reduce • Realize the potential of rural areas through unemployment and ensure the investment in human agricultural transformation, niche sectoral capital is better utilized. However, jobs alone are opportunities, and connecting to markets. insufficient. Workers should be better equipped for Advancing land reform (management of state emerging opportunities, labor supply and demand land, taxation, consolidation, etc.), strengthening mismatches need to be addressed, and the labor market value chains by promoting linkages between should be more inclusive. Increasing participation and sector participants and reorienting public support better skills can add around 0.4 pp to long-run GDP programs towards public goods and more per capita growth. This is likely to be an underestimate beneficiaries are priorities for the agriculture sector. as skills are also embedded in the TFP contribution. A Further gains may be available for some regions range of policies can support a nationwide effort to from niche opportunities in sustainable tourism and improve skills, link them to the demand of the markets forest management. Better connectivity with large and match workers with jobs: agglomerations can open opportunities for product and labor market integration and attract investment, • Improve access to pre-school education and with interventions focused on areas with potential improve learning outcomes. With Georgia’s to take advantage of density. education sector performing poorly in building foundational skills (Figure 13), focus should be • Strengthen dynamism and reinforce density placed on general education. Greater pre-school in secondary cities. Effective use of public education enrollment can better prepare children assets, improved quality of public services and to enter school. This will require more and better- performance-based firms’ support could help build financed kindergartens that provide educational competitive industries in some secondary cities and (rather than caretaking) services. Growing pre- support efforts to attract FDI in secondary cities. school enrollment will also make the labor market Universities have attracted and retained knowledge more inclusive by facilitating greater female workers and revitalized secondary cities in parts participation. In general education, better-qualified, of the EU, and a few Georgian cities have regional paid and motivated (though not more) teachers can education institutions that could support the local improve students’ learning outcomes. Gains can be economy. Admittedly, many secondary cities will achieved by optimizing the school network (larger continue to shrink and will need to adjust plans to schools attract qualified teachers more easily and manage this process; this may be an opportunity to provide education services more efficiently) and re-invent some cities. increasing instruction hours. With digital skills increasingly demanded by employers even for • Prepare Tbilisi for sustainable and inclusive elementary occupations, these skills should be growth. Strengthening and effectively integrating mainstreamed in the education system. Finally, urban planning programs (with significant introducing and enforcing quality standards will be opportunities available for infill densification), important. improving public transport, and ensuring sufficient social (housing quality and affordability, schools, • Enhance the responsiveness of the vocational health facilities) and environmental (green areas, education system to the changing demand for parks) infrastructure can further propel the capital skills. A stronger Skills Agency can help define EXECUTIVE SUMMARY 17 vocational education standards in collaboration across the board. This means higher yields per hectare with the public and private sectors and foster the in agriculture and more output per labor and capital in provision of job-relevant skills. Building on this, the firms in the rest of the economy, i.e., reversing the VET programs can be expanded and tailored to the relatively weak performance of Georgian firms so far. In needs of the workers. addition, the more productive firms should grow and gain market share. Several factors have been associated • Strengthen labor market institutions to facilitate with increased productivity, including supportive school-to-job transition and better match workers institutions, firm-level capabilities and deepened cross- to jobs. The general secondary education system border integration. can be complemented with systemic options to acquire occupational or technical, job-specific (Gill, Izvorski, van Eeghen, & De Rosa, 2014) define skills. The dual VET model, combining school and “institutions” as the mechanisms to ensure stability, firm-based learning, can strengthen engagement deliver quality public services and regulate business between vocational colleges and employers. In activity. Against this metric, Georgia has a lot to build addition, strengthening Active labor market policies on but also a remaining agenda in few places. (evidence-based wage subsidies, internships, work- based experience arrangements etc.) can help tap • Georgia’s institutions are more and more capable underutilized sources of labor supply and facilitate of delivering stability, but dollarization is a the school-to-work transition. vulnerability, especially given high exchange rate volatility. Georgia’s de-dollarization agenda is in line with good practice and will bring results over Figure 13. Learning gap time. In the interim, more active communication of In years information on factors affecting the exchange rate can help delink exchange rate expectations from 15 non-economic trends. Learning-Adjusted Years of School Czech Republic Estonia • While Georgian institutions’ provision of basic 10 Ukraine Belarus services (e.g., primary and secondary education, Armenia basic utilities) is closer to EU-11 levels than Albania structural and income peers, the quality of services 5 needs to improve. Many Georgians fail to learn much Georgia in the present education system, firms report more electricity outages compared to peers, and twice as 0 much water is lost compared to what is supplied 0 5 10 15 to customers. The source behind these issues is Expected years of school often due to underfunding, but inattention towards results and lack of accountability in decision- Source: World Bank. making also play a role. Reforming SOEs is also part of this agenda, including through introducing Sustaining productivity gains key performance indicators and incentives for SOE management linked to productivity. Sustaining productivity growth will be critical. While the move away from agriculture can keep on • In terms of regulating economic activity, Georgian delivering for Georgia, over time, its potency in driving institutions have made significant strides, with productivity gains will decline as the number of workers some room for improvement. Bribery incidence in agriculture falls and the remaining ones may not and depth are lower compared to ECA, regulations have the skills required in the non-farm economy. For take less time to complete, and government TFP growth to be sustained, efficiency should increase effectiveness is on par with the ECA average. 18 CHARTING GEORGIA’S FUTURE However, informality and a still nascent ability to the capabilities of its firms and increasing their export ensure competitive markets may be making the orientation, improving the competitiveness of its playing field uneven. Tax policy and administration transport infrastructure, and facilitating the growth of a reforms, together with digitization and financial vibrant logistics industry. From a policy and institutional inclusion, can remove distortions that incentivize standpoint, progress on these goals would require: firms to stay small. Effective enforcement of the upgraded regulatory framework for competition • Supporting increased export orientation of (merger control, market monitoring) and the firms. A consensus on the importance of export introduction of a state aid framework in alignment orientation can be facilitated by an effective with EU requirements can also promote more National Trade Facilitation Committee (NTFC). competitive markets. Furthermore, firms can become export-oriented through programs supporting them to adopt Firm capabilities can be boosted through international certification and through stronger performance-linked support programs focusing on export promotion to overcome the information managerial practices and on innovation. In Georgia, asymmetry and discovery costs associated with like in other countries, better managed and organized seeking access to external markets (especially firms and firms that invest in innovation and in ICT non-traditional markets). Effective implementation do better. Training or consulting services programs of an FDI strategy that targets efficiency-seeking could improve managerial capacities, with Enterprise FDI can facilitate GVCs integration. And while the Georgia already exploring some promising initiatives. non-tariff barriers on trade between Georgia and Existing business support programs could be reviewed the EU are expected to be eliminated, in practice, to incorporate productivity and competitiveness that means that a wide range of regulations need requirements. Supporting firm growth, whether to be implemented in Georgia as EU norms are through export promotion or lower informality, can transposed. The transition costs associated with this also increase innovation, given that larger firms and will need to be managed. exporters are more likely to innovate. Still, innovation also requires complementarities, such as human capital • Promoting the growth of services as an export and a supportive innovation eco-system. Policies that engine. The relatively large share of jobs in “global improve coordination between RDIs and the private innovator services” and in “social services”, which sector and that ensure a sufficient supply of engineers are increasingly more tradeable, compared to the and scientists can support firms to innovate. relatively low export of these services suggests opportunities to scale up services exports. Improved access to financing can support firm Developing a Services Trade Restrictiveness Index growth. While banks have done a reasonably good job (STRI) and understanding how to make services in providing credit, firms still see access to finance as in high-potential sectors more tradeable (digital a major obstacle. This reflects the very basic services content, accreditation, visa policy) could help. offered by banks, as well as the relative absence of alternative sources of finance. An improved credit • Addressing the remaining infrastructure reporting infrastructure, a private sector with greater bottlenecks, revamping logistics and sustaining digital footprint, a strengthened secured transactions trade facilitation gains. Investment is needed to framework and an enabling legal framework for non- close infrastructure gaps (ports, rail, dry ports), but bank financial activities can help broaden access to so is better regulation (rail, ports). Connectivity finance. is increasingly multi-modal, requiring integrated logistics clusters with rail and road access and With the anticipated EU accession, Georgia has the warehousing and logistics services. Georgia should potential to significantly improve its trade performance also upgrade the Caucasus Transport Corridor and solidify its logistics and transport hub position for (CTC), managing it in real-time (increasingly in the region. It can achieve these goals by enhancing partnership with neighbors). Dialogue with the EXECUTIVE SUMMARY 19 private sector can help drive investment in strategic sharing mechanisms can speed up the processing of specialized logistics facilities, such as Tbilisi as a trade flow. Faster approximation of procedures and logistics hub. Regular reviews of processes and standards with the EU, including mutual recognition fees in trade facilitation, (which could also involve of Authorized Economic Operators (AEO), can also the Competition Agency) can ensure that gains help. Similar arrangements can be explored with are sustained. Greater use of joint border control trade partners that run programs equivalent to the facilities with neighbors and functioning data AEO. Figure 14. Low-skilled tradeable services Figure 15. Global innovator services Exports and employment Exports and employment 100 100 GEO 80 80 as % of exports as % of exports 60 60 40 40 20 20 GEO 0 0 0 10 20 30 40 0 10 20 30 as % of employment as % of employment Source: Sta calculations based on data from (Nayyar, Hallward-Driemeier, & Davies, 2021). 20 CHARTING GEORGIA’S FUTURE Priorities for a Competitive, Connected and Capable Georgia Sustaining long-term growth through 1. Higher savings • Improve SOE corporate governance and introduce cost-recovery pricing in regulated sectors • Improve financial literacy of households, especially regarding long-term decisions in education and health 2. Facilitating the structural and spatial transformation, through … … realizing the potential of rural areas … Complete land registration, promote land consolidation and adopt a policy on strategic management of state land Promote cooperation among farmers (producer associations, cooperatives) and value chain integration (contracting, out-growing) Increase public expenditures on research and extension services and rural infrastructure and adjust design of programs to ensure more farmers benefit from programs … strengthening the dynamism of secondary cities … Attract investment through efficient use of public land and facilities, better infrastructure services and support to local businesses to upgrade quality and reach new markets … and preparing Tbilisi for sustainable and inclusive growth. Improve access to affordable and safe housing by strengthening land market monitoring systems, improving construction standards, supporting the retrofit of existing buildings and implementing a social housing program. Improve public transport, by further optimizing the bus network, considering environmentally friendly alternatives (light rail, commuter rail) and increasing cost of private vehicle use 3. Making the most of the human capital, through Reform the teaching profession by upgrading entry standards and requiring regular certification. Focus curricula on skills demanded by the market, especially digital skills, and establish partnerships with private sector to provide options for work-based learning 4. Sustaining productivity gains, through … stronger institutions that deliver quality public services and a level playing field … Improve quality of public services by linking spending to performance and accountability and reviewing functional assignments and sources of revenues for municipalities • Lower incentives for informality by reviewing thresholds and eligibility for simplified regime taxation, and better understand bunching of firms just below VAT threshold • Ensure markets are competitive by introducing a state aid framework in-line with EU rules and enforcing the improved competition framework (merger controls, increased fines) … improved access to finance … • Digitize transactions through reviewing fees, providing basic accounts, expanding payment options and ensuring interoperability and non-discriminative access • Improve credit information through collection of alternative data, reviewing pricing and non-discriminatory access to databases EXECUTIVE SUMMARY 21 • Promote asset-based financing, by adopting the legal framework and establishing a platform for factoring and reverse factoring … as well as building managerial capacities and promoting firm-level innovation … • Reform business support programs (design, criteria, implementation) to promote synergies, ensure alignment with priorities (productivity, innovation, jobs, digital, energy efficiency, regional development, managerial skills) and monitoring of results … increasing export-orientation of firms … • Facilitate GVC integration through assisting firm to acquire international certification (matching grants, advisory support, stronger National Quality Infrastructure) and a more efficient export promotion function. • Develop an STRI to understand constraints to services exports, especially in priority sectors … and better connectivity. • Review regularly processes and charges related to trade (including steps prior and post clearance), potentially involving Competition Agency • Upgrade the management of the Caucasus Transport Corridor, by better linking the various transport assets (ports, rail, logistics) • Support investment in an Integrated Logistics Center in Tbilisi and in multi-modal facilities 22 CHARTING GEORGIA’S FUTURE Bibliography Finn, P., Mysore, M., & Usher, O. 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In fact, with a growth rate of 5.2 percent from the difficult first years of transition, including civil on average in per capita terms during 2010-2019, unrest, armed conflicts, high crime rates, and the loss of Georgia was the second fastest growing economy in traditional markets and suppliers. The government was the Europe and Central Asia (ECA) region and the 14th left with little choice but to carry out swift and radical fastest globally. As a result, GDP per capita (at constant economic reforms, which earned the country the brand 2010 US$) increased from 23 percent of the EU-1112 of “star reformer”. average at the start of the decade to 27 percent by 2019. By contrast, the convergence in GDP per capita The COVID-19 pandemic disrupted these trends, but levels in Western Balkans13 and Central Asia14 stagnated also demonstrated the growing maturity and resilience and actually reversed in some Commonwealth of of Georgia’s economic institutions, with economic Independent States (CIS) countries.15 In 2019, Georgia activity rebounding strongly in 2021. Georgia’s strong moved to upper-middle income status, and the reliance on services, especially tourism, made its poverty rate (measured using the national poverty line) economy vulnerable to the pandemic. While Georgia’s declined to 19.5 percent from 37.3 percent at the start 6.8 percent contraction in GDP was among the largest of the decade. in ECA, the impact on living conditions was less severe, reflecting also a large and timely government response This success was underpinned by prudent economic made possible by a track record of disciplined policy. management and implementation of a sound growth As a result, despite the large economic blow, poverty strategy. The country’s policy mix included a sound increased by only 1.8 percentage points (pp) to 21.3 12  EU-11 includes Bulgaria, Croatia, Czechia, Estonia, Hungary, Latvia, Lithuania, Poland, Romania, Slovak Republic, and Slovenia. 13  Western Balkans includes Albania, Bosnia and Herzegovina, Kosovo, N. Macedonia, Montenegro, and Serbia. 14  Central Asia includes Kazakhstan, Kyrgyz Republic, Tajikistan, and Uzbekistan. 15  CIS includes Armenia, Azerbaijan, Belarus, Moldova, Ukraine, and the Russian Federation. 26 CHARTING GEORGIA’S FUTURE percent, and the recovery in 2021 was one of the fastest will become increasingly more binding. The gains in ECA, with output expanding by 10.4 percent. Still, as from structural transformation are delivering strong economic activity continues to recover, the pandemic’s productivity gains but will gradually be exhausted, also impact on employment, incomes and human capital is because the age and skills profile of workers engaged likely to persist. in agriculture may limit their ability to move to other sectors. This means that productivity growth will need Georgia has made European integration the to rely increasing on the ability of Georgian farms and cornerstone of its development agenda. Following the businesses to improve their efficiency. However, the 2014 signing of the Association Agreement (AA) with the track record so far is not very encouraging. Yields in European Union (EU), the country is making progress agriculture have been stagnant, while the total factor on approximating its institutions and policies with productivity (TFP) in a relatively large sample of firms those of the EU, and this is reinforcing key economic, has been weak. Low productivity across sectors had political, and social reforms. In March 2022, Georgia another important consequence: while Georgia’s GDP formally submitted its application for EU membership. growth was commendable, the creation of good jobs Integration with the EU will open up opportunities for was unspectacular. Consequently, many Georgians are faster convergence in income levels with aspirational unemployed, and among those that are employed, a peers, but it will also place much greater demands on large part continue to be engaged in low-productivity the Georgian government and economy (Box 1). agriculture. Georgians that have transitioned to other sectors are doing better, but not by much, as they are The past successes are commendable, and its future either self-employed or working in traditional low- aspirations are equally ambitious. The government’s paying jobs that are in stark contrast to their relatively 10-year economic plan envisages growth rates around high education levels. Finally, these existing and 5 percent per annum until 2030, and further halving emerging constraints will need to be managed in a of the poverty rate to below 11 percent. It intends to much more uncertain global environment. For example, open markets with 5.6 billion consumers by 2030 (up the Russian war in Ukraine is the third major shock to from 2.3 billion consumers today) and invest strongly affect Georgia’s economy in a span of less than four in connectivity (both physical and digital) to underpin a years, after the unilateral ban on flights from Russia robust response from exports of goods and services. introduced in 2019 and the COVID-19 pandemic during 2020 and 2021. Georgia is well-placed to make the next decade as successful as the previous one, although limitations These findings informed the choice of the topics loom on the horizon. A large part of Georgia’s success covered in this report: i) facilitating the structural model will continue to deliver: sound macroeconomic and spatial transformation; ii) increasing firm-level policies, a business environment that imposes a light productivity; iii) leveraging external opportunities, and burden on business and good governance. But there are iv) improving and better utilizing human resources. a few areas where Georgia can do better. Our analysis The key to sustaining growth in Georgia will be to shows that under a business-as-usual scenario, the preserve robust productivity growth. Significant potential GDP per capita growth rate will slow from gains remain possible by moving more workers from around 4-5 percent per annum currently to 3 percent in agriculture to more productive sectors of the economy 2030 and further to 1.9 percent by 2050. and addressing the corresponding spatial adjustment (chapters 1 and 2). But increasingly, growth will The country will need to address several constraints need to depend on improving TFP in Georgia’s firms if it is to live up to its reputation as a “star reformer”. (chapter 3), an agenda that will only be fully successful Some constraints are already binding: investments may if businesses are better able to exploit opportunities in need to moderate to stabilize and eventually lower external markets (chapter 4). Finally, a more active and external debt; an aging population is taking its toll; and better-skilled labor force (chapter 5) can help offset the skills deficit and mismatch are an acute problem demographic trends and augment productivity. These for doing business and firm growth. Other constraints reforms, supported by efforts to restore and beef up COMPETITIVE, CONNECTED, CAPABLE 27 savings, can make Georgia’s economy more capable, The remainder of this Overview outlines key global more competitive, and better connected — and help trends that will influence Georgia’s trajectory, sustain GDP growth rates at around 4-4.5 percent over followed by brief summaries of the chapters of the the long-term. Progress in these areas will also bring CEM. Chapter 1, “Understanding Georgia’s growth”, aims Georgia’s economy closer to the European norms (i.e., to understand the drivers of growth in Georgia, as well more integrated, more productive, more accountable, as risks and opportunities, while also looking in greater and more skilled) and facilitate Georgia’s aspirations detail into the implications of two of the identified for closer EU integration and eventual membership. global trends: i) the opportunities and challenges of Having submitted a formal application in March 2022 for digitization (Thematic Spotlight 1) and ii) energy use membership, Georgia will need to perform better than trends and the energy footprint in Georgia’s enterprise prospective candidates and demonstrate dedication for sector (Thematic Spotlight 2). Next, Chapter 2 provides reform and ability to match the EU average (Sabanadze, a deep dive on “Spatial transformation”, the corollary of 2021). structural transformation, and provides a framework to design regional development policies that will facilitate Undertaking transformational reforms will require the structural and spatial adjustments and ensure that a shared view among Georgians, something that has most Georgians are able to benefit from the available proven difficult in recent years. The share of Georgians growth opportunities. Chapter 3 on “Firm performance” thinking that the country is not going in the right direction looks at productivity trends in Georgia’s non-agriculture has grown in recent years, while political instability was firms and zooms in on a few economy-wide (access to the biggest constraint identified by businesses in the finance, informality, and competition) and firm-specific 2019 Enterprise Survey – hardly the environment for (firm capabilities and innovation) factors that appear to tackling the far-reaching reforms needed to sustain be hampering it. With economies of scale being key for growth. Still, Georgians showed some twenty years growth of firms, Chapter 4, “Connecting Georgia”, looks ago that they can manage to turn the tide despite at the extent of trade integration, as well as the challenges significant challenges and save their state (Kakachia & to connectivity. Finally, Chapter 5 on “Labor market and Lebanidze, 2021). With concerted efforts and mobilizing skills” unpacks the skills shortage and mismatch, one all potential, Georgians can do that again and ensure of the major constraints to firm operations reported by another decade of success. businesses. 28 CHARTING GEORGIA’S FUTURE Box 1. Going beyond association – the implications of the EU membership application Georgians and their policy makers have had no doubts about where they see the future of the country. In a turbulent geopolitical region, EU membership is synonymous for many Georgians with peace and stability and an anchor for economic and political reforms. As a result, integration with the European Union has been firmly on the agenda of all governments in the last two decades. An Association Agreement (AA), combined with a Deep and Comprehensive Free Trade Area (DCFTA), was signed in 2014 and has been in force since 2016. In March 2022, the government submitted an official application for EU membership. This formally put into motion a complex and thorough process of self-assessment, screening and negotiations and regular evaluations during which the candidate country needs to reform and adapt the institutional and administrative infrastructure and align the national legislation with the 35 chapters of the EU law (acquis communautaire). A unanimous position of all EU member states is required at all stages of the accession process, and while some temporary adjustment periods are given to acceding countries, a key principle in the negotiations is that there will be no permanent derogation from EU rules for new EU members. Looking at the experience of countries that have joined the EU previously, it is not surprising that Georgia wants to join the EU. The accession of each of the less developed countries that joined the EU (Greece in 1981, Spain and Portugal in 1986, Czech Republic, Estonia, Cyprus, Latvia, Lithuania, Hungary, Malta, Poland, the Slovak Republic, and Slovenia in 2004; Romania and Bulgaria in 2007, and Croatia in 2013) saw their incomes grow closer to those in more advanced EU members. This earned the EU the name of a “convergence machine”, taking in poor countries and helping them become high-income economies (Gill & Raiser, 2012). And while each EU country has its own rules and institutions in many sectors, the EU has put in place an “economic and social model” that has produced this unprecedented success, which consists of policies and institutions that foster trade and finance integration, accountable and innovative enterprises, skilled and protected labor and representative governments. Many of Georgia’s institutions provide a robust base to build on (low corruption, good investment climate, responsible economic management), and there is already reasonable integration in some respects. Yet the country still has a way to go. Trade integration is limited, firms’ capabilities are rather low, and labor is unproductive and, to a significant degree, informal. The essential conditions that are required from all acceding countries have been laid down by the Copenhagen European Council in June 1993. These include: a) political criteria (stability of institutions guaranteeing democracy, the rule of law, human rights and respect for, and protection of, minorities); b) economic criteria (a functioning market economy, as well as the capacity to cope with competitive pressure and market forces within the EU); and c) administrative and institutional capacity to effectively implement the acquis and the ability to take on the obligations of membership (including adherence to the aims of political, economic and monetary union). However, no two accession processes have been the same. The first wave of transition economies that acceded the EU in 2004 spent on average four years between the submission of their applications for membership (around 1995) and the start of negotiations (1998) and additional five years until membership. These are countries that also scored relatively high on various measures of reform efforts (e.g., the Worldwide Governance Indicators (WGI)1 or the EBRD Transition indicators) even at the application stage. The countries that acceded in 2007 (Bulgaria and Romania) had weaker starting positions and spent five years between their membership application and the start of negotiations and further seven years until membership. Despite significant reforms, even at the time of their accession in 2007, the performance of these two countries continued to lag the earlier set of acceding countries. 1  While the WGI criteria are not the official EU membership criteria, they can be relatively easily mapped to the political, economic, and administrative criteria for EU membership. COMPETITIVE, CONNECTED, CAPABLE 29 Croatia had a shorter time between application and start of negotiations (probably also reflecting its relatively better starting position) but took another eight years to join (also due to a bilateral issue with an EU member). The process has been much longer for the current wave of applicants. Montenegro has been negotiating for 10 years already and Serbia for 8 years, and neither is likely to join before 2025. Albania and North Macedonia are yet to start negotiations, more than a full decade after submitting their applications. The difference reflects both the different challenges faced by the prospective members, as well as the changing views of EU member states towards the enlargement agenda. On the one hand, perceptions that new members have not made sufficient progress and even backtracked on some of the criteria gave rise to an “enlargement fatigue” and raised the bar for future candidates. For example, following Romania and Bulgaria’s accession, the EU introduced benchmarks for both opening, as well as for closing, negotiations for each chapter of the acquis. The methodology for later applicants was amended to ensure a stronger focus on the rule of law, fundamental rights, the functioning of democratic institutions and public administration reform. On the other hand, later stage applicants typically had weaker starting positions (proxied by lower WGI scores) and have been reforming more slowly, reflecting both the limited capacity of institutions and less than adequate commitment to the reforms, especially on political criteria. Partly because of this, convergence in GDP per capita in the candidate countries from the Western Balkans with the EU may have plateaued (Besimi & Monastiriotis, 2019). The process of formal EU accession and membership perspective itself has been a powerful tool for reform and growth. For example, Serbia and North Macedonia became attractive for multinational businesses that were trying to diversify their networks that serve the EU markets. This, as well as increased access to academic programs and exchanges, facilitated transfer of technology and know-how. It also resulted in increased inflows of assistance and improved transport connectivity along the EU corridors. Accession has also produced a push effect for tough reforms to be implemented. For example, Croatia’s repeated attempts to reform companies receiving public subsidies was only resolved once it became part of the EU accession agenda. Subsidies to these companies (shipyards, an aluminum company and several agro-combinats) were a significant drag on the budget and were not in compliance with the EU rules. Similarly, crucial reforms in anti-corruption and judiciary were pushed through in Bulgaria as part of its EU accession (Mihailov, 2006). Georgia enters the accession process with many strengths, particularly in terms of its legislative framework. The AA was already ambitious, putting in place the framework for aligning Georgia’s institutions to those of the EU in several areas covering around 70 percent of the EU acquis (European Parliamentary Research Service, 2022). Five years into the implementation of the AA, around 50-60 percent of its requirements have been met. The country is doing relatively well in meeting the obligations for the banking sector, customs, public financial management, and the institutional infrastructure for agriculture and rural development. On paper, 98 percent of standards in Georgia are European or international; reforms in the digital area have gone beyond the requirements of the AA; the legal framework for important sectors are well on the way towards compliance with AA requirements (e.g., in energy, banking, insurance, food safety) or are being adjusted as planned (e.g., food safety, environment-related). However, there are areas where reforms have been slower. This includes judiciary reform, parts of the human rights agenda and aspects of the public administration reform. In addition, the official accession process is likely to put further focus on the implementation of the approximated legal framework, while also extending the approximation and alignment agenda to the additional areas covered by the acquis, including state aid, regulation of network infrastructure, etc. 30 CHARTING GEORGIA’S FUTURE Voice and accountability Political Stability and Absence of Violence / Terrorism 1.5 1.0 1.0 0.5 0.5 0.0 0.0 -0.5 -0.5 -1.0 EU-8 BGR/ROM HRV MNE/SRB Candidates GEO EU-8 BGR/ROM HRV MNE/SRB Candidates GEO at application at negotiation at member latest at application at negotiation at member latest Government e ectiveness Regulatory quality 1.0 1.5 0.5 0.5 0.5 0.0 0.0 -0.5 -0.5 EU-8 BGR/ROM HRV MNE/SRB Candidates GEO EU-8 BGR/ROM HRV MNE/SRB Candidates GEO at application at negotiation at member latest at application at negotiation at member latest Rule of law Control of corruption 1.0 0.8 0.8 0.6 0.6 0.4 0.4 0.2 0.2 0.0 0.0 -0.2 -0.2 -0.4 -0.4 -0.6 EU-8 BGR/ROM HRV MNE/SRB Candidates GEO EU-8 BGR/ROM HRV MNE/SRB Candidates GEO at application at negotiation at member latest at application at negotiation at member latest Source: World Bank, Worldwide Governance Indicators. CHARTING GEORGIA’S FUTURE 31 Whereas Georgia is well on track in terms of legislative processes, it still faces important challenges in actual implementation. A lot of the EU-related regulatory and institutional framework will eventually open more opportunities for Georgian businesses and provide more choice and better protection for Georgian customers. However, the transition will be difficult for many sectors. To start with, it adds additional regulatory requirements for a business sector that is wary of government involvement and for whom memories of rampant corruption are still not forgotten. New functions are being added and existing ones are being reformed. In addition, compliance with the legislation incurs additional costs. For example, the introduction of mandatory third-party liability insurance has been repeatedly delayed on the grounds of the costs that it will incur for households. Furthermore, EU standards (e.g., in food safety and energy efficiency) entail high costs for Georgian businesses and households, with relatively little clarity how will these be financed. Hence, in a few instances the Georgian authorities have prolonged the timeline for enforcing approximated legislation several times (European Parliamentary Research Service, 2022), while in other cases the regulation is not enforced or has been amended (not necessarily always in compliance with the AA). The EU integration will also likely alter Georgia’s trade policy and existing trade patterns. Certainly, trade volumes with the EU will grow. Restrictions on trade with EU members will increasingly be eliminated and trade patterns will gradually shift towards the EU, as local businesses increasingly implement the necessary standards. However, Georgia will increasingly need to trade with other countries (including some of its largest partners currently) under EU rules, which could pose a challenge for some of the existing trade flows, for example, imports and re-exports of vehicles that don’t meet EU homologation. In conclusion, Georgia’s EU accession provides an excellent opportunity for Georgia to continue its convergence with high-income economies, but the process will need to be carefully managed. The experiences of other countries point to the importance of political will to adopt, financial resources to implement and institutional capacity to enforce the EU requirements. Georgia’s current integration levels with the EU are limited, making the efforts and costs of approximation unpopular for many. On the other hand, closer alignment will open new opportunities. A gradual and carefully planned process will increase the chances of success. Importantly, it will be critical to ensure that the process of re-regulating economic activity doesn’t add excessive burden to businesses or create avenues for corruption. Additional requirements on businesses should be matched with support mechanisms to allow them to meet these requirements and access EU markets. New legislation needs to be accompanied with “regulatory impact assessments” (RIA), as well as adequate budgetary allocations. Reforms should be phased-in in line with existing capacity, while much stronger efforts need to be made to build institutions. This may mean a slower EU approximation compared to initial plans, but also one that would ensure businesses and households have sufficient support to adapt and ultimately reap the opportunities that emerge as part of the process. 32 CHARTING GEORGIA’S FUTURE Navigating global trends to ensure Global trend 1: Falling potential growth another successful decade globally Georgia’s trajectory in the next decade will not be Even before the pandemic, the global economy was shaped in a vacuum: the world is more uncertain than already experiencing a decade of declining potential ever and rapidly changing, with a few megatrends growth due to a combination of falling population promising both disruption as well as opportunity. growth and aging demographics, weak investment, Policy makers face the significant challenge of driving and slowing TFP growth.17 By 2019, growth in global a post-COVID recovery amid disruptions from the war potential output had fallen to 2.2 percent, well below its in Ukraine, while also grappling with falling potential annual average of 3.3 percent during the first decade of growth, rising debt, strains in global value chains, the the 2000s. This decline in potential growth was broad- changing nature of work, and climate change.16 These based, affecting three-quarters of countries, including trends have been taking shape during most of the two-thirds of emerging market and developing previous decade, but the combination of the pandemic economies (EMDEs) (Celik, Kose, & Ohnsorge, 2020). and the war has caused a few to accelerate, while Productivity growth fell by two-thirds in the ECA significantly increasing uncertainty (Figure 1). As a small region, the sharpest fall in any EMDE region, between open economy looking to increase its integration with the early 2000s and 2019 (Dieppe, ed. 2021); in Russia, the global economy, Georgia must carefully navigate for example, it has been close to zero in recent years, these trends by being well prepared for the risks and on whereas in Turkey, productivity growth fell by more than the lookout for emerging opportunities. half following the global financial crisis. Pre-pandemic Figure 1. World uncertainty index 60,000 Coronavirus US-China trade tensions, and Brexit 50,000 US presidential US fiscal cli and sovereign debt elections crisis in Europe 40,000 Iraq war and outbreak of SARS Sovereign debt crisis in Brexit Europe 30,000 Financial credit crunch US recession and 9/11 20,000 Gulf War I 10,000 FED tightening and political risk in Greece and Ukraine 0 1990q1 1993q3 1997q1 2000q3 2004q1 2007q3 2011q1 2014q3 2018q1 2021q3 Source: IMF Note: Computed by counting the percent of word “uncertain” (or its variant) in the Economist Intelligence Unit country reports. A higher number means higher uncertainty and vice versa. 16  This is not an exhaustive list of all challenges, but some that have the potential to be quite disruptive and re-shape the next decade. In addition, the world economy and Georgia, are facing spiraling trade costs and inflationary pressures that have not been seen for decade. While the prevailing consensus appears to be that these are expected to subside by 2022, prolonged disturbance cannot be ruled out. 17  Potential output is the level of output an economy can sustain at full capacity utilization and full employment. It is a function of labor, the capital stock, and total factor productivity, which is itself determined by technology and factor allocation efficiency. COMPETITIVE, CONNECTED, CAPABLE 33 trends in fundamental growth drivers suggested that The implications for Georgia could be significant, with annual average potential output growth would slow by risks but also potential new sources of growth. Lower 0.4 pp globally over the next decade (World Bank, 2021). growth in major trading partners will reduce external The pandemic may have further deepened the expected demand, remittances, and capital inflows. However, slowdown by an additional 0.3 pp per year (Figure 2), downturns are not recessions. Recessions are typically with losses concentrated among people who are already synchronous and affect most economic indicators. disadvantaged, making it harder for countries to return Performance during slowdowns is more mixed (Ayhan to inclusive growth after the shock recedes. & Ohnsorge, 2019), suggesting that opportunities for connected, capable and competitive economies will Figure 2. Estimated impact of the pandemic remain. Lower reliance on external savings can help on global potential growth (in percent) reduce vulnerability, and so can greater diversification. This report finds significant potential for Georgia to increase existing exports and to expand into new 3.5 products and services, as well as markets, for example, 3.0 in regions where productivity growth is expected to 2.5 remain robust (i.e., South and East Asia and the Pacific). 2.0 Demographic trends suggest Georgia’s potential growth may decline even faster than peers. To make up for this, Pre -COVID 1.5 Georgia will need to better utilize the existing labor force 1.0 (including to make up for the losses from COVID-19 0.5 disruptions to the education system delivery), as well as 0.0 boost productivity. 2000-09 2010-19 2020-29 Global trend 2: Rising debt levels Note: Aggregates of production function-based potential growth estimates calculated using real U.S. dollar GDP at 2010 prices and market exchange rates. Shaded area indicates The largest, fastest, and most broad-based increase pre-COVID baseline. Sample includes 30 advanced economies in global debt in five decades started in 2010, led and 50 EMDEs. by EMDEs. Total debt in EMDEs reached 176 percent of GDP in 2019, driven by private debt, which rose Periods of global economic downturns also make to 123 percent of GDP. The pandemic has provided trade and political tensions, geopolitical risks and a further burst of debt accumulation atop this trend, conflicts more likely. The war in Ukraine will exacerbate exacerbating debt-related risks as governments and the slowdown and undo much of the region’s recent firms borrowed heavily to mitigate the impact of progress at recovery from the pandemic. The immediate the pandemic. Among EMDEs, government debt is consequences of the war in Ukraine will all hurt growth estimated to have increased by 9 percent of GDP and include lowered exports of goods and services, in 2020, its largest increase since the debt crisis of increased inflation, as well as undermined investor the late 1980s (Figure 3). Private sector debt is also sentiment. But beyond this, existing global financial, trade estimated to have risen sharply as firms deal with the and transport arrangements could also be disrupted, fallout of the global recession. The rapid increase in which will further fuel uncertainty and undermine the debt is a concern, given how previous waves of debt longer-term outlook. Other hotspots in the broader ended – about one-half of more than 500 episodes of region could also flare up, as existing security and rapid sovereign and/or corporate debt accumulation in economic arrangements come under threat. That said, EMDEs since 1970 were associated with financial crises some opportunities may also open, including in making (Figure 4) (Kose, Nagle, Ohnsorge, & Sugawara, 2021). Georgia a more attractive destination for companies moving operations from affected countries and making Risks from high debt in many countries have been the region a more competitive transport route for the mitigated by low borrowing costs, but rising global Europe and China trade. interest rates may reveal vulnerabilities among EMDEs. 34 CHARTING GEORGIA’S FUTURE Figure 3. Government debt Figure 4. Debt accumulation ending in crises In percent of GDP In percent 150 60 100 40 50 20 0 0 Government Private debt Total debt 1970 1980 1990 2000 2010 2020 debt World Advanced economies EMDEs EMDEs = emerging market and developing economies. Financial crises as defined by Laeven and Valencia (2020).18 Aggregates are calculated using current GDP in U.S. dollars as Sample includes 267 episodes of government debt and 280 weights. Data for 2020 are estimates. episodes of private debt in 100 EMDEs over 1970-2019. On a global level, borrowing costs have been trending Global trend 3: Strains in Global Value up as inflation picks up and central banks around the Chains and growing importance of services world, including in Georgia’s neighborhood, have tightened monetary policy. Combined with elevated Greater participation in global value chains (GVCs) is geopolitical uncertainty, this has contributed to financial associated with a host of positive economic outcomes. market volatility, with capital outflows and currency Firms participating in GVCs show significant gains in depreciation in some EMDEs. Against this background, productivity—a 1 percent increase in GVC participation many borrowers would struggle to finance fiscal and is estimated to boost per capita income by more than 1 current account deficits if investor sentiments were to percent, five times the gain from standard trade (World deteriorate suddenly. Underdeveloped capital markets Bank, 2020b). GVCs are also linked to employment in many EMDEs pose risks to financing in the event growth and reduced poverty. However, even before the of tightening in global financial conditions (IOSCO, spread of the pandemic, the growth of GVCs had already 2020), given that investor appetite for EMDE debt slowed. GVCs’ share of global trade peaked at just over has proved sensitive to perceptions of risk, domestic 50 percent prior to the global financial crisis and slipped inflation pressures, and the return on safe assets. thereafter as trade liberalization efforts stalled (Figure Globally, bankruptcies are rising as credit conditions 5). GVCs were further strained by international trade tighten, which is likely to result in substantial credit tensions, disruptions from the pandemic and associated losses that will need to be absorbed (Banerjee, Cornelli, lockdown measures, and most recently, the war in & Zakrajsek, 2020). Georgia’s debt levels appear Ukraine and associated sanctions. sustainable under most plausible scenarios; however, balance sheets are somewhat stretched and exposed The desire of companies to increase the reliability of to risk due to large foreign currency liability exposure. their supply chains can lead to a reconfiguration of Rebuilding buffers will be key for preparedness, while the existing GVCs. Repeated negative shocks could progress on developing domestic capital markets and lead companies to consider reshoring of operations. de-dollarization can further help.18 However, previous experience suggests that GVCs are typically more reshaped, rather than reshored, with 18  An episode of rapid debt accumulation is defined as a period during which the debt-to-GDP ratio rises from trough to peak by more than one (country-specific) ten-year rolling standard deviation. The trough-peak years are identified with the algorithm in Harding and Pagan (2002). COMPETITIVE, CONNECTED, CAPABLE 35 companies looking to increase the geographic diversity tradeable, prone to innovation and with strong spillovers of inputs, and therefore the robustness of their supply to other parts of the economy (Nayyar, Hallward- network. In other words, despite the additional costs, Driemeier, & Davies, 2021). Services also have important the case for international trade, through differences in complementarities for the manufacturing sector, with comparative advantage, specialization, and economies manufacturing activities receiving additional value- of scale, remains strong. Georgia has struggled to added by embedding services, such as customization or integrate in GVCs, despite its trade openness and good servicing (Ariu, Breinlich, Corcos, & Mion, 2019). Despite business environment, and the reshaping of GVCs continued weakness in global tourism, global services provides an opportunity to catch up. When considering trade has surpassed its pre-pandemic level, led by potential locations to invest, the large multinationals strong activity in the telecommunication and financial that form the backbone of most value chains place a sectors. The widespread normalization of teleworking high premium on a predictable and efficient legal and and advances in telecommunications may make it easier regulatory environment, a skilled workforce, low taxes, for firms to outsource and coordinate complex activities and a level of quality of physical infrastructure (World at a distance, opening more sectors to international Bank, 2020c) that would enable a seamless integration competition. of new locations in their supply chains. While Georgia boasts competitive business conditions, its attractiveness Georgia has shared in this growth in a narrow way and may be undermined by considerable informality of can capitalize on the emerging opportunities. Georgia’s the labor force, shortages of skilled workers, high trade in services has grown strongly, but largely due to transport costs and limited logistics offerings. The EU the growth in tourism, and mostly in the low value- accession process has the potential to make Georgia added segments of the value chain. In addition, while more attractive to foreign investors even during the services accounted for 70 percent of export value added negotiations stage, in line with the experience of current in Georgia, Georgia’s services are characterized by one candidate countries (e.g., Serbia, North Macedonia). of the shallowest linkages with other sectors (both with other services sectors and with manufacturing). Over the previous decade, global services trade grew At the same time, some potentially tradeable services nearly twice as rapidly as trade in goods, and now (finance, education, digital) have a much higher share accounts for nearly one quarter of global trade (Figure in employment compared to their share in exports, 6). Importantly, services increasingly share the same suggesting that with the right policy and institutional attributes that made manufacturing a potent force of support, there are opportunities not only for more structural transformation in a number of developing services to be exported, but also for services to improve countries, i.e., services are increasingly scalable and the competitiveness of the rest of the economy. Figure 5. Global value chains Figure 6. Exports of goods and services growth As a share of global trade 2010-2019, in percent 55 6 100 50 80 4 45 60 40 40 2 35 20 30 0 0 1970 1975 1980 1985 1990 1995 2000 2005 2010 2015 Goods Services Annual growth rate Share of total trade (RHS) Source: Word Development Report 2020. Source: Word Development Report 2020. 36 CHARTING GEORGIA’S FUTURE Global trend 4: The changing nature of work Georgia’s economy is increasingly being digitized; however, businesses and households remain at risk of The role of digital technologies in the workplace being excluded from new opportunities or displaced has been steadily increasing (World Bank 2019), by technologies. At the macro level, ICT investments generating opportunities for developing countries but have strong spillovers into demand and jobs. One million also carrying risks. Digital technologies allow firms to lari of additional demand for the ICT sector was found reach a wide range of people quickly and to scale up to generate lari 1.45 million in revenues and lari 450,000 operations to a global level far more rapidly than had of investment in the economy, while creating 22 full- previously been possible. The accelerated adoption time-equivalent jobs (ISET, 2020). In addition, strong of digital services caused by the pandemic could help backward and forward linkages suggest a broad-based increase the returns to investing in human capital and effect of digitization. However, the widespread adoption bolster future productivity growth. But technologies of basic ICT tools (e.g., computers and Internet) across also carry risks. Alongside shifting globalization patterns, Georgian companies has not been accompanied with changing technologies (i.e., advanced robotics, the uptake of more sophisticated technologies, such industrial automation, and 3-D printing) have brought as e-commerce, electronic invoicing or other software the feasibility of manufacturing-led development (Figure 8). Without upgrading, the Georgian economy into question (Hallward-Driemeier & Nayyar, 2018). could remain concentrated in the production of low- For developing countries like Georgia, competing in tech, labor-intensive, commodity-based tradeable the global economy now requires much more than goods, sold to small, regional markets at low margins. low labor costs. In fact, automation is threatening to On the jobs side, the immediate pressures from significantly alter jobs and make some occupations automation are less acute, as Georgia appears to obsolete. The benefits and risks of digitization became have a smaller share of its employment in professions especially visible during the pandemic, as it helped many that are more easily automated (Figure 7). Still, even individuals avoid some of the economic consequences basic occupations are becoming more demanding, of the pandemic through telework or distance education. especially in requiring digital skills, something that However, those without access to the internet or the many Georgians are lacking. A digital agenda that will skills needed to leverage digital technologies have been target skills development, address access and quality less fortunate. Moreover, the longer-term impacts of gaps, and facilitate digital technology adoption can disruptions to schooling are likely to particularly affect ensure that most Georgians benefit from the digital those populations with limited access to the internet or transformation. The Thematic Spotlight 1 of Chapter 1 personal computers. elaborates this further. Figure 7. Risk of automation Figure 8. ICT use by businesses In percent of jobs In percent of firms ARM Accessing and using the internet Internet connection of GEO 100Mbps+ speed MKD Using a webservice Receiving orders via web MDA page 0% 20% 40% 60% 80% 100% 0 50 100 High Medium Low EU27 GEO Source: World Bank analysis based on STEP Source: Geostat 2019; Eurostat 2019. Note: High risk of automation: probability > 70%; medium risk: Note: Numbers are not fully comparable: for Georgia all firms 30% - 70% probability; low risk: probability < 30%. with workers; for EU firms with more than 10 employees. COMPETITIVE, CONNECTED, CAPABLE 37 Global trend 5: Climate change and the commitments under the Nationally Determined energy transition. Contributions (NDCs). Meeting the baseline NDC target (35 percent reduction from 1990 level by 2030) will Climate change is increasingly disrupting both require that the recent improvements in decoupling of ecosystems and economies. The effects of a changing economic activity from emissions are sustained (Figure climate could push between 68 and 132 million people 9); the more ambitious scenario would, however, into poverty within the decade, adding to the toll from require a considerable adjustment. Presently, Georgia is the pandemic and slowing potential growth (World exposed to the impacts of climate change, especially its Bank, 2020f). Many categories of extreme events are agriculture sector.19 Given the large share of agriculture becoming more frequent, with the poor suffering in the economy, it will be key to make the sector climate- disproportionately from changes in agricultural and smart. Climate resilience in other sectors should also be fishing yields, on which their livelihoods predominantly supported. Investing in green infrastructure projects, depend. offering incentives for environmentally sustainable technologies and tightening energy efficiency standards Reducing carbon emissions will require the world to can buttress long-term growth and help adapt the shift from a reliance on fossil fuels toward greater use economy to the effects of climate change. As a metal of renewable energy. Global efforts at both climate exporter and energy importer, Georgia could benefit change mitigation and adaptation are critical and will from the ongoing energy transition and should explore remain so for a long period to come. Many countries and the potential for environmentally friendly mining or companies have announced commitments to achieve producing metals and other goods with low-carbon zero-carbon by 2050. This transition now extends intensity via the use of renewable energy, such as beyond the energy sector to other sectors, including hydroelectricity. A low-emission model would allow the agriculture, industry, and transportation, which will also country to take advantage of the growing market for need to reduce emissions. The energy transition will emissions-free or low-carbon products. have significant implications for the demand for different commodities, including reduced demand for fossil fuels, There are significant opportunities to make Georgia’s particularly coal, and increased demand for the metals enterprise sector “greener.” Energy efficient companies and minerals required for renewable energy generation. are more productive, and the potential gains from Low-carbon technology is typically significantly more improving efficiency are substantial (Figure 10). However, metals-intensive than fossil fuel energy. Solar-generated the awareness of companies about the need to increase electricity, for example, requires twice as much copper energy efficiency is very low. Energy efficiency can as natural gas, and wind requires three times as much be improved by: i) strengthening the reliability of the (World Bank, 2017). The same is true for electric vehicles electricity network; ii) providing the right incentives (e.g., (EVs). A traditional internal combustion engine car uses energy prices that are fully reflective of costs, as well around 20kg of copper, while EVs require more than four as programs to support businesses make the required times as much. The requirement is even larger when investments); iii) implementing the energy efficiency factoring in charging infrastructure, which also requires package adopted in 2020 (standards, labeling, etc.); significant amounts of copper for wiring. The transition and iv) encouraging investments in renewable energy will also significantly alter the trade environment, as self-generation. Building green objectives into the countries increasingly tax emissions at the border. various business support packages will increase firms’ resilience to future shocks. The EU’s proposed carbon Georgia should prepare better for the climate change border adjustment mechanism (CBAM), which would while exploring opportunities that the energy levy a charge at the border proportionate to the carbon transition may offer. Carbon use is low in absolute terms emitted in the production of imported goods, raises the (per capita) in Georgia, though less so when adjusted importance of these interventions. Chapter 1’s Thematic for productivity. Still, the country has made significant Spotlight 2 discusses these issues in more detail. 19  Notre-Dame Global Adaptation Initiative. Rank close to 1 is better (less vulnerable). Georgia’s eco-systems are especially vulnerable (rank 112), followed by infrastructure (114) and human habitats (101). On the other hand, the vulnerability on food, water and health is relatively low. 38 CHARTING GEORGIA’S FUTURE Figure 9. Energy and emission intensity Figure 10. Simulating improved energy 2010=100 e ciency (in lari) Energy consumption Total costs Value added +11% 200 -2% 150 1,088 -63% 100 34,360 33,673 6,150 6,837 401 50 2010 2011 2012 2013 2014 2015 2016 2017 2018 2019 Actual Simulated Actual Simulated Actual Simulated TES/GDP CO2/TES CO2 emmissions GDP Source: Sta calculations based on IEA data. Source: World Bank’s calculations based on GeoStat. Note: TES is total energy supply in TJ. Note: simulation involves increasing energy e ciency of firms below median to the median of the sector. Synopsis In a more uncertain and changing world, Georgia’s Encouragingly, in many ways, Georgia, will have to do authorities need to steer the economy towards what it was doing before (i.e., continue to strengthen sustaining pre-COVID growth rates, while also economic management, improve governance, and improving the quality of growth and allowing invest in infrastructure) as noted in the Georgia people to access better-paying jobs. The challenges Systematic Country Diagnostic (World Bank Group, to this are centered around the need to facilitate 2018). However, the agenda to make businesses more the structural transformation and the accompanying competitive so that they can create more and better spatial adjustment; improve firm-level productivity, paid jobs; workers capable and more mobile; and the especially in sectors that have historically country better connected internally and externally is underperformed; strengthen connectivity (within significant. The remainder of this Overview presents Georgia and beyond national borders); and improve summaries of the chapters, including the analytical labor market outcomes. findings and policy recommendations. 1 CHAPTER EXECUTIVE SUMMARY 39 Understanding Georgia’s growth 40 CHARTING GEORGIA’S FUTURE G eorgia has set itself an objective to progress in unemployment and poverty reduction become a European state, with an was more modest, strong domestic demand pushed economy that resembles those of EU down national savings, and firm-level productivity was members.20 Assessed against the metrics largely stagnant. The reports recommended more that underpinned Europe’s economic successes savings, reforms to boost productivity and improve (integration; innovation; responsible governments; export performance, as well as sector-specific reforms productive workers; etc. (Gill & Raiser, 2012)), Georgia (apparel, wine production) to unlock the potential of the has plenty to build upon, but also opportunities to economy. improve. On one hand, many of Georgia’s institutions do provide a robust starting point, with low corruption, Since then, and until the COVID-19 pandemic, an investment climate that puts a light burden on Georgia’s economy continued to perform remarkably businesses, responsible economic management, and and addressed many constraints, even as some reasonable integration in some respects. However, persisted and new ones emerged. GDP growth trade integration is limited, firms’ capabilities are low, rates remained robust, investment had moderated and labor is unproductive and, to a significant degree, but remained relatively high, savings improved, and informal. In fact, if it were to join the EU today, Georgia economy wide TFP, after going through a slump during would be the poorest economy in the bloc, with income 2014-15 due to external shocks, had recovered, as levels half of that of the poorest EU-member and less structural transformation picked up pace. On the other than 15 percent of the EU average. hand, savings still fell short of investments, external debt increased, firm productivity did not improve, skills When the previous growth reports for Georgia were became an even more acute problem for businesses, produced in 2013 and 2014, Georgia was reforming and and the integration of the country in regional and global growing rapidly, but had limited success in creating jobs value chains remained underwhelming. Consequently, and growing macroeconomic imbalances. GDP growth while the Georgian economy generated strong growth, averaged 6 percent per annum since the 2003 Rose it continued to perform less well in the net creation of Revolution, as the private sector responded to the rapid well-paying jobs. More polarized domestic politics and and far-reaching reforms that kept TFP (at the macro geo-politics also affected Georgia’s economy, while a level) and gross capital formation strong. However, few potentially disruptive global trends (climate change, 20  Government of Georgia: Program for 2021 – 2024; “Towards Building a European State”, February 2021. COMPETITIVE, CONNECTED, CAPABLE 41 digitization, etc.) became increasingly visible. An domestic and foreign). Investment activity took a hit increasing old-age dependency ratio will progressively during COVID and has not recovered so far, with the be a constraint – among 51 UMICs, Georgia had the investment rate falling to 22 percent of GDP in 2021. fifteenth highest dependence ratio in 2018 and is Gross national savings increased from 9 percent of projected to have the tenth highest by 2050. GDP in 2010 to around 20 percent of GDP prior to COVID-19, before plummeting during the pandemic The pandemic dealt a strong blow to the economy, and significantly widening the investment - savings but also demonstrated the maturity of its economic imbalance. While the public sector savings were positive institutions. Output contracted by 6.8 percent, one of during 2010-2019 (though adding SOEs will lower the largest contractions in ECA, also due to a relatively public savings), the improvement in gross national large share of services in output, including tourism. savings prior to the pandemic appears to have been Still, a large (around 6-7 percent of GDP) and timely driven by the household sector. Even so, household policy response limited the impact on living conditions savings were below levels seen in aspirational peers.21 and facilitated a robust rebound in 2021, with output A corporate sector that posted relatively low profits and expanding by 10.4 percent. However, labor market and actually registered losses in five years between 2010- human capital losses will probably take a bit more time 2020 didn’t contribute to savings. The mirror image of to recover, with the unemployment rate still above pre- a sizeable investment - savings gap is a relatively high COVID levels. In addition, investment levels remain current account deficit, which averaged around 10 below pre-pandemic levels. percent of GDP over the last decade (though with a marked improvement in the few years just prior to the The rest of this section reviews Georgia’s growth pandemic). A large current account deficit and a volatile performance through a few lenses to identify drivers exchange rate of the lari has kept the gross external debt of growth, opportunities to build on Georgia’s many of Georgia above 100 percent of GDP since 2015; this accomplishments, as well as emerging challenges despite significant inflows of foreign direct investment to growth. The investment – savings analysis aims (FDI). to identify macroeconomic concerns; the structural transformation deep-dive examines to what degree Georgia’s debt levels appear sustainable under most growth has transformed the economy; and finally, the plausible scenarios, but balance sheets are stretched growth accounting framework is applied to ascertain the and exposed to risk due to large foreign currency contribution of the various factor inputs and productivity liability exposure. Georgia’s public debt, at around 50 to growth. In doing so, the analyses set the stage for the percent of GDP at end-2021, is below the EMDE average discussions in the following chapters. but has risen around 10 pp of GDP compared to pre- COVID levels. Similarly, households and corporate debt An investment - savings gap has resulted in have increased. On the corporate side, the leverage higher external debt ratio (liabilities / equity and reserves) for the non- financial corporate sector increased from around one While Georgia doesn’t necessarily have a low in 2013 to 1.4 by 202022 and corporate debt exceeded investment problem, it saved relatively less, translating 50 percent of GDP in 2020. On the household side, into higher external debt levels. Investment levels, at by end-2020, loans to households from the banking around 27 percent of GDP on average between 2015 - sector were 60 percent of their disposable income, 2019, exceeded most aspirational and structural peers, compared to 31 percent in 2013.23 A key vulnerability reflecting strong public sector investment activity and stems from the fact that debt (both private and public) also a robust response from the private sector (both is largely denominated in foreign currencies. In 2019, 21  A fully comparable dataset is not available, but based on data from Geostat, savings of Georgian households (income minus consumption expenses) reached around 10 percent of disposable income only in the last few years and averaged less than five percent between 2010-2020. Eurostat and OECD data put these averages around 8 percent for Czech Republic and Hungary, 14 percent for Mexico, 10 percent for Chile, 6 percent in Russia. 22  GEOSTAT, Financial Soundness Indicators on Non-Financial Corporations. However, there is a lot of volatility in the indicator. 23  NBG, Financial Soundness Indicators for client sectors. Still, as incomes increased also, debt service deteriorated only slightly. 42 CHARTING GEORGIA’S FUTURE Figure 11. Gross capital formation Figure 12. Gross national savings In percent of GDP 40 40 30 30 20 20 10 10 0 0 2010 2011 2012 2013 2014 2015 2016 2017 2018 2019 2020 2010 2011 2012 2013 2014 2015 2016 2017 2018 2019 2020 GEO ECA UMIC GEO ECA UMIC Source: World Development Indicators. three-quarters of Georgia’s government debt and 95 Manufacturing is probably where Georgia’s structural percent of the country’s external private sector debt transformation is least visible; despite strong growth, its was denominated in foreign currency, which increases contribution to GDP remains under 10 percent, below vulnerability to currency depreciation. On one hand, this what would be expected given income level. risk is mitigated partially by the fact that the country’s refinancing needs over the next few years are expected In this process, Georgia’s economy is becoming more to be limited; on the other, the Georgian lari has been productive. Structural change, that is, the reallocation of one of the more volatile currencies in the region. labor from less productive to more productive sectors, contributed, on average, 2.4 pp to GDP growth during Structural transformation is making the the past decade (Figure 13). In other words, almost half economy more productive, but remains of the total growth in GDP per capita came from workers incomplete moving from agriculture towards services, and to some extent into manufacturing. Within-sector growth in Georgia’s economy is undergoing a structural output per worker contributed, on average, 2 pp to GDP transformation. The share of agriculture in GDP has per capita growth over the last decade, mostly from been on a gradual but persistent decline, with the sector growth in labor productivity of the services sectors, contributing around 7-8 percent of GDP in recent years, followed by agriculture, then manufacturing. While similar to peers in the region. Employment in agriculture within-sector growth in value added per worker has peaked much later compared to peers and, despite been robust, it falls short of the contribution of within- declining relatively fast in recent years, remains large at sector productivity in ECA over the last two and a half 19 percent of total employment.24 Services are the largest decades. In addition, based on firm-level data, analysis sector of the economy, though their expansion appears done as part of this report shows that growth in output to have plateaued over the last decade. Compared to per worker in a relatively large sample of non-agriculture other UMICs, Georgia’s economy is more reliant on firms25 was driven largely by capital deepening, rather services for value-added, but less for employment. than more efficient use of inputs, keeping firm-level 24  The 19 percent of total employment is calculated based on new methodology, but is close to 40 percent according to the old methodology, which is more comparable to peers. 25  There should be some caution in interpreting the firm-level data to be representative of the entire economy. The initial sample of firms was from Geostat’s Business Statistics survey which covers most larger companies and a sample of smaller companies in manufacturing, construction, and some services sectors. Further entries were lost due to insufficient data to compute TFP. See Chapter 3 for details. COMPETITIVE, CONNECTED, CAPABLE 43 Figure 13. Labor productivity decomposition Figure 14. Di erences in value added per worker 6 40.000 % Yearly Contribution to Inter-sectoral, Services 5 Inter-sectoral, Industry lari per person 4 30.000 3 Growth Inter-sectoral, Agriculture 2 20.000 1 Within, Services 0 Within, Industry 10.000 -1 Within, Agriculture -2 0 2010-2019 Agriculture Industry Services Total=4.5% 2010 2019 Source: World Bank sta based on Geostat data. Source: World Bank sta based on Geostat data. TFP performance weak (Chapter 3 on firm productivity). driven by the ongoing structural transformation away Similarly, agriculture yields have not improved markedly from agriculture, as among non-agriculture firms, based over the last decade (see Box 2 of Chapter 1). on firm-level data, TFP in 2019 was 6.7 percent below its 2007 level (see Chapter 3 on firm performance). Despite While advancing, Georgia’s structural—and associated an improving employment rate during this period, the spatial—transformation remains incomplete. This shrinking labor force meant that the contribution of means that many Georgians remain in rural areas and the stock of labor to growth was negligible (0.6 pp, or engaged in low productivity agriculture.26 Many of these 14 percent), while the small gains in the human capital workers have to rely on transfers and irregular off-farm per labor added around 9 percent of the observed GDP jobs or migration to make a living. This is also because growth (0.4 pp). urban areas have not provided the necessary dynamism to absorb more of the agriculture labor – in fact, most secondary cities have shrunk over time, while the Figure 15. Growth accounting results economic pull of Tbilisi and Batumi is somewhat smaller compared to major urban areas in other countries (see 6 Chapter 2 on spatial transformation). 5 4 54% 46% 33% Capital accumulation drove growth, with 3 14% 31% TFP gains coming largely from structural 2 10% 13% 9% 14% transformation 1 8% 85% 43% 28% 44% -2% 0 Capital accumulation and TFP drove Georgia’s growth -31% -1 between 2010-2019. Capital accumulation explained 44 -2 percent of total growth. In other words, 2 pp of the 4.6 2010-2013 2014-2016 2017-2019 2010-2019 percent GDP growth during 2010-2019 was generated by investment (Figure 15). TFP accounted for one third of TFP HC / labor Labor Capital stock output growth (equivalent to 1.5 pp of GDP growth per annum). This strong TFP growth appears to have been Source: World Bank sta based on Geostat data. 26  Defined here as low overall value added per worker and not considering actual time worked (Fuglie et al, 2020) – indeed, the issue for agricultural work in Georgia may be more about underemployment than low productivity per se. 44 CHARTING GEORGIA’S FUTURE An agenda for strong and sustained growth higher savings to be able to finance the investments would require … without raising debt sustainability issues. Georgia’s development needs are substantial: households need to Under a business-as-usual scenario, potential growth invest in improving their living conditions and to build up is likely to slow, as gains from structural transformation their assets; firms need to invest to improve productivity; are exhausted, macroeconomic constraints limit and the public sector needs to invest to close gaps in investment and demographics takes a toll, but these access to quality public services. These investments headwinds can be offset. In this scenario, investment, will need to be matched by higher savings by the a key driver of past growth, will need to moderate to government and households and a more profitable reduce the reliance on external savings and reduce the corporate sector. Global evidence that higher old age current account deficit. Alternatively, savings would dependency negatively impacts the private saving rate need to be increased and maintained at levels that (Loayza, Schmiddt-Hebbel, & Serven, 2000) together Georgia has achieved only for a few years before the with Georgia’s demographics further strengthens the pandemic. At the same time, TFP, another important case for policies to promote savings. source of growth, will slow, as the gains from structural transformation gradually fade and as an aging population In the public sector, buffers need to be restored, further depresses potential growth. On the other hand, while monitoring and managing of fiscal risks should higher savings, more active and better educated labor improve. Georgia’s fiscal rule is robust and will see and unlocking the productivity potential of Georgian a gradual restoration of fiscal buffers. Still, with a firms can still deliver sustainable and strong growth strong recovery from the pandemic underway, it may (Figure 16). be prudent to consider a faster fiscal adjustment. Some ease in spending pressures may arise with the unwinding of COVID-19 mitigation measures, but Figure 16. Long-term growth further opportunities to reevaluate fiscal policies In percent are available. For example, government revenues can benefit from the review of select tax policy 6.0% and administration issues, such as the threshold for simplified regime, vehicle taxation and energy 4.0% pricing. In addition, with spending pressures on the rise, spending should be carefully reviewed for 2.0% opportunities to improve efficiency and better target to priorities. Improved prioritization of properly- 0.0% appraised public investment projects, better targeted 2023 2025 2027 2029 2031 2033 2035 2037 2039 2041 2043 2045 2047 2049 support programs for businesses, and making better use of big-data (for example, in public procurement), Baseline Scenario can produce considerable gains. In addition, the ability to monitor fiscal risks from off-budget activities is likely Source: WB. to become increasingly important as Georgia starts to Note: In the baseline TFP declines to 0.5 percent by 2040, human capital declines by 0.01 percent annual, labor market rely more on complex private-public engagements in participation stays constant; under Scenario, TFP declines to service delivery. Georgia has made good progress in 1.5 percent by 2040, labor force participation and human this area in recent years, but further efforts are needed capital increase to high-income levels. to manage contingent liabilities, including by reforming SOEs, scrutinizing various public-private arrangements, … restoring investment and increasing as well as understanding climate and disaster risks. savings … Household savings need to increase. Too few Georgian Going forward, Georgia will need to reverse the households save, due in part to the paucity of good recent decline in investment rates, and will also need jobs in the economy, but also the lack of diversity of COMPETITIVE, CONNECTED, CAPABLE 45 savings options. Economic growth and job creation Georgia’s spatial economy will also need to adjust. That will help private savings – that is what happened prior would mean less, but more productive jobs in the rural to the pandemic; however, saving rates need to exceed economy, more jobs in the urban economy (mostly in pre-pandemic averages. Pension reform is helping Tbilisi, but also in a few of Georgia’s secondary cities), to increase savings, and additional savings could be and certain other areas that would not be economically mobilized through instruments like unemployment viable. While growth will be unbalanced by nature, and disability insurance or life insurance products. it can still be inclusive (World Bank, 2009). This will Improving financial literacy, especially regarding the require policies that facilitate orderly concentration importance of decisions with longer-term implications (agglomeration, urbanization, migration) and equalize (education, health) can also help. In addition, anecdotal opportunities for everyone through economic evidence suggests that people save by purchasing real integration (providing basic services, connective estate or jewelry. Maintaining financial sector stability infrastructure). and reforming tax policies (increased taxation of second home, unused land, and luxury goods) may help channel … making the most of the available human these alternative savings into the financial sector. capital … Finally, the National Bank of Georgia’s (NBG) prudential measures, while avoiding buildup of risks in households Going forward, sustaining growth will require a larger that are unable to service debt, can also help savings. contribution from Georgia’s labor force. High inactivity Already over-indebted households could benefit from and unemployment rates mean that more than 30 the introduction of a personal insolvency framework percent of the labor force is not actively contributing—a that would allow for speedy resolution and provisions high price to pay for any country. It will be important to that adequately balance the availability of second increase female labor force participation (by changing chances for individuals on one hand, with creditor rights social norms, providing more child and elderly care on the other. opportunities, tackling discrimination); reintegrate more of the discouraged and long-term unemployed (around … facilitating the structural and spatial a quarter of Georgians who did not work cited “gave transformation … up looking for work” as the reason (UN Women, 2018)) and the recipients of social assistance programs and Large sector differences in output per worker and other transfers. In addition, the quality of human capital persistence of a high share of the labor force in should be addressed. A child born in Georgia today will agriculture suggest that the potential for structural be 57 percent as productive as his/her full education transformation is not fully exploited. Labor in and health potential. While this is in line with countries manufacturing and services produces around seven at similar levels of development, it is below the ECA times more output compared to agriculture (Figure 14). average (excluding high-income countries) (63 percent), This means that further shifting of labor resources from and the EU average (74 percent). agriculture will be productivity enhancing, given that around 19 percent of the labor force are still engaged in Two priority areas are likely to be relevant to improve agriculture, generating only around 7-8 percent of value the quality of the labor force. First, given identified added. On one hand, agriculture needs to become more shortcomings in foundational skills, Georgia is well- productive, so that the remaining farmers can have better advised to invest more in lower education levels to close livelihoods. On the other hand, the rest of the economy access gaps in early education and build core skills in will also need to increase productivity to generate the general education system. Second, to increase the wage differential needed to attract workers away participation and facilitate the school-to-job transition, from the agriculture sector. Addressing the structural greater focus should be put on vocational education and bottlenecks to productivity growth in agriculture and training (VET) (OECD, 2019). Beyond skills, labor market the rest of the economy, as well as constraints to labor intermediaries should be strengthened to facilitate and capital mobility and connectivity, will facilitate the efficient matching of workers and jobs. In our estimates, transformation. increasing labor force participation and improving skills 46 CHARTING GEORGIA’S FUTURE can add around 0.4 percentage points to GDP per activity. Against these metrics, Georgia has already laid capita growth over the long term. This is likely to be an strong foundations upon which to build, but a significant underestimate, as improved skills are also embedded in agenda remains. a strong TFP contribution. Chapter 5 of this report looks in greater details at the agenda for addressing the skills • Georgia’s institutions are increasingly capable shortage and making the labor market more efficient of delivering stability, but dollarization is a and inclusive. vulnerability. Georgia’s macroeconomic framework – fiscal policy underpinned by a robust fiscal rule, There are additional gains to be achieved from inflation-targeting monetary policy, a flexible improvements in other aspects of human capital. exchange rate and a financial sector increasingly Improving human capital will also require improving regulated in line with good practice – has helped financial access to health services (out of pocket it to grow and to adjust to shocks. However, this payments are still exceptionally high despite recent was accompanied by significant exchange rate declines), reducing stunting (which can still be observed volatility, in many instances triggered by non- in 6 percent of children) and promoting healthier economic events and amplified by a shallow foreign lifestyles (Georgians face among the highest incidence exchange market. The volatility keeps dollarization of non-communicable diseases in ECA due to high high, contributes to price volatility and is a pressing prevalence of tobacco and alcohol consumption and constraint reported by businesses. There has been unhealthy diets). some progress in de-dollarizing the economy, but exposures remain large and mostly unhedged. … and sustaining productivity gains Georgia’s policies to promote de-dollarization are in line with good practice and will bring results over Sustaining productivity growth will be critical. While time. In the interim, authorities could more actively the move away from agriculture can keep on delivering communicate information on factors affecting for Georgia, over time, its potency in driving productivity the exchange rate and help delink exchange rate gains will decline as the number of workers in agriculture expectations from non-economic trends. falls and the remaining ones are unlikely to have the age profile and skill set required in the non-farm economy. • While access to basic services is improving, quality Hence, it will be critical to increase efficiency across the of services also needs to improve. Georgian board, meaning higher yields per hectare in agriculture institutions are doing a fairly good job at providing and more output per labor and capital in manufacturing access to services. For example, years spent in and services. As mentioned earlier, on this metric, school and access to some services (electricity, the performance of Georgian firms has been more water) are closer to EU-11 levels rather than mediocre. Several stylized facts have been associated structural and income peers (CIS and Western with increased productivity (see (Dieppe, ed. 2021) for Balkans). However, gaps are larger on a few services, an extensive discussion), including “proximate sources”, such a road connectivity or sewage. In addition, the mostly related to the quality of factors of production quality of services, which has been shown to be an (capital and labor), within a “supportive environment” enabler of productivity growth, lags. For instance, (institutions, cross-border integration, social conditions, many Georgians fail to learn much in the education urbanization) which nurtures “firm-level capabilities” system, Georgian firms report more frequent (innovation, management). The rest of this section electricity outages compared to peers, and twice focuses on institutions, with firm capabilities, labor, more water is lost compared to what is supplied urbanization and integration being discussed in to customers. Some of these issues are due to subsequent section. underfunding, but inattention towards results and lack of accountability in spending decisions also (Gill, Izvorski, van Eeghen, & De Rosa, 2014) define play a role. Linking spending to performance and “institutions” as the mechanisms to ensure stability, strengthening accountability and efficiency across deliver quality public services and regulate business the public sector will improve quality of services, COMPETITIVE, CONNECTED, CAPABLE 47 Figure 17. Access to and quality of roads Figure 18. Access to and quality of education Score, on a scale from 0-100, high value is better Score, on a scale from 0-100, high value is better 100 100 80 80 60 60 40 40 20 20 0 0 Road connectivity Quality of roads School life Skills of current index expectancy workforce GEO EU-11 WB CIS GEO EU-11 WB CIS Source: WEF GCR 2019. Source: WEF GCR 2019. supporting both productivity as well as savings. much lower in Georgia than in ECA and globally; Reforming SOEs is also part of this agenda, including regulations take less time to complete; goods flow through introducing key performance indicators and faster through Georgian borders; and government transparent incentive systems for SOE management effectiveness is at par with the ECA average (and that are linked to SOE productivity. above UMIC). However, Georgian institutions may be doing a relatively weaker job in ensuring a level • When it comes to regulating economic activity, playing field, due in part to informality and to the Georgian institutions have come a long way but slow pace at which its ability to ensure competitive can do a better job at leveling the playing field. markets is evolving. The anchor provided by the EU Supportive institutions provide a light administrative DCFTA has the potential to further strengthen the and regulatory burden while being able to control ability of Georgia’s institutions to level the playing corruption. Bribery incidence and depth are field. 2 CHAPTER 48 CHARTING GEORGIA’S FUTURE Spatial transformation COMPETITIVE, CONNECTED, CAPABLE 49 Georgia’s spatial transformation translates into continued high levels of poverty in rural areas. The second concern relates to the large disparities is proceeding in parallel to its in economic activity and socio-economic outcomes structural transformation across regions and between Tbilisi, secondary urban and G rural areas. This is typically articulated by policymakers eorgia’s structural transformation has as a desire to spread out economic activity from Tbilisi also altered its spatial trends. There is to other parts of the country. It is worth noting that now greater concentration of people in addressing the first concern of low productivity would the largest cities, while the population of not necessarily address the second concern of regional rural and smaller cities has declined. Following a period disparities. Indeed, in the short term at least, it may of de-urbanization in the 1990s, a consequence of the exacerbate it. civil strife and the difficult economic transition, Georgia started to urbanize from the 2000s. Initially, the process Looking to the future, Georgia should follow the path was confined to just a few larger cities, but over the last that most successful countries have gone through: decade, a few additional smaller cities have started to re- fewer, but more productive, workers in rural areas gain scale. In fact, since 2000, Georgia has been among increasingly engaged in non-farm activities and the faster urbanizing countries in ECA, with the urban further concentration in more dense urban areas. To population reaching around 60 percent in 2020, around illustrate this, the share of agriculture employment in the average for the transition ECA countries (Figure total employment in Georgia would need to fall by half 19). Still, most locations, including most secondary to reach levels seen in structural and income peers in cities, remain below their scale from the start of the ECA; the gap with aspirational peers is even bigger. century (Figure 20), and a relatively large share of the Many of these workers will need to find jobs in the urban population remains in rural areas with limited economic economy, but there can also be opportunities in off- opportunities. farm rural jobs. That seems to be the case in a few ECA countries that have around 40 percent of their population This economic geography has given rise to two related, living in rural areas, even though agriculture accounts for but distinct, concerns among policymakers over a much smaller share of employment. On the urban side, the past decade. The first is that a significant share of Tbilisi and its agglomeration should grow to exploit the Georgia’s population, and most of its rural population, is potential for agglomeration, with a few other urban areas engaged in low productivity agricultural activities, which likely to potentially have scale (Batumi, Kutaisi). 50 CHARTING GEORGIA’S FUTURE Figure 19. Urban population, by countries Figure 20. Population change, by municipality 2020, as % of population and change compared to 2000 2010-2020 100 25 80 20 15 60 10 40 5 20 0 0 -5 BLR TUR BGR RUS CZE HUN UKR EST LVA LTU MNE ARM ALB POL GEO MKD KAZ HRV SRB AZE SVN ROU SVK TKM UZB BIH MDA KGZ TJK 2020 change ECA av. change ECA av. 2020 Source: WDI. Source: Geostat. Regional disparities in GDP per capita in Georgia in Georgia are home to some of its main cities (e.g., are high, though not extraordinary, but are likely Gori in Shida-Kartli, Kutaisi in Imereti), underscoring to increase. Variation in regional GDP per capita in the challenges facing secondary cities and the Georgia is above the average of newer EU member limited links between cities and adjacent rural areas. states and the countries of the Western Balkans, though Spatial patterns are, however, matched by patterns a few countries do have higher differences (Figure in investment and business demography. Outside of 21). Disparities could increase further. First, as Georgia the Tbilisi agglomeration (including Rustavi and parts deepens its integration into regional and global markets of Mtskheta-Mtianeti) and Adjara, the firm structure is to support faster productivity growth, spatial disparities comprised mainly of SMEs and microenterprises, and are likely to widen, similar to the experience of the recent FDI is almost non-existent. The limited pull from urban EU accession countries in central and eastern Europe. areas and barriers to labor mobility explains why a Second, evolving technologies and skills demands will large part of the population remains in rural areas and also aggravate tendencies toward spatial divergence. engaged in agriculture. Returns are likely to increase for workers with the skills to complement new technologies. This will benefit Agriculture is a significant source of jobs, but workers in leading metropolitan areas at the expense of agricultural earnings make only a limited contribution peripheral and rural areas, as most productive firms and to household incomes in rural Georgia, and workers workers concentrate there. And while the COVID-19 continue to gradually transition away from agriculture pandemic and advances in digital connectivity may have (Figure 23). This suggests that agriculture lacks the lessened the appeal of urban areas, the concentration of productivity to generate sufficient earnings for most economic activity in cities is likely to persist. rural households. Indeed, non-farm wages (likely from informal and possibly irregular employment) contribute Georgia’s economic geography is characterized a higher share of income than agriculture to most rural by the poles of Tbilisi and Batumi, the small scale households. However, non-farm earnings are still a of other cities, and absence of non-agricultural relatively small component of rural household earnings, economic activity outside of cities (Figure 22). Only as opportunities are limited. Small farm sizes, limited Tbilisi and Adjara, home to Batumi, Georgia’s second skills, weak land markets (unclear and unregistered largest city and a main port, have GDP per capita ownership, lack of strategic management of state land) above the national average. The pattern of leading and and fragmented supply chains contribute to these lagging regions does not necessarily show a clear link outcomes. Growing public support to address these key to urbanization – in fact, some of most lagging regions constraints has thus far had limited success. COMPETITIVE, CONNECTED, CAPABLE 51 Figure 21. Variation in regional GDP per capita Figure 22. Nightlights intensity, by raster 2018 or latest year 2016 0.6 0.5 0.4 0.3 0.2 0.1 0.0 SWE FIN GRC ESP AUT PRT BEL NOR ITA NLD DNK FRA IRL DEU GBR CZE SVK SVN MLT LTH HRV EST ROU POL BGR HUN LVA ALB SRB MKD GEO Source: Eurostat; various national statistics agencies (Western Source: Global Human Settlements Index; OpenStreetMaps. Balkans); Geostat. Note: Data presented at NUTS-3 level for EU and Western Balkans and at regional level for Georgia. Figure 23. Income of rural households (2019) 100% 2.500 Other 90% 80% 2.000 Self empl. 70% Own prod. 60% 1.500 Non-farm inc., av., rhs 50% 40% 1.000 Pensions / Soc. Assist. 30% 500 Wages 20% 10% Agr. sales 0% 0 < 0.1ha 0.1-0.5ha 0.5-1ha 1-1.5ha 1.5-2.5ha >2.5ha Farm inc., rhs Source: World Development Indicators. A framework for regional development seen be transformational for some areas; however, they are through the lens of density and connectivity unlikely to work if distortions are not removed, the market opportunities are not there, or interventions are To create the most opportunities for the Georgian not properly appraised and coordinated. Growth that labor force, growth needs to be efficient and its spatial takes this dimension into consideration will be efficient, consequences adequately managed. That means but it will have two important spatial consequences. First, putting in place a policy framework that allows markets not all areas have the potential to support sustainable to identify growth opportunities and people and capital economic activities. While these regions may continue to move to be able to capture those opportunities. Such a to lag in terms of per capita output, redistributive fiscal policy framework starts with broadly universal policies to policies, equal access to opportunities and migration build up endowments, such as human capital (education, can help equalize per capita income and consumption. health, and access to basic services) and institutions, This is already happening to some degree in Georgia. as well as policies that target market, government and Second, urbanization will deliver the productivity coordination failures that limit growth opportunities or dividends only if it is managed to ensure that cities are hinder factor mobility. Place-based investments can better connected, planned and livable. However, most 52 CHARTING GEORGIA’S FUTURE Georgian cities having a considerable unfinished agenda they only account for 27 percent of the population. in this area. These areas face substantial structural constraints that likely limit their potential and viability. Place-based Regional development policy should build on these policies should be deprioritized in favor of policies to principles, complemented with a clear understanding enhance equality of opportunity, with a focus on human of the regional context and capabilities. Territorial capital. Niche sectoral development based on territorial development strategies are often set out with the endowments (natural resources, tourism) may also offer objective of achieving convergence in economic opportunities, along with policies to support agricultural outcomes across regions. And while labor and capital transformation that address fragmented supply chains mobility are important for the effectiveness of regional and weak land markets. For example, many rural people development policies (McCulloch & Yellen, 1977), cannot efficiently use one of the few assets they possess, locations also differ dramatically in their starting points, as banks are reluctant to lend to the agriculture sector or in their structural conditions, and in the assets that they consider agricultural land as collateral. Finally, a further have available to exploit. Effective regional policy needs nine municipalities across seven regions account for 20 to begin with an understanding of the specific context, percent of the population and are sparsely populated, scale and nature of the potential of differential locations, centrally located regions. 27 These regions are typically as well as the forces that led to the spatial inequalities. located close to larger agglomerations, so the priority While a variety of factors potentially impact sub- is generally to improve the connectivity of the region to national productivity, the literature has demonstrated a the agglomeration. few key determinants as robust across methodologies, time periods, and territories (Roberts, 2016), including Figure 24. Mapping Georgian municipalities urbanization and economic density, as well as market by density and connectivity access and local transport connectivity. Density allows 2019 firms and workers to take advantage of the productivity benefits of agglomeration. Market access enables firms to lower costs of trade and inputs and take advantage of scale economies. Georgia lacks locations with significant density, and more generally, possesses some rural areas with significant structural barriers; it should accordingly take these factors into consideration when planning its regional development policy. Bringing together density and market connectivity can help differentiate policy priorities for various regions. About 53 percent of Georgia’s population, but only eight municipalities, are densely populated, centrally located Source: Authors. (well-connected) regions which are not lagging (Figure 24). Properly appraised place-based interventions Quality and mobility of human capital and may make sense and would probably be best directed local institutions will play critical roles towards improving connectivity, urban planning and providing affordable and safe housing. For example, The degree to which regions take advantage of their Tbilisi performs relatively poorly on affordability of potential depends on the quality of human capital. rental prices compared to capitals in eastern and Availability of skills is a critical determinant of productivity central Europe. On the other side of the spectrum, nationwide, as well as at the regional level (see chapter the bulk of municipalities in Georgia (60 out of 76) are 5 on Labor market and skills). In addition, the challenge sparsely populated and peripherally located, though in many parts of Georgia is as much one of quantity as 27  Densely populated, peripherally located regions is the most common category for lagging regions in the EU, but there is no such region in Georgia. COMPETITIVE, CONNECTED, CAPABLE 53 of quality. While sharp demographic declines during the Figure 25. Quality of local institutions matters 1990s and early 2000s have abated somewhat over the 2019, cities with 10,000 population and more past decade, low fertility and outmigration continues, capita, relative to national average 1.5 with rural areas and regions outside of Tbilisi and Adjara Investments in fixed assets per 1.4 being hit hardest. A nation-wide effort to increase the 1.3 skills of the labor force and ensure universal access to 1.2 quality education will improve labor mobility and benefit 1.1 lagging regions, where skills are less available. Some 1.0 spatially targeted efforts may also be helpful in areas with 0.9 identified potential (e.g., training on tourism-relevant 0.8 skills or climate-smart agriculture). Equally importantly, 0.7 better functioning land markets, more efficient labor 0.6 markets as well as availability of affordable and secure 0.8 0.9 1.0 1.1 1.2 1.3 1.4 housing can improve labor mobility. PEFA scores, relative to national average Source: Sta calculations based on PEFA data from MOF and Local institutions also matter. Quality of local Geostat. Note: PEFA scores are average for scores on indicators that are available for all municipalities and lilkely administrations has been strongly associated with to depend less on central level institutions. regional economic outcomes in the EU (Charron, Dijkstra, and Lapuente, 2015; Rodriguez-Pose and Ketterer, 2016), due to their role in investment, An agenda for efficient spatial service delivery, and establishing the environment for transformation investment and enterprise operations. Despite progress, local governments in Georgia remain relatively weak, Completing Georgia’s structural and spatial lacking capacity on the one hand and autonomy on transformation will require addressing the structural the other. In fact, except Tbilisi and Batumi, the quality factors that limit opportunities and cause frictions of public financial management at the local level is in the functioning of factor markets and building rather weak across the board, with poor revenue up of endowments. Productivity improvements and planning, weak public investment management, sustainable economic growth at the subnational level limited performance information on service delivery are impeded by: i) lack of density and connectivity and so on (World Bank, 2018), which is likely to be (outside of a few larger cities); ii) disconnected and impacting economic outcomes (Figure 25). Most local stagnant rural areas; iii) inefficient land markets and governments lack finances needed to support significant lack of affordable housing; iv) limited human capital; as development efforts and have limited capacity to raise well as v) limited capacity of local institutions. Georgia revenues, in part due to poorly developed rural land should invest to build up endowments (human capital, markets. And while the Local Self-Government Code basic services and institutions) through broadly universal defines the responsibility of municipalities to prepare policies, and complement these by focusing on three spatial planning documents, most local governments broad priorities: neither prioritize the creation of new master plans, nor have sufficient funds and capacity to update existing • Realizing the potential of rural areas by focusing plans to meet current socioeconomic realities (Asian on agricultural transformation, niche sectoral Development Bank, 2016). More generally, the legal opportunities, and connecting to markets. framework increasingly envisages a greater role for local Advancing land reform (registration and strategic government units (i.e., subsidiarity principle coupled management of state land, land taxation and efforts with commensurate financial resources); however, lack to promote consolidation, etc.), strengthening of human, material and financial resources necessary for value chains by promoting linkages between the exercise of power prevents local self-governments sector participants, and reforming public support to fully and effectively execute their mandates are key priorities for the agriculture sectors. (Government of Georgia, 2019). Beyond agriculture, progress in sustainable forest 54 CHARTING GEORGIA’S FUTURE management provides additional opportunities to build competitive industries in some secondary develop the forestry and wood-processing value cities. Universities have been key in attracting and chain. Tourism has delivered growth and jobs, but retaining knowledge workers; this strategy has sustainable development in the future will require: proven critical in revitalizing some secondary cities i) strengthened land use planning; ii) managing and in the European Union. Georgia has a few regional protecting tourism assets; iii) diversifying business education institutions that could support the opportunities around those assets (e.g., agritourism local economy through more impactful research or nature-based tourism); and iv) finally, and most and development (R&D) and attracting talent. importantly, focus on sharing the benefits and Admittedly, many secondary cities will continue making sure that they reach local communities. to shrink, and cities will need to adopt urban and For central regions, better connectivity with large economic plans to manage shrinkage; this may be agglomerations can open opportunities for product an opportunity to re-invent some cities. and labor market integration and attract investment in manufacturing and services activities, though • Preparing Tbilisi (and Batumi) for sustainable and investments need to be focused on regions with inclusive growth by strengthening urban planning, clear potential to take advantage of density. expanding public transport, and improving social (housing quality, schools, health facilities) and • Strengthening dynamism and reinforcing density environmental (green areas, parks) infrastructure. in secondary cities by facilitating investment in Tbilisi’s urban planning efforts needs to contain tradeables (especially as market towns to connect the urban expansion through sustainable infill rural areas to market), leveraging the potential of densification. While a number of plans have been education institutions, ensuring basic infrastructure adopted to advance urban development, there and services to support improved livability, and is a risk that they may not be fully coordinated. managing assets in response to structural changes. Furthermore, investment in the appropriate social Currently, the urban system outside of Tbilisi infrastructure, including schools, childcare facilities, is narrow, with most secondary cities lacking healthcare, and green and public space in the density and stagnating. Policies to attract FDI in center and periphery appears not to be happening secondary cities, effective use of public assets and in a consistent way, forcing residents to travel performance-based support to firms in improving across districts to access services, contributing to standards and expanding markets could help congestion and air pollution. Like most large cities, Figure 26. Availability of education services Figure 27. Rent prices Tbilisi vs major cities As percent of average wage 70 Batumi 60 50 Kutaisi 40 30 Tbilisi 20 Zugdidi 10 0 0 .2 .4 .6 .8 Kyiv Warsaw Tbilisi Yerevan Minsk Tirana Istanbul Baku Podgorica Belgrade Prague Bratislava Ljubljana Pristina Sofia Bucharest Skopje Budapest Zagreb Vilnius Riga Talin Sarajevo Education services* per 1000 people City centre Periphery Source: OpenStreetMaps. Source: Numbeo and Livingcost.org *Colleges, kindergartens, schools, and universities. Note: rent price for 1 bedroom apartment outside of city center. COMPETITIVE, CONNECTED, CAPABLE 55 Tbilisi faces large and growing challenges with inclusion, especially in access to affordable housing. Finally, for a more sustainable and livable city, urban expansion should be driven more by sustainable urban planning, rather than real estate development. Recent improvements in public transport should be sustained and built upon, policies should be strengthened to deal with transport emissions to lower pollution, and green spaces should continue to increase. 3 CHAPTER 56 CHARTING GEORGIA’S FUTURE Firm Performance EXECUTIVE SUMMARY 57 Productivity has been held back by weak the analyzed period (i.e., reported positive within-firm improvement in firm-level efficiency, and by productivity); but firms in services generally didn’t. In growth of relatively less productive firms addition, except in the construction sector, it appears that resources are not being re-allocated towards more F productive firms (i.e., registered negative “between” irm-level productivity growth in Georgia component). In both manufacturing and services in a relatively large sample of firms during sectors, the correlation between market shares and the 2007-2019 period was somewhat weak, TFP levels is typically negative and detracts from overall though with significant heterogeneity across productivity growth. The contribution of firm entry sectors.28 Among non-agriculture firms, based on and exit has been relatively small, and not always in a firm-level data, TFP in 2019 was 6.7 percent below its productivity-enhancing manner. 2007 level, with the construction sector becoming more productive, manufacturing TFP declining Large firms dominate employment growth in Georgia, slightly (1.4 percent) and services TFP plummeting and to a lesser extent productivity growth; startups (Figure 28). Overall TFP performance can be driven are dynamic but fail to expand after their initial growth by three channels: a “within” component measuring spur. Large firms have significantly higher employment the gains from firms’ own productivity performance; growth rates. At the same time, young firms are a “covariance” (also called “between”) component characterized by high growth rates, both in terms of measuring gains due to the change in the efficiency of employment and in terms of TFP; however, starting allocation of resources between firms; and an “entry” from year three this growth path quickly stabilizes, and and “exit” component (presented sometimes together stagnates in many cases. These findings can explain as “selection”) measuring gains due to entering and Georgia’s low contribution of allocative efficiency exiting firms. Decomposing Georgia’s TFP trends to TFP growth: large firms with relatively lower TFP along these lines shows that Georgia’s manufacturing are expanding, while small, productive firms are not and construction firms became more productive over growing. 28  There should be some caution in interpreting the firm-level data to be representative of the entire economy. The initial sample of firms was from Geostat’s Business Statistics survey which covers most larger companies and a sample of smaller companies in manufacturing, construction, and some services sectors. Further entries were lost due to insufficient data to compute TFP. Most of the lost entries were for smaller and newer companies which could be more productive. See Chapter 3 for details. 58 CHARTING GEORGIA’S FUTURE Figure 28. Productivity growth decomposition, by sectors 2010-2019 average, 3-year di erencing Manufacturing Construction and Services Textiles, Wearing Apparel & Leather prod. Construction Mach., Equip., Elec., Inst., Medic. Land, Water & Air Transport Non−metallic products Hotels & Restaurants Wood & Paper Retail Trade Chemicals, Rubber & Plastics Wholesale Trade Food, Beverages & Tobaco Publishing & Printing Supporting & Aux. Transport act. Basic & Fabricated Metals .05 Sales and Repair of Vehicles -.15 -.10 -.05 0 .15 .20 .25 .30 -.15 -.10 -.05 0 .05 .15 .20 .25 .30 Within Covariance Exit Entry Within Covariance Exit Entry Source: World Bank sta calculations based on GeoStat. Note: Average TFP annual growth calculated at the two-digit level of NACE Rev. 3. Annual averages are arithmetic averages. Aggregate employment is the average 2007-2019. Weak firm-level productivity and allocative efficiency An agenda for improved productivity, suggest that, despite a good business environment, through more efficient markets and firms Georgian markets are not functioning very efficiently and that firm capabilities are weak. Georgia’s good Access to finance is improving, but firms still see it as business environment was strongly emphasized in a major obstacle to their operations. While banks have interviews with businesses during the preparation of done a reasonably good job in providing credit to the the CEM. However, the limited reallocation of market private sector, the offering is basic while alternative shares from less productive to more productive firms, sources of finance are largely absent. Better functioning as well as the exit of relatively more productive firms, land and product markets, an improved credit reporting point to the importance of deepening reforms that infrastructure, greater financial inclusion (through a promote better market functioning and allow more more formal, digital and transparent private sector and productive firms to scale up and gain a larger share better availability of financial services), a strengthened of the market. A few economy-wide and firm-specific secured transactions framework and an enabling legal issues could be contributing to these outcomes. framework for non-bank financial activities can help Challenges to firm growth may be related to access improve access to finance. to finance, the second biggest obstacle reported by businesses. In addition, promoting formalization could Sizeable, though declining, informality could also be help, as informality is likely to explain the fragmentation hampering the opportunities to scale up Georgian of the enterprise sector and inability to scale up companies. Various measures provide different results (opportunities for scaling up through exporting are for the size of Georgia’s informal sector (Figure 29). analyzed in Chapter 4). Competition is key, especially While output informality models put the size of the in small markets like Georgia and given evidence that non-observed economy significantly above peers, competitive pressures, while improving, may be weaker labor informality estimates appear to be similar to in certain sectors. In addition, the limited contribution peers, and in terms of perceived informality, Georgia of “within” productivity component points to weak actually outperforms most peers. Still, all measures firm capabilities, including firm-level innovation and point consistently to a decline in informality over the last managerial practices. two decades, coinciding with strong growth, improving COMPETITIVE, CONNECTED, CAPABLE 59 Figure 29. Informality and development: Is Georgia an outlier? Output informality Labor informality Perceived informality MIMIC-based informal activity 100 100 7 WEF index (reversed order) (percent of employment) 80 80 6 Self-employment (percent of GDP) Georgia Georgia 5 60 60 4 40 40 3 20 20 2 Georgia 0 0 1 4 6 8 10 12 4 6 8 10 12 4 6 8 10 12 Ln(GDP per capita) Ln(GDP per capita) Ln(GDP per capita) AE EMDE AE EMDE AE EMDE Source: (Yu, 2020). Note: AE: Advanced Economies; EMDE: Emerging markets and developing economies. governance and regulatory quality. As a result, less firms mandates, and adopting a state aid framework in line in Georgia appear to be competing against unregistered with EU requirements. and informal firms. However, in the sectors where informality is more present (retail trade, non-food Innovation is an important driver for productivity manufacturing), it is also a bigger obstacle for firms. growth; however, few firms innovate, and the Tax policy and administration reforms can help lower innovation eco-system is nascent. To innovate, firms the incentives for informality (reviewing the threshold need to invest significant resources in machinery, and eligibility for simplified regimes, understanding equipment, and R&D, and devote time to improve better the bunching of firms around the VAT threshold, the productive processes. Hence, promoting etc.), while greater financial inclusion and digitizing innovation also requires a diversified range of financial transactions can also help. instruments that mirror the type of innovation and the stage of development of firms. Traditional financial Firm-level data point to increased competitive institutions are often risk-averse towards early stages pressures in product markets, though competition of innovative firms (seed, start-up, early-growth). may be weaker in some sectors. Average markups of Technical assistance/training, network support, grants Georgian firms show a downward trend in recent years and equity financing instruments are usually more with regression results showing that TFP, rather than suitable mechanisms to support these firms, and there market share, drives markups. However, heterogeneity is some room to reform Georgia’s business support in markups between firms is large, and the trend in programs to focus on innovation by firms. Market size markups in services is still driven by a small number appears to be playing a significant role in promoting of firms with high markups and not by the median innovation in Georgia: evidence shows that larger firm. Also, sectors characterized by higher markups firms and exporters are more likely to innovate, which dispersion tend to also have higher levels of markups, suggests export promotion and lowering informality indicative of imperfect market functioning. Promoting can encourage firm innovation. Innovation also competition can improve consumers’ welfare (through requires complementarities, including human capital lower markups) and also promote employment growth. (Chapter 5 on Labor market and Skills), as well as a This would require better enforcement (merger supportive innovation eco-system. Policies should be control, market monitoring) of the recently improved put in place to improve coordination between research regulatory framework, adopting a competition lens in and development institutions and the private sector policy-making (including in regulated sectors), stronger and to ensure a sufficient supply of the human capital cooperation between regulators with competition that is needed for innovation (engineers and scientists). 60 CHARTING GEORGIA’S FUTURE Evidence of spillover effects of innovative activities suggests that managerial skills are limited. Support further strengthens the case for such support. programs to build managerial capabilities could have a huge impact on business performance. Enterprise Management practices are key to improving firm Georgia, the agency implementing most of the performance, but many Georgian companies are poorly government’s business support program, is currently managed. Adopting better management practices exploring the feasibility of managerial capabilities and is positively associated with employment, sales, and digitization programs, as well as creating a local market labor productivity (Figure 32). However, management for firm consulting services. The agency should consider practices in Georgian firms lag peers. In addition, the combining different modalities for providing training quality of management practices differs widely across and technical assistance to firms, in close coordination companies. The low survival rates of businesses also with industry participants. Figure 30. Average markups Figure 31. Average markups and dispersion Manufacturing All sectors 120 2 8 3. Markup (index 2007 = 100) 4 2. Markup dispersion 110 0 2. 8 1.2 1.6 2. 100 90 4 0. 0 0. 80 0. 6 0. 8 0. 1.0 1.2 1.4 1.6 1.8 2. 0 2 2. 4 2. 2007 2008 2009 2010 2011 2012 2013 2014 2015 2016 2017 2018 2019 Weighted avg. Markup Markups Markups (weighted) Manufacturing Services and Construction Source: World Bank's calculations based on GeoStat. Source: World Bank's calculations based on GeoStat. Note: Dots represent sector at the two-digit level. Figure 32. Firm performance and management practices Firm size Sales per worker 6.0 13 Log Sales per worker Log Employment 5.0 12 4.0 11 3.0 10 2.0 9 0.0 0.2 0.4 0.6 0.8 1.0 0.0 0.2 0.4 0.6 0.8 1.0 Management Score Management Score Source: World Bank’s calculations based on WBES (2019). Note: Scatter bin with 50 bins. Management score is the unweighted average of the score for each of the 8 questions in the World Bank’s Enterprise Survey (WBES), where each question is normalized to a 0-1 scale, following the spirit of Bloom et al (2019). The sample contains all WBES observations in 2019 with at least 4 non-missing responses to the set of 8 questions of management practices questions and have positive employment and sales values. Sample size is 275 establishments. Depen- dent variable is management score (in levels). 4 CHAPTER EXECUTIVE SUMMARY 61 Connecting Georgia 62 CHARTING GEORGIA’S FUTURE E xploiting the opportunities from the global And while recent developments in globalization and new economy has been a common feature technologies may have raised the bar for developing of all successful development episodes countries to integrate, openness will remain important (Commission on Growth and Development, for growth. Export opportunities in manufacturing 2008). And it is even more important for small will remain for competitive, connected and capable economies like Georgia. Openness gives exporters from economies (Hallward-Driemeier & Nayyar, 2018), small markets an opportunity to achieve economies of while services can provide additional opportunities scale. It also makes domestic companies more efficient for countries that can lower barriers to trade, expand by facilitating access to inputs that are not available at use of digital technologies and build up skills (Nayyar, home (or are available at higher prices or lower quality) Hallward-Driemeier, & Davies, 2021). and gives consumers more choices and lower prices. More importantly, openness allows ideas, technologies, Georgia is integrating, but needs a more and know-how from the rest of the world to flow freely. sophisticated product offering, more open markets and more efficient export and Figure 33. Index of Export Market Penetration investment promotion Integration has been an important element of BGR 12.4 Georgia’s growth story, and much potential remains 8.2 to be tapped. Trade expanded briskly in the decade HRV 10.8 6.4 prior to COVID-19, and in 2019, Georgia’s external EST 9.6 trade in goods and services exceeded the expected 5.9 level given its income. Georgia was also increasingly GEO 4.2 2.8 able to position itself as a supply hub for the region, ARM 2.7 with re-exports gaining a greater share of trade. Yet 1.8 even though Georgia now exports more products to ALB 1.5 1.6 more markets, goods exports remain concentrated in 0 5 10 15 low value-added and unsophisticated products, with concentration increasing over the last decade. The fact 2019 2010 is, few companies export, and export relationships do Source: Based on data from UN Comtrade / WITS. not last long. Opportunities provided by deeper trade COMPETITIVE, CONNECTED, CAPABLE 63 Figure 34. GVC participation index: Georgia and comparators 2009 vs 2018, percent of gross exports 80 60 26 25 27 34 33 32 40 27 38 35 26 28 21 50 50 20 30 28 24 26 29 30 17 16 19 19 0 2009 2018 2009 2018 2009 2018 2009 2018 2009 2018 2009 2018 GEO (LP) ALB (LC) ARM (LM) BGR (LM) HRV (LM) EST (AMS) Backward participation Forward participation Source: Author’s calculations based on UNCTAD-EORA. Note: GVC participation categories: LP Low commodity; LC Limited commodity; LM Limited manufacturing; AMS Advanced manufacturing and services. integration with more developed markets have not fully though these initiatives would need to increasingly be materialized. Indeed, Georgia exploited only 4.2 percent coordinated with the EU’s foreign trade policy. And of the market potential of its exports structure in 2019 while the DCFTA envisages almost complete elimination (Figure 33). Services generate 70 percent of the exports of non-tariff barriers on bilateral trade between Georgia value-added, exceeding most peers, but most exported and the EU, in practice, a wide range of trade regulations services are low-skilled. Also, the largest share of will need to be implemented in Georgia as EU norms exported services value-added is generated within the are transposed. The EU accession process will increase same sector, and only 30 percent adds value to other the ambition of these efforts. The associated transition export sectors (other services, agriculture, or industry). costs will need to be managed. To increase export sophistication, Georgian firms Georgia should aim to increase participation in global need to innovate, absorb technology more rapidly and value chains (GVCs), something that is has struggled oriented towards export markets. Government support to achieve (Figure 34). Implementing an FDI and programs with clear indicators to measure improvements export promotion strategy that focuses on efficiency- in productivity and competitiveness can help (see seeking FDI can help attract multinational companies Chapter 3 on Firm Productivity). This would also mean (MNCs), which typically form the backbone of GVCs. supporting firms to adopt international certification for These investors place a high premium on factors that their products and services, something that even less will facilitate the seamless integration of new sites into demanding export markets are increasingly looking for. their existing supply chains, as well as a predictable and A stronger export promotion function, including through efficient legal and regulatory environment, a skilled an efficient network of foreign offices, can help potential workforce, low taxes, and connectivity (World Bank exporters benefit from greater availability of information 2020c). As MNCs attempt to find alternative locations to overcome the information asymmetry and discovery for their sites in response to the sanctions over Russia costs associated with seeking access to external markets. due to its invasion of Ukraine, Georgia could be a Greater availability of trade financing can help more strong candidate. In addition, the EU accession process firms orient towards exports. Further gains are available can provide further assurances to investors, as it did through trade policy, for example, via efforts to expand in current candidates (e.g., Serbia, North Macedonia). markets through free trade agreements (especially with Later, local supplier programs can ensure gains are more countries in the Gulf and Asia). Such efforts could be widely shared, although this would require that local combined with more flexible rules of origin that allow firms already have capacity to absorb the more stringent more products to carry the label “made in Georgia”, requirements associated with participating in GVCs. 64 CHARTING GEORGIA’S FUTURE Figure 35. Low-skilled tradeable services Figure 36. Global innovator services Exports and employment Exports and employment 100 100 GEO 80 80 as % of exports as % of exports 60 60 40 40 20 20 GEO 0 0 0 10 20 30 40 0 10 20 30 as % of employment as % of employment Source: Sta calculations based on data from (Nayyar, Hallward-Driemeier, & Davies, 2021). There is significant room to grow services as an export regime and modern customs administration have been engine. Apart from tourism and transport, there have outweighed by perceptions of relatively low quality of been few services on Georgia’s export list. However, transport infrastructure, high costs of infrastructure use the relatively large share of employment in “global and an underdeveloped logistics industry (Figure 37). innovator services” and in increasingly more tradeable Removing transport and logistics barriers is even more “social services” (e.g., health, education) compared important for participation in GVCs, where predictability to the relatively low export of these services indicates and reliability requirements are much more stringent. significant opportunities to scale up services exports (Figure 36). This will mean more exports of financial, Georgia is strategically located in a challenging and education and a whole range of digitally provided changing regional context. It has direct access to services. Importantly, a more diverse and modern offering large markets (Turkey to the south, EU across the Black of services will also develop deeper linkages between Sea and the Russian Federation to the north). It is also services and other sectors (e.g., manufacturing), as well a logistics gateway for the Caucasus region, where as capture a bigger share of the supply chain (e.g., in multiple conflicts have resulted in border closures and tourism). Global experience suggests that Georgia may trade blockades. In addition, it potentially serves as want to focus on training and technology adoption to a port option for the countries of Central Asia, which unlock opportunities for services exports. In addition, are aiming to diversify their port access. Finally, the developing a Services Trade Restrictiveness Index (STRI) Caucasus Transport Corridor (CTC), which is part of the and analyzing how services in high potential sectors can Belt and Road Initiative connecting Europe and China, be made more tradeable or embedded in other sectors traverses Georgia, though its multi-modality and multi- (digital content, increasing quality of tertiary education stakeholder nature affect its competitiveness. Still, the and its international accreditation, visa policy) could also increasing challenges on the northern route in response help support growth in services exports. to sanctions of Russia could increase the attractiveness of the CTC and redirect cargo flows through Georgia. An agenda to improve logistics, close More generally, the increased uncertainty of the trade infrastructure gaps and sustain gains in trade and transport environment due to the pandemic, local facilitation but also broader regional conflicts, and geopolitics, is putting a premium on more diverse connectivity Georgia needs to be better connected. Georgia’s options. The November 2020 tripartite Peace Statement connectivity is restrained by high transport and logistics by Armenia, Azerbaijan and the Russian Federation costs and unpredictable delays. A simplified regulatory could lead to the eventual opening of corridors that are COMPETITIVE, CONNECTED, CAPABLE 65 Figure 37. Georgia’s trade facilitation and logistics needs and gaps 1 2 3 4 5 Trade facilitation Quality of logistics Cost of Strategic Volumen of and logistics and support logistics and location demand infrastructure institutions transport Georgia is strategically Lack of high-valued Specialized logistics Low level of ICT Relatively higher costs located in the exports to aggregate facilities are not penetration and lack of for logistics operations Trans-Caucasus demand from other available to support a common privale and compared lo other Corridor, but is a ected countries valued-added and public view for logistics CAC by the cul-de-sac trading operations. priorities operation of the Black Sea Maritime lines Source: World Bank. Figure 38. LPI and other logistics indicators: Georgia and selected comparators (2018) Country Pop. GDP LPI Rank LPI Score OECD TFI WEF GCI WEF QPI UNCTAD LSCI Armenia 2.9 12.4 92 2.61 1.38 61.3 - - Azerbaijan 9.9 46.9 89 2.64 1.23 62.7 - - Bulgaria 7.0 65.1 52 3.03 1.62 64.9 4.3 7.25 Georgia 3.7 17.6 119 2.44 1.58 60.6 4.1 6.84 Lithuania 2.8 53.4 54 3.03 1.70 68.4 4.8 20.69 Romania 19.5 239.5 48 3.12 1.55 64.4 3.9 25.47 Turkey 82.3 771.3 47 3.15 1.55 62.1 4.7 57.45 Ukraine 44.7 130.8 66 2.83 1.04 57.0 3.9 26.88 Source: World Bank LPI, World Economic Forum. Note: LPI Logistics Performance Index; LSCI – Liner Shipping Connectivity Index; WEF – World Economic Forum; GCI – Global Competitiveness Index; QPI – Quality of port infrastructure. presently closed. A broader commitment to regional Infrastructure gaps are gradually narrowing. connectivity could also see the Armenia and Turkey Businesses perceive the quality of the country’s border opening. Even if these opportunities eventually transport infrastructure to be on par with the Central materialize, it will take time for the new corridors to Asia and Caucasus (CAC) peers, but below the average match the quality of the existing connections going for the ECA region. Significant investments have helped through Georgia. Still, over time, Georgia may see narrow the infrastructure gap, but bottlenecks remain. growing competition for its transit role. Improved Ports require not only new investment, but also a connectivity can ensure Georgia remains the preferred modern regulatory structure to lower costs and capture transit corridor. the potential benefits of transit opportunities. Road 66 CHARTING GEORGIA’S FUTURE connectivity is improving, and highway tolling could Figure 39. Freight volumes in the broader help ensure sustainable financing. The railway needs region (Thicker lines signify larger volumes) to be modernized through both additional investment and institutional reforms. Enhanced connectivity will require multi-modal services. Integrated logistics clusters with access to rail and road networks and with sufficient warehousing and logistics service provision have promoted multimodality in Europe and can do so in Georgia. Finally, Georgia should upgrade the CTC, manage it in real-time and connecting it to a network of transport and logistics centers. Presently, the corridor is a collection of disparate transport assets with limited logistics connections. The logistics industry is probably Georgia’s weakest link. With few exceptions, sector participants are small, fragmented and provide limited services of poor Source: World Bank. quality. The still relatively low trade volumes (Figure 39) keep costs of good quality logistics services high can help improve efficiency of processes. Greater use and demand low, thus reducing the attractiveness of of joint border control facilities with neighbors and investments in the sector. Promoting exports, especially functioning data-sharing mechanisms can speed up of higher-value added products, as well as cargo the processing of trade flow. Faster approximation of consolidation (including from the broader region), can procedures and standards with the EU, including mutual offset this disadvantage. Programs can help to upgrade recognition of Authorized Economic Operators (AEO), skills of logistics professionals through the entrance of can help. Similar arrangements can be explored with international logistics companies, and training plans can other trade partners that run programs like the AEO. be introduced for road operators, as well as measures to develop transport cooperatives. Regular dialogue Improving coordination within Georgian institutions between the private sector and the government will be and with neighbors is key for Georgia to be a transit essential. This will help drive investment in developing and logistics hub and elevate its export orientation. a network of specialized facilities that will provide Domestically, a consensus on the importance of complex logistic services. The focus should be on strengthening Georgia’s export performance can strategic projects with potential transformational help sustain the momentum for reforms and the impact, such as: a) developing Tbilisi as a key logistic interagency cooperation needed. This would require a hub and trade platform, providing integrated logistics stronger public private dialogue process, which can be services to cover the industrial center and catchment provided by effective functioning of the National Trade area around the capital region, and attracting logistics Facilitation Committee (NTFC). A review of the funding chains from Armenia, Azerbaijan and Central Asia; and and administration of the NTFC should be undertaken. b) analyzing the potential of Tbilisi airport to increase Bringing more of the national institutions involved in air freight operations, particularly for perishables trade closer to the capacity of the Customs can ensure and e-commerce, as well as for services such as an effective single interface for business at all clearance maintenance, repair, and overhaul (MRO). points, as well as harmonized controls and permit systems with regional trade blocs including the EU. In Gains in trade facilitation need to be sustained. Regular addition, the plethora of transit systems would need to time-release studies (covering also steps prior to and be implemented and seamlessly integrated. Developing post border clearance), as well as periodic review of standard operating procedures across agencies and processes and fees (especially in areas identified as being private operators and with neighboring administrations expensive – ports, air), should be undertaken. Greater to deal with future climate and health emergencies can use of big data (artificial intelligence, machine learning) help limit their impact on trade. 5 CHAPTER EXECUTIVE SUMMARY 67 Labor Market and Skills 68 CHARTING GEORGIA’S FUTURE J obs are the cornerstone of economic and cognitive skills is declining (World Bank, 2019b). Instead, social development. People work their way high-level cognitive skills (e.g., problem-solving and out of poverty through jobs. Economies grow verbal ability) acquired through strong foundational as people get better at what they do, as they education are seeing increasing demand, and so are move from farms to firms, and as more productive technical skills. Future workers will need to more than jobs are created, and less productive ones disappear ever rely on social and behavioral skills to work in (World Bank, 2013). While a dynamic private sector is interdisciplinary teams. The Georgian labor market is needed to create jobs, workers should have the skills, already going through this transition, and developing a key component of human capital, to take on these high-level cognitive and digital skills will be essential to opportunities. Better human capital has been linked help Georgians take on higher productivity jobs. to growth; in fact, (Hsieh & Klenow, 2010) show that human capital accounts for around 10-30 percent Georgia’s labor market performance has of the differences in income across countries. This is been mixed probably an underestimate, as human capital also helps the operation and adoption of technologies (Acemoglu, Georgia’s unemployment rate, while declining, is 2005), thus supporting TFP, which itself accounts for high (Figure 40), and most jobs are in traditional, around 50 percent of income differences. Beyond skills, low-productivity sectors. Economic reforms have an efficient labor market is needed to facilitate labor proved effective for increased growth and poverty force participation and efficiently match workers with reduction but were less successful in creation of the most suitable jobs for their skillset. good jobs. In fact, net job creation has struggled to keep pace with economic growth (Posadas, Makovec, Changing technologies are increasing the skills bar, Jaef, Gruen, & Ajwad, 2018), as robust job creation in even for basic occupations. In high-income countries, manufacturing and industry was offset by shrinking the reduced intensity of routine tasks is associated agriculture employment. As a result, even though the with the increased use of computers and other digital unemployment rate had been declining since the start technologies. In developing countries, on average, of the 2010’s, 18 percent of the active labor force (using two-thirds of all jobs are susceptible to automation the new methodology) was still unemployed prior to (World Bank, 2016b). Low wages and slower technology the pandemic. The pandemic reversed some of these adoption may have slowed the transition in developing modest gains, with the unemployment rate edging up countries, but still, demand for routine manual and to 20.6 percent in 2021. COMPETITIVE, CONNECTED, CAPABLE 69 Figure 40. Labor market indicators: Georgia vs comparators (2019, in percent) Labor force participation rate (15+) Unemployment rate 70 20 60 15 in percent in percent 50 10 40 5 30 0 HRV GEO* UKR EU-27 ARM CZE ALB GEO EST CZE EST HRV EU-27 UKR ALB GEO GEO* ARM Source: ILO and Geostat for Georgia according to new methodology. Note: * refers to Georgia using new methodology. In the EU-27, the new standards would not substantially a ect labor indicators as own-account workers only represent 9.9 percent of total workers. Many job openings remain unfilled due to skills skills (such as critical thinking and problem solving), and mismatches and shortage of skills. Most jobs that socio-behavioral skills (such as leadership and initiative). are created are basic positions that require only basic Georgia needs better skills development mechanisms skills; however, most Georgian workers have secondary across the board to respond to the demands of the education and above. In addition to creating difficulties firms, but also to the emerging challenges driven by for employers to fill these basic positions, this also results technology and globalization trends. in well-educated workers ending up in jobs requiring low skills (Figure 41), which in turn keeps returns to Unemployment and inactivity (i.e., not even looking education low and pushes out workers with lower for a job) are also due to a difficult school-to-work education. The end result is a cascading effect, with transition, which especially affects young women high unemployment among the workers with tertiary and people in rural areas. Only 40 percent of workers education, who also crowd out workers with secondary find jobs within six months of leaving school, leading education (including in agriculture) (Rutkowski & to unemployment and inactivity. The youth (15- Honorati). On the other hand, the few good jobs being 24 age group) unemployment rate is very high (39 created frequently remain unfilled because, in many percent) compared to the ECA average (16 percent), cases, education doesn’t equate to relevant skills, and and aspirational peers (Czech Republic, 6 percent; occupations, even basic ones, are becoming more Estonia, 11 percent). The share of young people not in skills-intensive (for example, basic digital technologies education, employment, or training (NEETs) was also and foreign languages are now required even for drivers) one of the highest among peers (Figure 43). Economic (Figure 42). Finally, an underdeveloped labor market inactivity (which excludes those in education or training) information system keeps information asymmetries high is the most prevalent condition for non-employment and lowers mobility. among NEET women, whereas unemployment is the most common status among NEET men (Buitrago- The skills shortage reflects challenges experienced Hernandez, Fuchs, & Cancho, 2019). In addition to up and down the education system. Too few kids the lack of skills which prevents graduates from being attend early childhood education; as a result, they hired, the school-to-work transition is also made more enter the general education system unprepared to complicated by job search practices that tend to rely learn. Next, the general education system fails to instill on personal networks and may put people with better good foundational skills (basic literacy and numeracy). connections at a clear advantage, perpetuating the The lack of relevance of the skills offered by VET and inequalities that keep certain groups out of jobs, as well tertiary education, compounds the problem, leading as limited labor market information and employment to a shortage of technical skills, higher-order cognitive search support. 70 CHARTING GEORGIA’S FUTURE Figure 41. Occupational mismatch (2019, in percent of total, aged 15-64) Workers with upper secondary education working Workers with tertiary education working in in elementary occupation semi-skilled occupation 18.1 15.8 41.1 14.4 38.2 35.6 Female Male Total Female Male Total Source: World Bank Sta calculations based on LFS 2019. Note: Excluding self-employed working in agriculture. Figure 42. Task scores standardized against baseline year by task content measure Change in task skill intensity indexes among workers, change in scores units standardized with base in 2017 All workers Young workers cohorts; born 1985 and later 0.10 0.10 Standardized task scores Standardized task scores (using baseline year) (using baseline year) 0.05 0.05 0.00 0.00 -0.05 -0.05 -0.10 -0.10 2017 2018 2019 2017 2018 2019 Non routine cognitive: Analytical Non routine cognitive: Interpersonal Routine cognitive Routine manual Non routine manual physical Source: Authors’ calculations using Georgia LFS 2017, 2018 and 2019. Note: Based on the approach of Acemoglu and Autor, 2011, each occupation is assigned a skill intensity value for each of the five skills (ranging from 1 to 5). Then, the weighted average across all occupations for each skill is computed based on the share in the labor force of each occupation. Results are finally standardized over time. For details on the methodology see (Aedo, Hentschel, Luque, & Moreno, 2013). A shrinking population and large inactivity add to the high price to pay for any country, and Georgia is no challenges. High unemployment and low participation exception to this. rates mean that around 30 percent of the labor force is not actively contributing to economic development. The An agenda for better skills, and a more youth, women, minorities, and vulnerable groups, such inclusive and efficient labor market as internally displaced persons, are disproportionally affected. Many Georgians, especially women, are A better functioning labor market will require more not actively participating in the labor market due to jobs, better skills, efficient matching of workers and prevailing social norms, limited support services and an available jobs, and greater inclusion. First, more jobs inefficient labor market. The resulting under-utilization are needed to reduce unemployment and ensure of human capital due to low skills and inactivity is a very that the investment in human capital is better utilized. COMPETITIVE, CONNECTED, CAPABLE 71 Figure 43. NEET rates for youth 15-24 years old 40 Percent of populations 31 30 ages 15-24 23 20 10 0 POL HRV BGR MNE SRB ROU MKD UKR BIH MDA ARM GEO XKX TUR 2019 2019 2019 2019 2019 2019 2019 2017 2019 2018 2019 2019 2019 2019 Female NEETs Male NEETs Source: Geostat LFS for Georgia, WDI for comparators. Importantly, better jobs are needed to absorb the well- from optimizing the school network and classes educated and would require expansion of the modern, and increasing instruction hours. In VET, increased high value-added sector of the economy. But job investment in quality of infrastructure, equipment and creation is also needed in more basic occupations outside instructor skills is needed. Given labor market demand agriculture to facilitate reallocation of labor away from and existing capacity, further increasing tertiary subsistence farms and provide opportunities for many education enrollment may not be most efficient. of the currently unemployed who are less educated and skilled. Second, given existing skills gaps, jobs alone will Importantly, the education systems should flexibly not resolve Georgia’s labor market underperformance; adjust to the changing demand for skills by employers. workers need to be better prepared to take on these Feedback from employers should be incorporated in the opportunities. Next, the contrast between educational overall skill development cycle, from the identification attainment and employers’ complaints about the level of skills, to curricula design, material, delivery of training of skills points to a mismatch between labor supply (on-the-job and classroom-based), and students’ and and labor demand, which requires more efficient labor teachers’ assessments. Although the recently adopted market institutions. Finally, Georgia needs to activate legislative framework for VET has enabled greater more of its scarce labor force. collaboration between education institutions/training centers and the private sector, interaction is still limited Given the weak performance of Georgia’s education due to low interest from the private sector and lack of sector in building foundational skills (Figure 44), an funding and capacity to manage the coordination. The immediate area of focus should be placed on general new Skills Agency should perform an important function education. With the skills frontier moving rapidly, the in this respect, defining vocational education standards cost of inaction on human capital development will in collaboration with the public and private sectors, and only go up (World Bank, 2019b). Greater enrollment in fostering the provision of job-relevant skills by upscaling pre-school education can ensure children enter the and diversifying vocational trainings among public education system better prepared – this will require providers and stimulating training by private providers. more and better-financed kindergartens that provide better educational, rather than caretaking, services. Digital skills should be mainstreamed throughout the While in school, having better trained teachers will education system to unlock new job opportunities. be key to improving students’ learning outcomes; Basic digital skills are now part of the foundational skill this will require better qualified, better paid and more sets of workers and are demanded by employers even motivated teachers. Additional gains can be achieved for elementary occupations. Stronger digital skills are 72 CHARTING GEORGIA’S FUTURE Figure 44. Learning gap labor market institutions should provide stronger career In years advisory services, and intermediation and job matching services to reduce labor reallocation frictions for both 15 workers and employers. To improve the quality of job Learning-Adjusted Years of School intermediation services, new tools should be developed Czech Republic Estonia to profile and orient vulnerable jobseekers. In case of 10 Ukraine Belarus capacity constraints at the State Employment Support Armenia Agency (SESA), outsourcing can be a good option too, Albania though SESA would need to set standards and frequently assess the providers’ performance. Analysis of big data, 5 Georgia such as real-time vacancy data posted in private online job portals, should be part of the SESA’s methodology to identify and forecast skills in demand. Worknet’s, 0 0 5 10 15 SESA’s e-portal for employment services, partnerships should not be limited to collaborations with public Expected years of school sector bodies but also should include the private sector. Source: World Bank. By establishing linkages with privately managed job portals, the government can play an important role in expected to have an impact on the employability of coordinating labor market information and ensure that youth, as well as productivity of small firms. In addition, all stakeholders in the labor market have accurate and more attention should be paid to transversal skills (i.e., timely information for decision making. languages, organizational skills) that are adaptable to the changing nature of jobs. The longer-term education Finally, more can be done to make the labor market reforms imply rethinking the role played by the general more inclusive. To reduce gender disparities, the secondary education system. Given the limited demand Government of Georgia may consider adopting for workers with only generic skills, secondary general measures for pay transparency similar to those education needs to be complemented by systemic recently proposed by the European Commission.29 options to acquire occupational or technical, job- Improvements to childcare, including early childhood specific skills, for example, by developing a system of education, and elderly care will be particularly crucial. In post-secondary technical occupation. addition, tapping underutilized sources of labor supply by strengthening active labor market policies (ALMPs) Enhanced labor market information systems are (e.g., evidence-based wage subsidies, internships, work- needed to lower information asymmetries, inform based experience arrangements etc.) would increase labor market, education, and training policies, and economic growth and inclusion. The school-to-work inform budget allocations. Information on occupations transition could be facilitated by expanding work- and skills in demand is crucial to better align skills based experience arrangements and strengthening the supply with demand. It allows educational and training linkages between schools and employers (mandatory institutions to better adjust program offerings and short-term internships, integration of firms’ capstone curricula to labor market needs, while helping students projects in curricula). The dual VET model may be an (prospective workers) and jobseekers to make informed option for stronger and more systematic engagement career decisions and invest in skills that are in demand. To between vocational colleges and employers. start with, more—and more frequent—statistical surveys, coupled with “real-time” labor market information from Georgia’s pre-existing skills mismatches and high online job postings and administrative data is needed unemployment have been accentuated by the labor to provide up-to-date, granular data and shed light market disruption from the COVID-19 pandemic. on how the demand for occupations is evolving. Next, While the economy is recovering, education and labor 29  The proposal sets out measures, such as pay information for job seekers, a right to know the pay levels for workers doing the same work, as well as gender pay gap reporting obligations for big companies. COMPETITIVE, CONNECTED, CAPABLE 73 market losses may have long-term consequences on implies an increased demand for both basic digital equality of opportunity, vulnerability, and gender gaps. skills and socio-emotional skills, which not all workers Targeted policies may be needed to compensate for the in Georgia possess. Jobs in the post-COVID phase learning and health losses. In addition, the pandemic will require investment in up-skilling workers, broad may have accelerated the structural shifts imposed by improvements to foundational human capital, as well technological changes (e.g., automation, digitalization). as enhanced employment services to facilitate labor The increased use of computers and digital technologies reallocation. 74 CHARTING GEORGIA’S FUTURE Bibliography Gill, I., & Raiser, M. (2012). Golden Growth: restoring the lustre of the European economic model. Washington, Acemoglu, D. (2005). Understanding Productivity D.C.: World Bank. Differences. presentation. 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