The FINANCIAL - Georgia Macroeconomic Review, SP Advisors

Georgia Macroeconomic Review, SP Advisors

The FINANCIAL -- The Georgian economy continues to grow, but the trend remains unstable because the base underpinning the expansion is still narrow. According to our estimates, the 1H GDP increase was driven by a surge in FDI, heightened government spending, and a spectacular increase in the number of foreign tourists.

Private household consumption is meager and remains the key drag on growth. Inflation decelerated rapidly in recent months after the lari strengthened. In 2015, the external environment was the key source of risk, but it has turned much more favorable in 2016. Steady FDI and debt inflows are covering the C/A deficit (which is poised to increase slightly this year) and enabling the NBG to replenish reserves.

GDP growth remains sluggish and volatile

The Georgian economy has maintained a moderate pace of growth after the economies of its key trading partners decelerated sharply from 2014 onwards. GDP expanded 2.9% yoy in 5M16, but the monthly trend has been volatile – decent growth of 4.3% yoy in April was followed by a much less impressive 2.1% in May. By our estimates, the construction sector (+25.7% yoy in 1Q16 in real terms) contributed nearly half of the increase in total output. Other sectors growing rapidly and contributing materially to growth include hotels and restaurants (+11.7% yoy) and real estate (+9.4%). At this point, growth is being supported on the demand side by an increase in government spending and strengthening external demand backed by tourism inflows. Private domestic demand remains weak and has so far not played a major role in the recovery. Household consumption is hindered by sluggish growth in real wages (partly the effect of high inflation in 4Q15 and 1Q16) and a drop in migrant remittances. We don't foresee any major surprises to the current growth trend, although a symbolic acceleration is likely in the 2H as post-shock effects from 2014-15 are fading. We maintain our 2016 GDP growth forecast at 3.1% yoy.

Inflation decelerated sharply in recent months and came in at 1.1% in June vs. 6.3% last November. The CPI has reacted swiftly to exchange rate movements as the lari strengthened from c. GEL 2.5/USD in Jan.-Feb. to c. GEL 2.15/USD in early June before reversing slightly recently. We believe demand and supply pressures to higher inflation are insignificant at this point, but FX rate volatility remains an issue for the inflation outlook. The NBG has so far maintained a cautious policy stance – the regulator only cut its key interest rate twice in 1H16, by 100 bps to 7%. We see inflation at around 4% at end-2016, broadly in-line with the NBG's target of 5%, and we expect bolder easing action by the NBG in late July.

External misbalances alleviated, FX market driven by short-term factors

The NBG let the lari depreciate 21% in 2015 to GEL 2.4/USD to absorb external shocks. This proved to be the only feasible and effective way to take control of growing external misbalances. Georgia's external position improved materially in 2Q16, which was reflected in improvements in the FX market. We expect the positive trend to persist through end-2016 mainly thanks to two factors: i) a material increase in service exports – tourism is surging, with arrivals by air to Georgia up 37% yoy in 5M16, ii) FDI is on the rise – net inflows doubled yoy to USD 376 mln in 1Q16. Meanwhile, migrant remittances (a material C/A component) remain weak (see chart on the left) and commodity exports are still some 10% lower yoy. The supply of foreign currency has been on the rise since March, which has enabled the NBG to boost FX reserves by 6% in March-May to USD 2.57 bln – entirely sufficient to maintain the confidence of markets.

We see the C/A deficit growing slightly to 13.2% of GDP in 2016 (vs. 12.5% last year), but it should remain fully covered with capital inflows to leave the FX market largely stable. The current pressure on the lari that resulted in a 6% depreciation in the past two weeks looks temporary. On balance, we bring our end-2016 exchange rate forecast up to GEL 2.25/USD from GEL 2.35/USD previously.