Document ofThe World Bank

FOR OFFICIAL USE ONLY

Report No. 67922-GE

INTERNATIONAL DEVELOPMENT ASSOCIATION

PROGRAM DOCUMENT

FOR

A PROPOSED CREDIT

IN THE AMOUNT OF SDR 39.8 MILLION(US$60 MILLION EQUIVALENT)

TO

GEORGIA

FOR A

COMPETITIVENESS AND GROWTH DEVELOPMENT POLICY OPERATION

July 20, 2012

Poverty Reduction and Economic Management UnitSouth Caucasus Country UnitEurope and Central Asia Region

This document has a restricted distribution and may be used by recipients only in the performance of theirofficial duties. Its contents may not otherwise be disclosed without World Bank authorization.

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GEORGIA - GOVERNMENT FISCAL YEAR

January 1 - December 31

CURRENCY EQUIVALENTS(Exchange Rate Effective as of June 19, 2012)

Currency Unit LariUS$1.00 1.62

Weights and Measures:Metric System

ABBREVIATIONS AND ACRONYMS

AAA Analytic and Advisory Activities LDR Loan to Deposit RatioADB Asian Development Bank LEPL Legal Entities of Public LawBCP Border Crossing Points MDGs Millennium Development GoalsCFAA Country Financial Accountability MIP Medical Insurance Program

Assessment MoE Ministry of Economic DevelopmentCIS Commonwealth of Independent States MoF Ministry of FinanceCPS Country Partnership Strategy MoLHSA Ministry of Labor, Health, and SocialDCFTA Deep and Comprehensive Free Trade Affairs

Agreement MOU Memorandum of UnderstandingDPO Development Policy Operation MTEF Medium-Term Expenditure FrameworkDSA Debt Sustainability Analysis NBG National Bank of GeorgiaEBRD European Bank for Reconstruction and NICE National Institute for Health and Clinical

Development ExcellenceEC European Commission OECD Organization for Economic Co-operationECA Europe and Central Asia and DevelopmentEIB European Investment Bank PER Public Expenditure ReviewENP European Neighborhood Policy PFM Public Finance ManagementESIA Environmental & Social Impact PIRLS Progress in International Reading Literacy

Assessments StudyESMP Education Sector Master Plan PISA Program for International StudentFDI Foreign Direct Investment AssessmentCG DPO Competitiveness and Growth Development PF Partnership Fund

Policy Operation PRSO Poverty Reduction Support OperationFTA Free Trade Agreement ROA Return on AssetsGDP Gross Domestic Product ROE Return on EquityGEL Georgian Lari ROSC Report on the Observance of Standards andGNP Gross National Product CodesGoG Government of Georgia SBA Standby ArrangementGIZ German Agency for International SCF Standby Credit Facility

Cooperation SDR Special Drawing RightsIBRD International Bank for Reconstruction and SIDA Swedish International Development Agency

Development Sims Social Information Management SystemIDA International Development Association TEDS-M International Association for the EvaluationIDPs Internally Displaced Peoples of Educational AchievementIFC International Finance Corporation TIMSS Trends in Mathematics and ScienceIMF International Monetary Fund TSA Targeted Social AssistanceIPSAS International Public Sector Accounting UNDP United Nations Development Program

Standards UNICEF United Nations Children and EducationISO Independent System Operator FundJSAN Joint Staff Advisory Note USAID United States Agency for International

MW German Development Bank Development

Acting Vice President: Philippe Le Hou6rouCountry Director: Henry G. Kerali

Sector Director: Yvonne M. TsikataSector Manager: Ivailo V. Izvorski

Task Team Leader: Rashmi Shankar

TABLE OF CONTENTS

I. INTRODUCTION ............................................................................................................................ 1

II. COUNTR Y CONTEXT ................................................................................................................... 2

A. RECENT ECONOMIC DEVELOPMENTS ................................................... 3B. POVERTY DEVELOPMENTS ........................................................ 6

C. MACROECONOMIC OUTLOOK AND DEBT SUSTAINABILITY .............................. 7

III. THE GOVERNMENT'S PROGRAM AND PARTICIPATORY PROCESSES ....................... 11

IV. BANK SUPPORT TO THE GOVERNMENT'S PROGRAM..................................................... 14

A. LINK WITH THE CPS ...................................................... 14B. COLLABORATION WITH THE IMF AND OTHER DONORS ................................ 15C. LINKS WITH OTHER BANK OPERATIONS ............................................. 15D. LESSONS LEARNT AND ANALYTICAL UNDERPINNINGS ................................ 16

V. THE PROPOSED PROGRAMMATIC DEVELOPMENT POLICY OPERATION.............19

PILLAR I: COMPETITIVENESS ............................................................................................................... 20

A. TRADE AND TRADE FACILITATION ................................. .. ............... 20B. STRENGTHENING THE INVESTMENT CLIMATE IN POWER ............................... 24C. EDUCATION..................................................................... 26

PILLAR II: PUBLIC FINANCIAL MANAGEMENT ........................................................................... 30

PILLAR III: EFFECTIVENESS OF SOCIAL SPENDING.................................................................. 32

VI. OPERATION IMPLEMENTATION......................................................................................... 36

A. IMPLEMENTATION, MONITORING AND EVALUATION..................................36B. POVERTY AND SOCIAL IMPACTS AND GENDER IMPACTS ............................... 36C. ENVIRONMENTAL ASPECTS........................................................37D. FIDUCIARY ASPECTS.............................................................38E. DISBURSEMENT AND AUDITING...................................................39F. RISKS AND RISK MITIGATION..................................................... 40

ANNEXES

ANNEX 1: OPERATION POLICY MATRIX ........................................................... 42ANNEX 2: MATRIX OF OUTCOMES AND MONITORING INDICATORS ................................. 46ANNEX 3: IMF PUBLIC INFORMATION NOTICE.................................................... 47ANNEX 4: COUNTRY AT A GLANCE ............................................................... 49

TABLES

Table 1: Georgia Selected Economic Indicators, 2003-2011............................................4Table 2: Selected Banking Indicators...........................................................5Table 3: Georgia Selected Economic Indicators, 20011-2015...........................................8Table 4: Composition of Expenditure Adjustment, 2009-2015..........................................9Table 5: Projected Sources of External Financing..................................................10Table 6: Links between the CG DPO Program and Selected Prior Analytical Work............... ................ 18

FIGURES

Figure 1: GDP and Trade Show an Upward Trend..........................................3Figure 2: FDI Still Lower Than Pre-Crisis...............................................3Figure 3: Most Spending Components Are Down..........................................5Figure 4: Cuts in Current Spending Are Significant.........................................5Figure 5: Poverty Headcount Trends, 2007-10............................................7Figure 6: Growth Incidence Curves, 2008-2009, and 2009-2010................................7Figure 7: Fiscal Framework (2009-2015)................................................9Figure 8: External Current Account and Financing.........................................9Figure 9: Standard Debt Stress Scenarios................................................ 1

BOXES

Box 1: Good Practice Principles for Conditionality....................................17

The proposed Competitiveness and Growth Development Policy Operation was prepared by a team consistingof Mariam Dolidze, Elene Inmadze, Owen K. Smith, Nino Kutateladze, Meskerem Mulatu, Arman Vatyan,Salvador Rivera, Ramya Sundaram, Adriana Eftimie, John E. Strongman, Adriana Damianova, Tamuna

Namicheishvili, Zakia Nekaien-Nowrouz, Sarah Babirye, Ahmed Eiweida, Joseph Melitauri, Jose LuisGuasch, Faruk Khan, Uzma Khalil, Salvador Riviera, Michel Zarnowiecki, Karen Grigorian, Claudia Rokx,Nino Moroshkina, Ghada Youness, Pedro L. Rodriguez, Darejan Kapanadze, Sarosh Sattar, Maria Davalos,Carola Gruen, and Rashmi Shankar (TTL). The team gratefully acknowledges the excellent collaboration ofthe Georgian authorities, development partners, as well as the support and guidance of Asad Alam, YvonneTsikata, Ivailo V. Izvorski, Sophie Sirtaine, Roumeen Islam, and Erika Jorgenson.

OPERATION AND PROGRAM SUMMARY

GEORGIA

COMPETITIVENESS AND GROWTH DEVELOPMENT

POLICY OPERATION (CG DPO)

Recipient Georgia

Implementing Agency Ministry of Finance

Financing Data IDA Credit of SDR 39.8 million (equivalent to US$ 60 million)IDA terms: 25 year maturity including a 5 year grace period

Operation Type Programmatic Development Policy Operation (Competitiveness and Growth DPO or CGDPO)

Main Policy Areas The proposed series of three programmatic development policy operations is intended tosupport the Government of Georgia's medium-term reform program for competitiveness andinclusive growth. The main policy areas supported by the CG DPO are: (i) competitiveness;(ii) public financial management; and (iii) effectiveness of social spending.Actions under the competitiveness pillar for the proposed CG DPO will help deepen reformsto support trade policy and trade facilitation, the quality of general education, and theinvestment climate in the power sector, which will lead to higher investment and exports,and more jobs.The second pillar, improved effectiveness of public financial management, includesmeasures that will be implemented over the course of the three year DPO program tosupport increased transparency and coverage of financial reporting as well as the phasedimplementation of international accounting standards.The third pillar, effectiveness of social spending, will support actions to improve quality andaccess of health services. In addition, the supported reforms will improve the efficiency ofthe medical insurance plan and the targeted social assistance by lowering transactions coststo beneficiaries.

Key Outcome Indicators Selected key outcome indicators expected by 2015 include (the baseline is for 2011 unlessindicated otherwise):1.1: Promote market access with a view to enhancing exports and foreign investment:* Trade with the EU reaches 22 percent of GDP (Baseline: 17 percent of GDP);1.2: Improve customs efficiency to facilitate trade:* Score on the customs component of the World Bank's Logistics Performance Index

improves to 3.5 (Baseline: 2.37 in 2010)1.3: Enhance climate for attracting investment in the power sector:* Power exchanges increase to 3 TwH (Baseline: 1.5 TwH).I.4: Strengthen the quality of general education to support competitiveness throughimproved national curriculum and better human resource policies:* Learning outcomes from national assessments of Grade 9 in Georgian language and

literature and mathematics improve. (2009 Baseline scores: above average performancein Georgian and mathematics was achieved by 44% and 45% of students respectively) -

II.1: Strengthen the efficiency of treasury management:* Improvement in the relevant PEFA indicator (PI 25) to C (Baseline: D+ in November

2008).111.1: Improve access and quality of health care:* Coverage under the Government's Medical Insurance Program increases to 35 percent

of the population, an increase of about 600,000 persons (Baseline: 21 percent);111.2: Improve the efficiency of targeted programs:* The time taken for issuing first benefits after assessing beneficiary eligibility will fall to

60 days for the TSA and the MIP (Baseline: 90 days for the TSA and 120 days for theMIP).

1

Program Development The Program Development Objective is to support competitiveness and inclusive growth.Objective(s) and This will be achieved by:Contribution to CPS (i) Improving competitiveness through efforts to enhance market access for exports and

foreign investment, facilitate trade, strengthen the investment climate in the power sector,and modernize and build a high quality education system. These measures will supportinvestment and exports as well as productivity increases needed for both capacity and jobcreation;(ii) Strengthening public financial management by improving accounting controls throughthe phased introduction of IPSAS and better coverage and transparency of the budget. TheGovernment has already started expanding performance based budgeting to all levels of theGovernment. As part of the focus on results and quality of spending, the measures under theproposed CG DPO series will support better accountability, coverage, and transparency ofthe budget; and(iii) Enhancing the effectiveness of social spending by strengthening social safety netsthrough improved quality of and access to health services and efficiency of the targetedsocial assistance program. The measures under this pillar will support the enforcement ofupgraded quality standards in hospitals and laboratories and will also support wider accessto health care services through an expansion in state-funded insurance. In addition, theefficiency of administration of the targeted programs will be improved to ensure thatapplicants to both the Targeted Social Assistance and the Medical Insurance Program facesmaller processing times before receiving benefits.This development objective is also central to the 2010-2013 Country Partnership Strategy(CPS), which is built upon the pillar of strengthening competitiveness for post-crisis growth.

Risks and Risk There are two main sources of risk: (i) risks to the macroeconomic framework; and (ii)Mitigation program-specific risks. Macroeconomic risks stem from vulnerability to contagion from the

Euro zone crisis, which may adversely affect FDI, exports and growth. In addition, regionaltensions may affect investor and consumer confidence. Pressures to increase social andinvestment spending may challenge fiscal consolidation efforts, also considering thepossibility of downside risks relating to the Euro zone crisis and the domestic politicalcalendar. Program specific risks stem from potential capacity and implementationconstraints.These risks are mitigated through several actions. A first cushion against the Euro zonecrisis will be provided by the Government's inflation targeting and flexible exchange ratepolicies, large Government savings, comfortable international reserves, the PrecautionaryStandby Arrangement and Standby Credit Facility with the IMF, and Georgia's marketaccess, as evidenced by the successful sovereign Eurobond issuance in April 2011.Regarding regional tensions, Russia's WTO accession and Georgia's unilateral waiver ofvisa requirements for Russian citizens may contribute to improved economic ties.Regarding fiscal risks, the authorities committed to remaining on track with their fiscalconsolidation strategy, including through the IMF SBA and SCF. These risks will be closelymonitored. Capacity and implementation constraints are mitigated by the authorities'commitment to the program and to working with all key stakeholders. Other internationaldevelopment partners are providing complementary technical assistance in specific reformareas that will also mitigate implementation risks. USAID, EBRD, and IFC are collaboratingwith the Government on the power sector strategy. The EU is providing technical assistanceto support the legislative and regulatory reforms required to enter the Deep andComprehensive Free Trade Agreement.

Operation ID P129597

11

IDA PROGRAM DOCUMENT FOR THE COMPETITIVENESS AND GROWTHDEVELOPMENT POLICY OPERATION TO GEORGIA

I. INTRODUCTION

1. The proposed competitiveness and growth operation (CG DPO) is a ProgrammaticDevelopment Policy Operation for Georgia. The CG DPO is in the amount of $60 millionequivalent and supports measures aimed at facilitating competitiveness and inclusive growth.The proposed DPO series is a central component of the Country Partnership Strategy (CPS) for2010-13. The program outlined in the document was prepared following two years of post-crisisrecovery, and at a time of strengthened focus on the competitiveness pillar of the CPS.

2. The proposed DPO series is anchored in the developmental objectives of theGovernment's "Ten Point Plan of Modernization and Employment." The Plan includes awide range of policy and institutional reforms, several of which are under implementation. Theseinclude efforts to strengthen the power sector and infrastructure, to position the country as aregional trade and logistics hub, and to intensify investment and export promotion.Modernization of agriculture, tourism, and regional development are also critical components ofthe Plan. The government's program combines broad-based reforms with targeted sectoral effortsaimed at achieving sustained high and inclusive growth.

3. The CG DPO series supports the Government's reforms that are critical to theachievement of competitiveness and inclusive growth. The proposed series supports anadequate macroeconomic framework and policy measures under three pillars:(i) competitiveness; (ii) public financial management; and (iii) effectiveness of social spending.These pillars are consistent with and build upon previous policy lending to Georgia. The policyactions supported by the CG DPO were developed in close collaboration with the Governmentand focus on areas where the Bank has comparative advantage and is leveraging expertise andtechnical support through cooperation with international partners. The strong commitment to theprogram on the part of the government is expected to ensure implementation and sustainability ofthe DPO program.

4. The strategy adopted by the Government is to promote a virtuous cycle of productivityimprovements and higher investment and exports to generate growth and employment, andadequately strengthen social safety nets. First, trade and trade facilitation, modernization ofeducation, and deepening of investment climate reforms in the power sector will supportcompetitiveness. This enhanced competitiveness is expected to facilitate investment, improveproductive capacity, create jobs, and provide easier access to world markets. Focusing on jobs iscritical for Georgia, where high pre- and post-crisis growth has been accompanied by thepersistence of social vulnerabilities. Second, improvements in the efficiency of public financialmanagement will continue to support fiscal adjustment and improved quality of spending in linewith growth and social priorities by strengthening budgetary accountability, coverage, andtransparency. Third, greater effectiveness of social spending will help ensure that the benefits ofgrowth are broadly shared, along with a strengthening of social safety nets.

1

II. COUNTRY CONTEXT

5. Georgia has been implementing far-reaching reforms since 2004 with impressiveresults. Prior to 2004, Georgia was one of the poorest performing economies in the regionmainly due to conflict and governance issues, with 2003 GDP at 40 percent of the 1989 level.Starting in 2004, reforms undertaken to strengthen public finances, improve the businessenvironment and social services, fight the then all-pervasive corruption, liberalize trade, andupgrade infrastructure, helped achieve an annual average growth of more than 9 percent over2004-08. Foreign direct investment (FDI), encouraged by stronger investor confidence due to animproved business environment, was the main driver of this growth. Georgia's Doing Businessrank improved from 112th in 2005 to 15th in 2008. Effective public debt management led toexternal public debt declining from 46 percent of GDP in 2003 to 17.5 percent by 2007. Duringthe same period, better public administration led to tax revenues increasing by 11 percentagepoints of GDP.

6. However the double shocks of the crisis and conflict of 2008 represented a set-back.While the Government's reforms were successful in pulling Georgia out of "fragile" status, thecountry then experienced a sharp downturn in economic growth as a result of the double shocksfrom the August 2008 conflict, which was preceded by the closing of the Russian market, and thesubsequent global economic crisis. These shocks had severe consequences for growth due to asharp deterioration in investor and consumer confidence, contraction in foreign directinvestment, exports, and remittances, and a cutback in bank lending.

7. The Government responded with a countercyclical fiscal stimulus that led to economicrecovery by 2010. Bolstered by public investment, growth reached 6.3 percent in 2010 after theeconomy contracted 3.8 percent in 2009. The Government reprioritized expenditures and raisedthe level of spending from about 34 percent of GDP in 2007 to 38 percent in 2009. Expenditureson transport infrastructure, education, health, and social protection were scaled up significantly,with the fiscal space for these increases coming in part from a marked reduction of defenseexpenditures and tightening of public sector administration. At the same time, revenuecollection suffered, leading to a widening of the fiscal deficit by 2009 (Table 1). The higherfiscal deficits were financed primarily through increased donor support on concessional terms.

8. The Government's reforms address two priorities - increasing employment andnarrowing the current account deficit. High growth during 2004-2008 was accompanied byunemployment rates of about 13 percent range. This was due to three main reasons: (1) a sharpdecline in public sector employment following an efficiency enhancing reorganization; (2) lowemployment base in fast growing sectors and slower increase in number of jobs in these sectorscompared to losses in shrinking sectors; and (3) growth occurring on the back of more effectiveutilization of excess capacity. Looking forward, several actions will boost job growth.Modernization of agriculture and education, and new investments in infrastructure, transit andlogistics systems and power will support growth in both capacity and productivity, leading toincreases in both the supply of jobs and demand for workers. It is also expected that agriculturalproductivity increases will release labor into higher value employment in light manufacturing,agro business and services. The Government also aims to improve the current account balanceand ensure sustainable financing through policies that will lead to higher exports and inflows ofFDI. Low savings and high import demand as well as investment needs have led to persistentcurrent account deficits in Georgia. The saving rate in the early 2000s was about 25 percent of

2

GDP but fell due to sharp increases in demand (driven by the credit boom) and later, after thecrisis, by the need to smooth consumption. As these factors recede in importance, householdsavings are expected to recover, which should ease pressure on the current account.

9. Domestic political conditions remain stable. Parliamentary elections are scheduled forOctober 2012 and Presidential elections will follow in 2013. All the main political parties arecommitted to economic and institutional reform policies.

A. RECENT ECONOMIC DEVELOPMENTS

10. The Georgian economy continued to recover strongly in 2011, growing by 7 percent.The external environment remained challenging, with weaker than expected world economicgrowth and a deepening Euro zone crisis that dragged down growth in the emerging economiesof Eastern and Central Europe. Georgia's performance, however, was strong across the board.Agriculture recovered robustly after contracting each year between 2008 and 2010. Industrycontinued to grow strongly, driven largely by mineral products and food processing.Merchandise exports, mainly metal and metal products, repaired and re-manufactured vehicles,fertilizers, fruits and nuts, and wines and beverages, increased by a third in 2011, recovering topre-crisis levels. The rebound in the growth of the service sector was supported by transit-related transport (particularly to and from Armenia, Azerbaijan, and Central Asia). In addition,the government's efforts to promote Georgia as a tourist destination helped raise tourismrevenues by 57 percent in 2011, reflecting a 39 percent increase in tourist arrivals. Growth inservices was also driven by wholesale and retail trade, financial intermediation, hotels andrestaurants, and communication. While remittances continued to increase, FDI stayed below pre-crisis levels, and is an area of renewed focus in the Government's 10 Point Plan.

Figure 1: GDP and Trade Show an Upward Trend Figure 2: FDI Still Lower Than Pre-Crisis(in percent) (in millions of US dollars)

15 - 80 2000

60

10 - 40 1600

5 20 12000

0 -20800

-40-6040...................... --60

40010-

Real GDP growth (%) Exports (right axis) YRO6 YRO7 YRO8 YRO9 YR10 YR11-4- Imports (right axis)

Source: Calculations based on Georgia Ministry of Finance, NBG, and IMF data.

11. Inflation has declined further. Prices fell 3.3 percent (y-y) in May 2012 after increasing bya recent high of 14.3 percent in May 2011. Food prices were down 11 percent (y-y) in May, butwere partially offset by higher prices for transportation (21.3 percent, y-y) due to higher oilprices. The NBG reduced its refinancing rate by 25 bps to 6 percent in May 2012 followingreductions by 0.25 ppt each month between October and January and then in April.

3

Table 1: Georgia Selected Economic Indicators, 2003-2011

2003 2007 2008 2009 2010 2011eNational accounts Annual percentage change, unless otherwise indicatedGDP nominal (in millions of Lari) 8,564 16,994 19,075 17,986 20,743 24,229GDP Growth (in percent), ofwhich: 11.1 12.3 2.3 -3.8 6.3 7.0

Agriculture 10.3 3.3 -4.4 -6.8 -4.8 5.5Industry 15.8 14.5 -3.9 -3.5 9.1 9.7

Manufacturing 7.9 15.9 -2.4 -6.6 12.7 12.0Services 10.1 12.1 5.4 -4.8 10.1 6.7

CPI (in percent) 4.8 9.3 10.0 1.7 7.1 8.5GDP per capita (in U.S. dollars) 922 2,318 2,920 2,455 2,623 3,213Unemployment Rate (in percent) 11.5 13.3 16.5 16.9 16.3 15.1Gross Investment (in percent of GDP) 31.3 32.1 26.0 13.0 21.6 23.3National Savings ( in percent of GDP) 21.7 12.4 3.3 2.4 11.3 11.5General Government Operations In percentage of GDP, unless otherwise indicatedRevenues and Grants 16.0 29.3 30.7 29.3 28.3 28.5Tax Revenues 14.6 25.8 24.9 24.4 23.5 25.4Expenditure and Net Lending 17.5 34.0 37.0 38.4 34.8 32.1Current Expenditure 14.7 25.0 28.5 30.1 26.0 23.3Capital Expenditure and Net Lending 2.8 9.0 8.6 8.4 8.8 8.9Overall Fiscal Balance -1.5 -4.7 -6.3 -9.2 -6.6 -3.6External SectorExternal Current Account Balance -9.6 -19.7 -22.1 -10.6 -10.3 -11.7Exports of Goods and Services 32.3 31.3 28.8 29.8 34.9 36.4Imports of Goods and Services 46.7 58.2 58.6 48.9 52.7 55.1FDI Inflows 8.3 17.2 12.2 6.1 7.0 6.8Intl Reserves (Months of Imports of G&S) 1.2 2.8 2.4 4.8 4.4 4.1Intl Reserves (millions of dollars) 191 1,361 1,480 2,111 2,265 2,819External Public Debt 1/ 44.9 17.5 20.9 31.4 33.6 29.0

Source: Georgian authorities and World Bank staff estimates.Notes: p=projections; 1/ public and publicly guaranteed.

12. As growth continued, the Government maintained a strategy of fiscal prudence. Theimproved fiscal position was due to lower current expenditures since higher tax revenues in2011, driven by strong growth, were offset by declining non-tax revenues and grants. Spendingcuts were mainly on defense, internal security, and general administration. Savings were realizedon social spending, even though the pension benefit was raised from GEL 80 in 2010 to GEL100 in 2011, mainly through improved targeting of the Targeted Social Assistance (TSA) andrenegotiation of Medical Insurance Plan (MIP) premiums. Given that the uncertain economicenvironment led to sluggish private investment (including FDI), the Government maintainedcapital expenditures. Investments in water and energy transmission remained priorities alongwith roads, IDP housing, and regional and municipal infrastructure.

13. The current account deficit widened from 10.3 percent of GDP in 2010 to 11.7 percentin 2011, driven by strong growth of imports. Imports grew 32 percent in 2011, driven byhigher food prices through the first part of the year and higher oil prices throughout the year.Higher demand from improved economic performance also contributed to the strong growth ofimports. Net inflows of FDI remained stable at 7 percent of GDP in 2011, while other privateinflows increased, most notably non-residents deposits in the banking sector and short termborrowing by banks. Official borrowing also contributed to financing the current account deficit.The exchange rate appreciated from 1.77 to 1.67 Lari per dollar over the course of 2011 in spiteof NBG interventions in the foreign exchange market that lead to an increase of $300 million tointernational reserves.

4

Figure 3: Most Spending Components Are Down Figure 4: Cuts in Current Spending Are Significant(in percent of GDP) (in percent of GDP)

35 .. 1.9........ ..................................................... -4- Gene ra public services

30

25*~ Transfers to local

20 --5 1 Defense

15

100-23 ............. ......... -411- Transport

2008 2009 2010 2011e 2012p 0el ae esion

Revenues, all m Current expenditure 2008 2009 2010 2011e 2012pCapital and net lending tdeficit (RHS)

Source: Calculations based on Georgia Ministry of Finance, NBA, and IMF data.

14. Prudent monetary policy supported price and exchange rate stability. The effective useof the policy rate as an instrument of inflation targeting and issuance of deposit certificateshelped sterilize the excess liquidity generated by capital inflows and the year-end spike in publicspending. At the same time the central bank modernized the mechanics of its interventions,reducing the frequency of exchange market transactions. This has contributed to exchange ratestability, with the real exchange rate appreciating by only 2 percent as of end-March.

Table 2: Selected Banking Indicators(in percent)

Indicator 2009 2011

Share of non-performing loans (NPLs) 17.9 8.6Loan loss provisioning/NPLs 71.4 80.4Return on Assets -0.8 2.9Return on Equities 4.3 17.3Loans to Deposits 163.3 141.8Capital Adequacy Ratio 18.3 16.6Source: World Bank Staff Calculations.Note: Share of non-perforling loans ratio and capital adequacy ratio are based on NBG methodology.

15. Profitability of the banking sector recovered substantially since 2009 due to animprovement in asset quality and reduction in loan loss provisioning following post-crisisrecovery. The returns on assets and equity (ROA and ROE) improved in 2011, driven bycontinued improvement in asset quality indicated by the decline in aggregate NPLs along withloan loss provisioning (though the coverage of NPLs improved). The loan to deposit ratio (LDR)also declined, as credit growth remains moderate compared with pre-crisis levels and greaterconfidence led to brisk growth in deposits in 2011. Dollarization of deposits continued to declinebut remains high. The improved strength of the banking sector reflects the better performance ofthe domestic economy and the Central Bank's efforts to strengthen financial sector regulatoryframeworks.

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16. External public debt declined from 33.6 percent of GDP in 2010 to 29.0 percent in2011. General government borrowing in 2011 was in line with public external debt managementobjectives. Public external debt, the bulk of which is provided on concessional terms and is oflong term maturity, is the main source of below the line financing. This financing strategy hashelped maintain a favorable public debt situation with low annual repayment volumes andservice costs (the average weighted interest rate on external public debt was only 2 percent as ofend-April 2012). Meanwhile, central government deposits of about GEL 700 million (over $450million) in treasury deposits provide liquidity against repayment needs, including a spike inamortization over 2012-2014. The domestic sources of deficit financing were the issuance oftreasury bills of about GEL 80 million and proceeds from privatization. The public external debtto GDP ratio is projected to go farther down by 2015 to about 23.2 percent of GDP under thecurrent amortization schedule.

B. POVERTY DEVELOPMENTS

17. Gains in terms of lower poverty were interrupted by the crisis, while consumptioninequality held fairly steady. Supported by high growth, poverty fell from 20.1 percent to 17.4percent between 2007 and 2009. Over the same period, consumption inequality (as measured bythe Gini coefficient) stayed at about 0.38. By 2010, the double shocks of the 2008 conflict andthe global crisis caused poverty to reach 21 percent with no change in inequality. Female-headedhouseholds saw an increase in their poverty rate that was twice as high as that for male-headedhouseholds. Evidence on the impact of the crisis suggests that greater hardship resulted mainlyfrom higher unemployment, and also through household debt. Unemployment is estimated tohave increased from 13.3 percent in 2007 to 16.9 percent in 2009.

18. The Government responded with several measures to assist the poor. The pensionbenefit was raised from GEL70 in 2009 to GEL100 in 2011, and will increase further to GEL125in 2012 (effective September). Coverage and benefits have also increased for the targetedprograms, both the targeted social assistance (TSA) and the medical insurance programs (MIP).While the old age pension is untargeted, it has a significant poverty mitigating impact. Inaddition, in 2011 and 2012, the Government gave electricity vouchers of GEL20 per year to allpower subscribing households because of unusually severe winter conditions. This measurebenefited an estimated 1.2 million households in each year. A food voucher was also distributedto 1.2 million households in March 2011 in the amount of GEL30. These actions, along with thecounter-cyclical fiscal stimulus, are estimated to have helped the poor especially in rural areas.

19. More recently, following two years of growth, unemployment declined in 2011. Thelatest estimates suggest that strong growth since 2010 led to a lower unemployment rate of 15.1percent in 2011. However, poverty numbers are not yet available. Given that growth has beenacross the board in 2010 and 2011, including robust recovery in agriculture, poverty is likely tohave declined as well. The most recent household survey data covering 2011 will becomeavailable in the third quarter of 2012 and will allow an updated analysis.

6

Figure 5: Poverty Headcount Trends, 2007-10(in percent)

30.0

25.0

20.00 2007

15.00 2008

10.0 IN2009

5.0 02010

0.0 Overall rban Rural

Area of residence

Source: Calculations based on the HBS 2007-2010, and national poverty lines, as provided byGeoStat.

Figure 6: Growth Incidence Curves, 2008-2009, and 2009-2010

(in percent)

14- Total (years 2008 and 2009) Total (years 2009 and 2010)

- Gmth-inddence 95% confience bounds - Growth-incidence 95% confidence bounds

- Growth at median - Growth in mean - Growth at median - Growth in mean

- Mean growth rate - Meangrowth rate

7-

91 4-

-e--5-

-11 -a-

1 10 20 30 40 50 60 70 80 90 100 1 10 20 30 40 50 60 70 80 90 100

Expenditure percentiles Expenditure percentiles

Source: Calculations based HBS 2008-2010. Consumption expenditures are measured in 2007 prices.

C. MACROECONOMIC OUTLOOK AND DEBT SUSTAINABILITY

20. Growth is likely to remain robust over the medium term despite a weak globaleconomy under the assumption of higher private domestic investment and productivity inthe tradable sectors. Georgia's growth strategy is based on a competitive and vibrant privatesector supported through the Government's comprehensive structural reforms aimed at bolsteringinvestment and productivity growth in tradables. This strategy is expected to lead to a significantincrease in exports, stemming from new products and the expansion of market share of existingproducts. The government is also developing a strategy to expand Georgia's high potential

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hydropower sector, with the Black Sea transmission line connecting to the Turkish grid comingon stream this year. Reforms are underway to facilitate new investment in hydros and otherrenewables to support Georgia's entry into regional electricity trade while providing reliable andcost-efficient energy to the growing domestic private sector. Turkey, in particular, is a significantpotential market for electricity exports. Transport and transit related services and tourism havealso been identified as having high employment and export potential. The Government istherefore continuing with efforts to strengthen the logistics system and improve the efficiency ofcustoms, areas in which noteworthy advances have already been made.

Table 3: Georgia Selected Economic Indicators, 20011-2015

2011e 2012p 2013p 2014p 2 015pNational accounts Annual percentage change, unless otherwise indicatedGDP nominal (in millions of Lari) 24,229 26,753 30,202 34,255 38,852GDP Growth (in percent) 7.0 6.0 5.5 5.0 5.0CPI (in percent) 8.5 6.0 6.0 6.0 6.0GDP per capita (in U.S. dollars) 3,213 3,547 4,005 4,542 5,152Unemployment Rate (in percent) 15.1 14.5 13.8 13.0 12.2Gross Investment (in percent of GDP) 23.3 23.0 23.0 23.0 23.0National Savings ( in percent of GDP) 11.5 13.3 14.1 15.4 16.6General Government Operations In percent of GDP, unless otherwise indicatedRevenues and Grants 28.5 27.4 27.3 27.1 26.9Tax Revenues 25.4 24.7 24.7 24.7 24.7Expenditure and Net Lending 32.1 30.9 30.3 29.7 29.0Current Expenditure 23.3 22.5 22.3 22.1 21.8Capital Expenditure and Net Lending 8.9 8.4 8.0 7.6 7.2Overall Fiscal Balance -3.6 -3.5 -3.0 -2.7 -2.1External SectorExternal Current Account Balance -11.7 -9.7 -8.9 -7.6 -6.4Exports of Goods and Services 36.4 39.2 42.2 46.5 50.2Imports of Goods and Services 55.1 56.5 57.7 59.0 60.5FDI Inflows 6.8 6.1 6.0 6.0 6.0Intl Reserves (Months of Imports of G&S) 4.1 3.9 3.5 3.4 3.4Intl Reserves (millions of dollars) 2,819 2,924 2,894 3,052 3,351External Public Debt 1/ 29.4 27.7 25.3 24.2 23.2Source: Georgian authorities and World Bank staff estimates.Notes: p=projections; 1/ public and publicly guaranteed.

21. Both capital and current expenditure consolidation will contribute to fiscaladjustment during 2012-15. The Government's medium-term fiscal framework projects areduction in the overall fiscal deficit to 2.1 percent of GDP by 2015 from 3.5 percent in 2012(Table 2). Total revenues are projected to remain fairly stable in the absence of an increase in taxrates. Given that collections are already high in Georgia and there are few exemptions, room forfurther expansion of tax revenues is limited. The Government's medium-term fiscal frameworkprojects that current and capital expenditures will make similar contributions to adjustment. Asprivate investment recovers and increases in response to the reforms, pressures to maintain highlevels of public investment should abate. While current expenditures will continue to grow innominal terms, particularly to meet social needs, the share in GDP will decline as part of thefiscal consolidation strategy.

8

Table 4: Composition of Expenditure Adjustment, 2009-2015(in percent of GDP)

2009 2010 2011 2012p 2013p 2014p 2 01 5 p

Total Expenditures 38.4 34.8 32.1 30.9 30.3 29.7 29.0Current Expenditure 30.1 26.0 23.3 22.5 22.3 22.1 21.8

Wages& Salaries 5.8 5.4 4.7 4.6 4.6 4.4 4.3

Goods& Services 6.1 5.4 5.0 4.4 4.3 4.3 4.2

Interest payments 1.0 1.0 1.2 1.3 1.0 1.1 1.1Subsidies& Grants 2.4 1.9 1.8 1.7 1.5 1.6 1.6Social expenses 8.4 7.8 6.8 6.8 7.3 7.0 7.0Other expenses (incl: clearance of arrears) 6.3 4.5 3.7 3.7 3.4 3.6 3.5

Capital expenditure and net lending 8.4 8.5 8.9 8.4 8.0 7.6 7.2

Source: Georgian authorities and Bank/IMF Staff estimates.Notes: p=projections.

22. Challenges stem from the Euro zone crisis, and from social and investment spendingneeds. A scenario in which the Euro zone crisis deepens may have adverse impacts on exports,FDI, tourism and remittances, leading to lower growth. Under this scenario, fiscal tighteningmay not be possible as envisaged. On the domestic front, the old-age pension, which thoughuntargeted has significant poverty-mitigating impact, requires periodic adjustment to protect thepurchasing power of beneficiaries. In addition, Georgia's infrastructure needs are still large,including in the areas of international and secondary roads (especially the East-West Highway),municipal infrastructure and urban regeneration, IDP housing, energy transmission, and water.Delivering on fiscal consolidation will require greater selectivity in investment spending throughfurther strengthening of the capital budgeting systems.

Figure 7: Fiscal Framework (2009-2015) Figure 8: External Current Account and Financing(in percent of GDP) (in percent of GDP)

40 16.307 29 271 2. 2011e

30 2132

20 244 3 25 5 247T 23.8 2.92014z

4 10 2015zS4-

00

0ME40-32 . 35 -2.9 -2.4 -1.5 -

-6.7

-20 ..... . ..................................................... ... ............................. .... External FDI Inflows Public Sector Other Private IMF2009 2010 2011e 2012p 2013p 2014p 2015p Current inflows resources,

Revenues and Grants -U--Tax Revenues Account net

- Expenditure and Net Lending -- - Overall Fiscal Balance Balance

Source: Calculations based on Georgia Ministry of Finance, NBA, and IMF data.

23. The current account deficit is projected to narrow in 2012 and onward, with aflexible exchange rate anchoring sustainability in the face of uncertain capital inflows. Thecurrent account improvement assumes that exports grow faster than imports, and that as incomegrowth remains steady, savings start to rise. In addition, the Government's reform programtargeted at agricultural modernization, building Georgia as a regional logistics hub, andstrengthening hydro-power and infrastructure, is expected to both improve tradables'

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productivity and output. The current account is viewed as stable, given projections on continuedofficial and private inflows, barring adverse events. Exchange rate flexibility will also continueto support external sustainability.

Table 5: Projected Sources of External Financing(in percent of GDP)

2007 2008 2009 2010 2011* 2012p 2013p 2014p 2015p

Current account deficit -19.7 -21.9 -10.6 -10.3 -11.7 -9.7 -8.9 -7.6 -6.4Capital account balance 1.3 0.9 1.7 1.8 1.1 0.7 0.6 0.5 0.4Financial account 22.8 20.9 12.6 8.4 14.4 10.0 9.3 8.9 7.2

FDI net 16.5 11.1 6.3 5.9 5.8 6.1 6 6 6Other private inflows net 6.2 4.7 0.5 -0.4 6.5 1.1 1.4 1.2 -0.1Monetary authorities net -1 0.2 2.3 0 0 0 0 0 0Public Sector net 1.1 5.1 3.6 2.9 2.1 2.8 1.9 1.7 1.3

Errors and omissions -0.3 -0.3 0.5 -0.1 -0.2 0 0 0 0Other financing -4.0 0.4 -4.2 0.3 -3.6 -1.0 -1.0 -1.7 -1.2

International reserves -3.7 -1.0 -5.7 -1.8 -4.0 0.5 1.2 -0.3 -0.8Use of IMF resources 0.0 1.7 2.9 2.4 -0.4 -1.5 -2.2 -1.4 -0.4Exceptional financing -0.3 -0.3 -1.4 -0.3 0.8 0.0 0.0 0.0 0.0

Source: Georgian authorities and Bank/IMF Staff estimates.

24. The impact of the Euro zone crisis on Georgia has been mild to date, althoughconsiderable vulnerabilities exist to a downside Euro zone crisis scenario. Given weakertrade and financial links to the Euro zone than to the CIS and Turkey, GDP growth is projectedat 6 percent a year for 2012-131. This strong growth outlook reflects robust performance ofexports and tourism, and an improved outlook for FDI inflows. Georgia, however, remainsvulnerable to the scenario of a deepening Euro zone crisis that could severely impact globalgrowth, capital flows, and commodity prices. This vulnerability stems from two main sources.First, the current account deficit for 2012-14 is expected to remain high and to require financingthrough a combination of official flows, inflows of FDI and other private inflows. Second, totalexternal debt remains high at about 58 percent of GDP. In the event of a downside Euro zonecrisis scenario affecting exports, tourism receipts, and private capital flows, growth couldtherefore fall to the 0-2 percent range. Under this scenario, the fiscal consolidation programwould be derailed and Georgia would require additional official financing, preferably onconcessional terms, to avoid a painful adjustment.

25. Georgia's baseline debt burden indicators are projected to remain well belowrelevant prudential thresholds. External debt is projected to decline from 58.1 percent of GDPin 2011 to 41.3 percent in 2017. External public debt decreased from 33.8 percent of GDP in2010 to 29.0 percent in 2011 due to strong GDP growth. The external debt service to export ratiowas 15.8 percent in 2011 and is expected to stabilize at about 16 percent by 2030. According tothe most recent debt sustainability analysis (DSA), the external debt position is not a cause forconcern under the standard stress scenarios, ranging from baseline to worst case (Figure 9).Domestic public debt is close to $1.2 billion or 5 percent of GDP and is projected to increase toover 10 percent by 2030 as reliance on domestic savings to finance public investment increases.Georgia's Eurobond refinancing in April, 2011 and the improvement in its sovereign creditratings in November-December 2011 confirm the country's favorable market access.

1 Georgia is relatively less exposed now than before to Europe via trade flows, as the share of export to EU in totalflows has fallen from the pre-crisis level of 22 percent to about 19 percent in 2011. However, Europe accounts forabout one third of FDI inflows to Georgia, which although lower than the pre-crisis levels is still significant overall.

10

Figure 9: Standard Debt Stress Scenarios(in percent of GDP)

Combined shock 1/ Real depreciation shock 2/70 95

9065 85

8060 Combined 75

shock55 .70 30 % *. 6

-. 65 - depreciation

50 - 51 605Baseline

45 450

40 45 Baseline 4140

35 J 35 1

2007 2009 2011 2013 2015 2017 2007 2009 2011 2013 2015 2017

Source: IMF Georgia executive summary, March 2012.1/ Permanent 1/4 standard deviation shocks applied to real interest rate, growth rate, and current account balance.2/ One-time real depreciation of 30 percent occurs in 2013.

26. Strong growth prospects and improved public finances led to recent upgrades ofGeorgia's sovereign ratings. Standard & Poor's Ratings Services raised its long-term foreignand local currency ratings on the Government of Georgia to "BB-" from "B+" in November2011. Fitch Ratings followed and also increased the country's Long-term foreign and localcurrency Issuer Default Ratings (IDR) to 'BB-' from 'B+' in December. Moody's assigned thecountry a first-time foreign and local currency sovereign credit rating of Ba3/Not-Prime withstable outlook in 2010 and maintained the assessment.

27. Georgia's overall macroeconomic policy framework is adequate for this operation.The government commitment to the fiscal consolidation path is sound and the 2012 budget isassessed as responsible. Public and publicly guaranteed debt is well managed and on asustainable path. The current account deficit is financed mainly by non-debt creating flows, andthe government's efforts to enhance exports of goods and services are paying off in terms oftourism and transit. The macroeconomic policy framework is supported by the IMFprecautionary SBA and SCF. The objectives of the previous 33-month SBA that expired in June2011 were largely achieved. The new precautionary IMF program will provide contingent accessto funds given that the external position is currently viewed as sustainable in the absence ofshocks.

III.THE GOVERNMENT'S PROGRAM AND PARTICIPATORY PROCESSES

28. The Government's medium-term reform program for 2011-2015 is described in itsTen-Point Plan. The Ten-Point Plan presents the framework within which the Government'sdevelopment policy objectives - to generate employment by restoring rapid economic growth -are to be attained. The Government's Reform Program focuses on three areas: a strongmacroeconomic framework, including continued commitment to fiscal consolidation andexternal sustainability; productivity growth in the tradable sectors, especially transport andtransit, tourism, light manufacturing, and agriculture; and continued efforts against poverty and

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inequality. In particular, the Government is moving away from a program of largely horizontalbusiness environment reforms to deeper, sector specific actions to help boost competitiveness.Active promotion of exports and tourism, modernized agriculture, power, and infrastructuresectors, and upgraded education and health care will all facilitate investment while bolsteringincreases in labor productivity and exports, and supporting both improved supply of jobs and thedemand for workers.

29. The main components of this framework include:

(i) Maintaining macroeconomic stability: This component identifies fiscalsustainability, low inflation, and financial stability supported by a healthy bankingsector as necessary components of Georgia's macroeconomic framework. Inparticular, the Ten-Point Plan reaffirms the Government's commitment to fiscalconsolidation and prioritization of public spending in line with results. TheGovernment also remains committed to the strategy of anchoring externalsustainability in flexible exchange rates and inflation targeting.

(ii) Improving the current account balance: The current account deficit was 23 percentof GDP in 2009 before narrowing to 11 percent in 2011, with both numbers widerthan most comparators in ECA. In the medium run, the Government hopes toreduce the current account deficit to 3 percent of GDP through a comprehensivestrategy to increase exports. The free trade agreements (FTAs) with the EU andwith Turkey mark significant and ongoing efforts in this context and are designedto both improve market access and align reforms to international good practice tostrengthen competitiveness. High potential export sectors are agriculture, agro-business, light manufacturing including textiles, and trade/transit related services,especially tourism.

(iii) Maintaining an improved investment and business environment: The Governmentintends to achieve and maintain a corruption-free environment as part of its strategyto reform institutions and provide an enabling environment to entrepreneurs andinvestors, while facilitating job creation. In particular, maintaining flexible labormarkets. One of the cornerstones of the improved business environment will be asimplified tax administration system, the provisions of which have been presentedin the New Tax Code. The country also seeks to maintain its place among the top15 countries in the Doing Business rating. Attracting investment (both foreign anddomestic) will be critical to the overall strategy of improving tradable sectors'productivity, output, and employment.

(iv) Transforming Georgia into a regional trade and logistics hub: The developmentstrategy of the Government also envisages that the country becomes both a transitcorridor as well as a platform for business development in the neighboringcountries and the region at large. The foundations of this transformation will be anopen economy with a developed infrastructure, excellent administrative service andtools such as a free industrial zones and liberalized warehousing. In addition, theDCFTA with the EU, which is currently under negotiation, and the FTA withTurkey (already effective) will support Georgia's aspirations to become a businessdevelopment platform in various ways, including by facilitating furtherimprovements in customs efficiency. In terms of transit, Georgia has already

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achieved notable success, both for goods from immediate neighbors and fromCentral Asia. The Government sees the transit and logistics services sector as beinga potential source of both exports and job creation.

(v) Improving infrastructure (including by promoting investment in hydro-power):Complementary to institutional and trade-related measures, the Government plansto develop the country's infrastructure with a view to facilitating investment andexports. In particular, Georgia will focus on developing into a regional multi-modalenergy and transport hub. Ensuring reliable and cost efficient electricity supply tohouseholds and businesses is an important objective of the Government, which isalso seeking to realize its electricity export potential. A Cross Border ElectricityTrade Agreement with Turkey has already been signed. The Government is activelyseeking to strengthen investment in hydro power, and has already started reformingthe regulatory and institutional framework of the electricity market to further thisobjective. In addition to exploiting hydro-energy, gasification will be a priority,along with the further development of roads, railways, and airport infrastructure.

(vi) Developing agriculture: The strategic plan intends to create a modernized andcommercially viable agriculture and agro business sectors. The intention is also tobuild modern agro-industry logistics centers while increasing the area of cultivatedland in the medium-term. Raising productivity in agriculture may also facilitate therelease workers into non-farm jobs, particularly agro business, which is viewed ashaving significant employment potential. Modernization of agriculture and agrobusiness is viewed by the Government as the critical means for ensuringsustainable improvements in livelihoods for the rural poor.

(vii) Improving the education system: To strengthen competitiveness, modernizededucation that prepares the work force for global markets is essential. To this end,the Government intends to both strengthen the quality of general education andimprove access to vocational and higher education. In particular, the Government'splan focuses on modernizing the high school curriculum and improving the qualityof teaching and school management to strengthen the overall learning environment.To improve education efficiency, school funding systems were strengthenedthrough the introduction of vouchers. Investments have started in improvingequipment, especially computers and school laboratories. Teachers' professionaldevelopment and training are being strengthened to complement new policies oncertification for teachers and principals.

(viii) Enhancing social policy: The objectives under this component are to strengthen thesocial safety net, which is comprised of two pillars - social assistance and thestate's health insurance, which includes the Medical Insurance Program - with afocus on enhancing access for the most vulnerable and improving living conditionsfor new and existing Internally Displaced Peoples (IDPs). Georgia intends to createan efficient and targeted pension and social assistance system and to improveaccessibility of vulnerable groups to health, education, and housing, while ensuringthat social spending is fiscally sustainable and compatible with growth, taxrevenues, and demographic trends. Improving the efficiency of administration ofthe targeted programs is part of this overall strategy for enhancing social inclusion.

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Currently application processing times are large for both the TSA and the MIP,with long lags before issuance of first benefits.

(ix) Creating an affordable and high quality health care system: Such a system wouldencompass a developed insurance market, wide choice of pharmaceutical products,and a modernized, widely accessible, and consumer-oriented healthcare system. Inthis context, the Government has identified five strategic tasks: affordability andaccessibility of healthcare services; improved quality of healthcare services; right ofchoice should rest with the patients and patient rights should be honored; preventionof disease, readiness to mitigate threats in public healthcare and remedial follow up;improved organization of the healthcare system, and improved management andefficiency of the sector. As the system is being privatized, effective stewardship ofthe health sector is essential. The Government is therefore also strengtheningenforcement of standards in all healthcare facilities and laboratories to ensurequality of health care services.

(x) Focusing on regional development: Georgia intends to reduce disparities in termsof economic development between urban and rural areas through the facilitation ofdevelopment projects, creation of employment centers, improved outreach, andmodernized agriculture infrastructure. According to the Regional DevelopmentStrategy of Georgia (2010-2017), the 2011-2012 Development Strategy and ActionPlan for each region of Georgia has the main goal of developing regionalinfrastructure, health care, agriculture, business, and tourism. The Kakheti RegionalDevelopment Plan is underway already with the support of the World Bank.

30. The Government has enhanced its consultations with civil society to receivefeedback on reforms and better explain its policies to the public. Public outreach efforts haveresponded to this need to strengthen consultative efforts and have taken several forms. TheGovernment has improved communication of its services, programs, and policies to the public,through media presentations, brochures, social media, and other means, with the Prime Ministerand members of the Cabinet directly reaching out to the public. Some of the specific publicoutreach efforts have been directly supported by the DPO program.

31. The DPO team held consultations with civil society over the course of thepreparation of this program. Broad support was expressed for the pillars and the reformmeasures and the need for continued engagement was emphasized. In particular, civil societyorganizations (CSOs) expressed strong support for measures aimed at improving public financialaccountability and budgetary coverage and transparency. CSOs also appreciated the results focusof the proposed operation. In addition, the Government of Georgia has teamed up with the WorldBank and the IFC to launch a series of discussions on key policy issues with a broad spectrum ofstakeholders.

IV. BANK SUPPORT TO THE GOVERNMENT'S PROGRAM

A. LINK WITH THE CPS

32. The DPO series is a central component of the Country Partnership Strategy (CPS)for 2010-2013. The CPS is built upon a two-pillar approach to the Bank's engagement withGeorgia, namely: (i) meeting post-conflict and vulnerability needs; and (ii) strengthening

14

competitiveness for post-crisis recovery and growth. The CPS Progress Report (2011) proposeda rebalancing of emphasis toward the second pillar in light of the need for a medium term reformagenda to support growth in both output and employment. The CPS is also fully consistent withthe Government's reform program as highlighted both in Basic Data and Directions (2011-14)and the Ten-Point Plan of the Government of Georgia. This DPO covers the core sectors targetedfor Bank Group support in the CPS, including public financial management, competitiveness forgrowth and employment generation, and social inclusiveness, which are rooted in a subset of theGovernment's broader policy reform program.

B. COLLABORATION WITH THE IMF AND OTHER DONORS

33. The Bank and the Fund teams maintain close collaboration. The teams coordinate onthe monitoring of macroeconomic developments, technical assistance, and policy dialogue.Collaboration is particularly close on issues pertaining to public financial management. TheBank has also worked closely with USAID and the EU during the preparation of the program tobe supported by the DPO series. In particular, USAID is complementing the proposed DPOseries with technical assistance on trade facilitation. The EU is providing both financing andtechnical assistance on trade and trade facilitation related measures, in the context of the DCFTAnegotiations. The Bank has also coordinated closely with the IFC and the EBRD on supportingthe Government's power sector strategy.

C. LINKS WITH OTHER BANK OPERATIONS

34. The proposed DPO exploits complementarities with other Bank operations. Inparticular, the policy dialogue underlying the proposed operation was facilitated by three keyprojects. The Public Sector Financial Management Reform Support Project assisted theGovernment in addressing the capacity constraints of key public sector agencies, therebycomplementing the dialogue on the new DPO series. Similarly, the health sector reformssupported in the DPO program are receiving significant support from the ongoing Health SectorDevelopment Project and a grant to support the PEFA. In addition the proposed Competitivenessand Growth DPO builds on the strong reform program developed under the previous DPO series,which concluded in July 2011.

35. Important results were achieved under the support of the previous DPO series.DPO 1 (2009) balanced immediate crisis mitigating measures with structural reforms whileDPO2 (2010) facilitated an orderly transition in the focus of the authorities from immediatemitigating measures toward preparing the conditions for post-crisis growth. Specifically, theeconomic downturn was contained in 2009, the economy rebounded strongly in 2010, and fiscalpolicy moved swiftly from stimulus to adjustment during 2010. On public finances, importantsteps were taken toward further improving efficiency by enacting the new Budget Code and forthe first time, including annexes on program and capital budgets in the 2012 Annual Budget. Onthe social safety net, coverage was scaled up and benefits were improved without significant lossof targeting effectiveness. On external competitiveness, significant improvements were achievedin reducing the time required for tax compliance and for trading across borders; furthermore,progress was made in identifying trade-related reforms for improved access of Georgian productsto international markets.

15

36. The proposed Programmatic Competitiveness and Growth DPO series builds on thesuccessful reform agenda supported by previous policy-based Bank lending to Georgia. ThePoverty Reduction Support Credit series (2005-08) focused mainly on public sector reform,education, and health care. The programmatic development policy operation series (2008-11)supported reforms in public finances, competitiveness, and social sectors. The CG DPO serieswill continue to build on and deepen the reforms supported by the Bank's previous policylending. For example, the previous operation included reforms under the public spending pillarthat supported the development of performance budgeting, which is being extended now to alllevels of government. This results focus is being complemented by the emphasis onaccountability, coverage, and transparency under the CG DPO series. Together, the reformefforts under the two DPO programs, support significant improvements in the quality of publicspending through the use of performance indicators, better accounting standards, better coverageof the state budget reports, and the resultant improved transparency and monitoring ofexpenditures. Under trade and trade facilitation, the previous DPO series initiated reforms insupport of Georgia's ongoing negotiations for a DCFTA with the EU, which will be carriedforward under the CG DPO. The CG DPO will also maintain the focus on strengthening socialsafety nets, through improved access to and quality of health care, expanded coverage of theMedical Insurance Plan (MIP), and improved efficiency of the Targeted Social Assistance(TSA).

D. LESSONS LEARNT AND ANALYTICAL UNDERPINNINGS

37. The DPO program draws on the lessons learnt from the successful implementationof previous development policy lending and IDA support. Three lessons were learnt fromprevious operations. First, strong ownership on the part of the Government is critical. Animportant factor underlying the success of previous policy lending was that the Government ledthe design of the reform program, while the Bank played a supportive role. Second, it isimportant for the operation to be well-defined and focused on priority issues where there is astrong track record of engagement with the Bank. Third, reforms must be grounded in a realisticassessment of the Government's implementation capacity. Balancing these factors led to a well-sequenced program, and has facilitated coordination with donors. Increasing the Government'simplementation capacity and leveraging IDA's resources through other donors' support havealso been critical elements in the design of this program in Georgia.

38. The design of the proposed CG DPO series is underpinned by extensive analyticalwork undertaken in collaboration with the Government. This list includes the CountryEconomic Memorandum (2011); Georgia Demographic Change: Implications for SocialPrograms and Poverty (2011); the Programmatic Poverty Assessment (2010), the CountryProcurement Assessment Report (2009), and the Bank-EC Joint PEFA (2008). An ongoingPEFA assessment led by the Ministry of Finance has also been very helpful. Ongoing work hasalso complemented the preparation of the proposed CG DPO Series. The ongoing ProgrammaticPublic Expenditure Review (PPER) identifies policy options to implement fiscal adjustment,improve the efficiency and quality of public services, provide effective social safety nets, andmeet infrastructure needs, and supported the design of the public financial management pillar ofthe CG DPO program. The ongoing work under the Programmatic Poverty Assessmentcomplements the dialogue on social safety net reforms and provides information on labormarkets, unemployment and skill mismatches. The ongoing Sources of Growth study will build

16

further on the policy conclusions relating to competitiveness and growth developed under the2011 CEM. Finally, the Bank team has prepared several quick notes on themes relevant to theproposed operation.

Box 1: Good Practice Principles for Conditionality

Principle 1: Reinforce OwnershipThe CG DPO series supports the Government's medium-term structural reform program. TheGovernment therefore has strong ownership of the proposed DPO. The Bank's analytic work hascontributed to the formulation and implementation of selected aspects of the Government's reformprogram. The DPO follows successful implementation of previous development policy lending, whichdemonstrates Georgia's track record of strong commitment to the reform process.

Principle 2: Agree up front with the government and other financial partners on a coordinatedaccountability frameworkAt the core of the accountability framework is the operation's policy matrix, which outlines actionsover the medium-term with clear and monitorable outcome indicators developed jointly with theGeorgian government during project preparation. Lessons from the PRSO program and the previousDPO series show that the policy matrix may evolve over time to reflect emerging reform priorities andthat the programmatic focus of the operation is appropriate.

The reform program benefits from close coordination and consultations with other developmentpartners including the IMF, the European Commission, USAID, SIDA, KfW, GTZ, IFC, and EBRD.The program supports important features of Georgia's Action Plan under the European NeighborhoodPolicy (ENP). In addition, the EC plans to provide financing under its Macroeconomic FinancialAgreement and USAID is providing considerable technical assistance on trade facilitation. The Bankhas also coordinated closely with the IFC, EBRD, and USAID on supporting the Government's powersector strategy. The policy actions proposed for support by the CG DPO are in areas where the Bankhas comparative advantage and can complement the work being supported by other developmentpartners.

Principle 3: Customize the accountability framework and moihditiev of Bank support to countrycircumstancesThe DPO team has been working closely with Government counterparts from various ministries indesigning and monitoring reform implementation. The agreed accountability framework is fullyconsistent with the Government's expressed policy intentions and internal accountability mechanisms.Principle 4: Choose only actions critical for achieving results as conditions for disbursementThe DPO program focuses on actions that are critical for the success of the reforms supported. Theprior actions are rooted in the reform priorities of the Georgian Government and in the CPS. Further,the program focuses on outcome-oriented actions, to calibrate the reform program's success inachieving its objectives.

Principle 5: Conduct transparent progress reviews conducive to predictable and performance-based financial supportProgress made with the implementation of reforms and achievement of outcomes will be monitoredregularly: a progress matrix, which outlines the status of reforms and outcome indicators, will beupdated and reviewed periodically. The DPO program is expected to provide predictable andperformance-based financial support in a manner consistent with the Government's annual budgetcalendar and macroeconomic framework.

17

Table 6: Links between the CG DPO Program and Selected Prior Analytical Work

Analytical Reports-Recommendations Links to DPLactions

Public Expenditure Overall efforts to improve the quality of public Pillars II & III: The DPO operation supportsReview (PER) spending will be necessary in the context of fiscal enhanced quality of spending through improved(2012) consolidation. An important obstacle to achieving key budgetary accountability, coverage and transparency.

health sector objectives in terms of improved health Both access and quality of health care is supportedoutcomes and financial protection is the low level of through greater MIP coverage and enforcement ofpopulation coverage with the MIP. On the supply- upgraded standards in healthcare facilities.side, a key challenge is to improve the quality of careprovided.

Regional Report on Strengthen market institutionality in the power sector Pillar 1.3: CG DPO supports two critical elements ofElectricity markets to support regional trade and facilitate future the Government's strategic action plan for power to(2012) investments. help implement these recommendations. The first is

amendments to market rules. The second is the law onrenewables and review of other aspects of the existinglegislative framework in the light of evolving marketdemands. Both will facilitate investment andproduction in hydropower, needed in the face ofrapidly growing domestic demand. These will alsosupport regional electricity trade, where Georgia ispotentially a significant exporter to Turkey.

Sources of Growth Improve market access for exporters while Pillar 1.1&I.2: The CG DPO series supports theseStudy (2012) strengthening the logistics chain to reduce the costs of recommendations through policy actions relating to

trading. Continue to improve customs efficiency. the legislative package to support progress on theDCFTA. In addition, measures to improve customsefficiency through electronic certification of origin,automated selectivity of risk assessment, andimproved interagency coordination are beingsupported by the proposed series of operations.

Georgia CEM Higher investment and productivity growth to sustain Pillar I: The CG DPO series helps fulfill these2011 job creation calls for trade facilitation, investment in recommendations by supporting trade facilitation and

infrastructure, and skills formation. Improved by improving the regulatory and institutionalreliability and cost-effectiveness of power supply will framework of the electricity market.be necessary for a competitive private sector.

Georgia Improve coverage of social safety nets and ensure Pillar III.1&I.4: The CG DPO Series supportsDemographic wider access to health care services. Strengthen skill measures to improve access to and quality of health

,I. '0 formation, especially in formative years. care through improved coverage of MIP and betterImplications for stewardship. The CG DPO also supports improvedSocial Programs quality of general education (grades I through XII).and Poverty (2012)South Caucasus Modernize education to address skills mismatch and Pillar I.4: The CG DPO supports improved quality ofSkills Study (2012) better prepare work force for positioning in job general education to support overall preparedness for

market. the labor market.

Georgia: While noteworthy progress has been made, continued Pillar 1.2: The CG DPO Series has a strong emphasisDiagnostics and strengthening of customs efficiency to reduce the time on trade facilitation in line with the Government'sNeeds Assessment taken to process transactions will help reduce overall objectives of transforming Georgia into a regionalof the Revenue costs of trading. Trade facilitation is typically of trade and logistics hub.Administration greater benefit to smaller entrepreneurs since the costs(2010) of logistics represent a higher share of total sales.Georgia Public Improve availability of systematic information on the Pillar II: The CG DPO series supports the inclusionExpenditure and resources received by service delivery units including of LEPLs in annual budget reports and in E-budgetFinancial LEPLs. Reporting should be carried out either through systems and the introduction of modified cash-basisAccountability the accounting system or by IPSAS to strengthen controls.(PEFA) routine data collection. Strengthen the capacity of theAssessment (2008) accounting systems to report financial resources

transferred accurately.

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V. THE PROPOSED PROGRAMMATIC DEVELOPMENT POLICY OPERATION

39. The program development objective of the proposed CG DPO is to supportcompetitiveness and inclusive growth. The three pillars of the proposed programmaticoperation - competitiveness, public financial management, and effectiveness of social spending- encompass a wide range of policy actions that embody the Government's priorities and sectoralplans. The proposed Competitiveness and Growth DPO series builds on previous policy lendingand is fully aligned with the ongoing CPS. The Bank's support is focused on measuresappropriate for the DPO instrument and is in areas where the Bank's comparative advantage iswell-supported by policy dialogue and/or analytical work. The broad-based nature of theprogram being supported is by deliberate design. The Government has achieved notablesuccesses, particularly improvements in governance and in the overall business environment aswell as in the design and establishment of a social safety net, but multiple challenges remain. Inparticular, supporting a virtuous cycle of investment, job creation and poverty reduction willrequire several actions on many fronts.

40. The reform program being implemented by the authorities is focused on growth andemployment. The overall reform program described in the policy matrix is targeted atconsolidating the achievements of previous policy-based lending, while supporting theGovernment's comprehensive structural reform program. This program reflects theGovernment's past reform successes and its future ambitions of achieving the overarching goalsof sustained strong output growth based in robust job creation. The Government's program iswide-ranging, and addresses the key challenges facing the country through a program ofeconomic modernization and social inclusion built on reforms in agriculture, health andeducation, export and investment promotion, logistics and trade facilitation, infrastructure -especially power - and tourism. The actions are designed to bolster the economy's productivecapacity on the back of both higher productivity and employment growth in new and existingsectors.

41. The CG DPO series supports the Government's reforms in several areas relevant tothe program development objective. Since exports and foreign investment are importantobjectives of the Government's plan, reforms supporting enhanced market access through theDCFTA with the EU and the FTA and Cross Border Electricity Trade Agreement with Turkeyare being prioritized. Demand for energy will also grow rapidly, driven by increased demandfrom the private sector and Georgian consumers. Cost efficient and reliable supply of energy istherefore a key element of the growth and employment reform program, especially if Georgia isto participate in the high potential regional electricity trade. These goals require the appropriateregulatory and institutional reform to facilitate responsible investment in the sector. Preparing amodem productive workforce is necessary since the demand for labor must grow along with itssupply - enhancing the quality of education and health care is therefore critical. So far theGovernment has taken several measures to develop performance budgeting. This enhancedresults focus is to be supported by the CG DPO series through measures designed to strengthenaccountability, coverage, and transparency of financial reporting, all of which will strengthen thequality of spending. Improved quality of spending will support the Government's strategic fiscalconsolidation objectives without compromising growth. Finally, strengthening inclusion throughjob creation in the medium run is to be supported by more immediate measures to strengthensocial safety nets.

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42. More specifically, gains in output and employment are underpinned by deepreforms under the proposed programmatic operation. There are three main areas in whichthe proposed CG DPO will support the Government's employment and growth objectives. First,there are measures to help improve market access, essential given the small size of the Georgianmarket. This market access, combined with continued reforms facilitate trade and improvelogistics efficiency, will help increase investment, exports, and employment. Second, the CGDPO supports skills, essential to building a productive workforce that can support Georgia'sgoals to integrate better in global markets and supply chains. In this context, the quality ofgeneral education will be strengthened through measures designed to modernize curricula andimprove both instruction and school management. These actions will build on importantgroundwork laid by the Government in the area of teachers' professional development, training,and investment in modernizing education facilities. Third, improving the investment climate inthe power sector is important both to ensure reliable and cost-efficient domestic energy supply -essential for a growing private sector - and to realize Georgia's electricity export potential.Efforts to strengthen the legislative and regulatory framework for the electricity market and alignthese with international best practice will support these objectives.

PILLAR I: COMPETITIVENESS

A. TRADE AND TRADE FACILITATION

Background

43. Georgia's strategy to promote and sustain growth has a strong focus oncompetitiveness. The objective of the Ten-point Plan is to support a vibrant and competitiveprivate sector and then facilitate its evolution as the engine of growth in output and employmentover the medium term. Rapid economic growth during 2004-2008 and since 2010 has not beenaccompanied by a significant increase in exports relative to GDP. Unlike several East Asianeconomies, strong inflows of foreign direct investment (FDI) in Georgia have also so far notresulted in growth in exports significantly higher than that of GDP. While this is not uncommonin a transition economy beginning a period of sustained economic growth, for growth to besustained over the medium to long run, Georgia needs to improve competitiveness, attractforeign investment, and expand exports. The Government's reform program has several elementsthat support these objectives, including plans to modernize agriculture and infrastructure,actively promote exports and tourism, and focus on health and education to improve laborproductivity and demand. While increases in agricultural productivity may lead to a fall in farmsector employment, improved productivity in manufacturing and services will help attractadditional investment that will ultimately increase both the supply of jobs and the demand forworkers.

44. Improving external competitiveness requires addressing the relevant policyconstraints. First, securing market access, via FTAs rather than the Generalized System ofPreferences (GSP or GSP+), is a pre-requisite for attracting domestic and foreign investment intotradable sectors. Second, improved external competitiveness, in a world that is increasingly flatin terms of tariffs, requires active trade facilitation, including efforts to lower logistics coststhrough improved customs efficiency, and improved access to transport, energy, andtelecommunications infrastructure. Third, upgrading skills of the labor force to compete

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effectively in world markets is important to support development of tradable sectors and exportcapacity in particular. Fourth, strengthening property rights and market competition andadopting international standards are important. Fifth, there has to be a strong and facilitatingbusiness environment, including trade and exchange rate policies that do not impart any anti-export or anti-tradable bias. Finally, in a world that is increasingly flat in terms of tariffs,logistics costs are an important determinant of trading costs and external competitiveness. Tradefacilitation therefore should remain a priority of the Government.

45. Georgia has advanced significantly in all of the above areas. Over the last few years,Georgia has been actively implementing trade reforms, including liberalizing trade restrictionsand reforming custom services. A new customs code consistent with international standards wasadopted in mid-2006. Under this code, Georgia reduced the number of tariff rates to 0, 5, and 12percent. In parallel, customs administrative arrangements were reformed and changes inmanagement and staffing were implemented to eradicate corruption, eliminate overlappingfunctions, and streamline procedures. To streamline customs procedures, the previous DPOseries supported measures to introduce and subsequently improve the Risk Management Systemat customs. The overall objective of the system is to provide different degrees of customsinspections for those with different records of compliance. Georgia is also adhering to its actionplan to meet the requirements for entering into a DCFTA with the EU including variouslegislative components and further improvements in customs.

46. Looking forward, the Government has recognized that to take advantage of existingand potential trade agreements and liberalization, there is a need to continue with an activeand complementary policy agenda. The Government has therefore requested the Bank'ssupport in furthering legislative and regulatory reforms necessary to promote and facilitate tradeand foreign investment. This support is proposed along two main lines: i) promote market accesswith a view to enhancing exports and foreign investment; and ii) improve customs efficiency tofacilitate trade.

i. Promote market access with a view to enhancing exports and foreigninvestment:

Context

47. The Government is taking action to secure market access both to increase exportsand attract FDI. Georgia has already made considerable progress on identifying andimplementing trade-related reforms needed to meet the requirements of the Deep andComprehensive Free Trade Agreement (DCFTA) with the EU, which is part of a broaderassociation agreement offered by the EU to its Eastern partners. In addition to the regularfeatures of an FTA, this agreement includes provisions for broader institutional integration intrade-related areas, including food safety, technical barriers to trade, and competition policy.While further legislative changes can be expected as progress is made on the various chapters ofthe agreement over the next three years, this first package including a framework law oncompetition, a Technical Barriers to Trade (TBT) Code, and amendments to the Law on FoodSafety, was approved by Parliament in May 2012. This package, an important first step towardslegislative and regulatory approximation to the EU, may pave the way to an FTA with the US inthe future, and will also encourage investment in tradable sectors by strengthening the credibility

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of Georgia's market access in the long run. The remaining operations in the CG series willsupport secondary legislation and the implementation of the new legislative framework.

48. The ability of Georgia to access European and international markets will largelydepend on compliance with quality and regulatory requirements in the EU destinationmarkets. Tariffs and quantitative restrictions do not significantly limit access of Georgianproducts to those markets, since Georgia has free trade agreements with the CIS countries andhas recently signed an FTA with Turkey. Additionally, Georgian products benefit from GSPstatus in the markets of the EU, the USA, Canada, Switzerland, Japan, and Turkey. Under theEU's GSP, Georgia has qualified for the special arrangement for sustainable development andgood governance (GSP+) which offers it enhanced access to the EU market. Access of Georgianproducts to European and international markets can however be impeded by a range of non-tariffbarriers including quality and regulatory requirements in destination markets. Reforms in trade-related areas in Georgia are therefore focused on achieving compliance with technical conditionsin the EU destination markets.

Policy Actions to be supported

49. The first operation under the CG DPO series proposes to support the followingpolicy action:

* Georgia has enacted laws adopting trade-related reforms which include theframework Laws No. 6155-Is on food/feed safety, veterinary and plant protection;No. 6148-Is on free trade and competition; and No. 6157-Is on general product safetyand liability dated May 8, 2012, needed to meet the requirements of the Deep andComprehensive Free Trade Agreement (DCFTA) with the European Union.

50. The indicative triggers for DPO 2 and DPO 3 are proposed as follows:

* Adopt secondary legislation as appropriate in order to facilitate implementation of theDCFTA legislative package.

* The DCFTA legislative package is implemented and operationalized.

Expected Outcomes

51. The expected medium term outcome of the actions under the trade component of thethree year program envisaged over the CG DPO series is that total trade with the EU reaches 22percent of GDP by 2015, from a baseline of 17 percent of GDP in 2011.

ii. Improve customs efficiency to facilitate trade:

Context

52. According to the "Ten-point Plan" of the Government of Georgia, developing thecountry as a regional and logistics hub is an important component of the modernizationand employment strategy. The aim of the Government is to make Georgia a "corridor" fortransit and a "Business Platform" for neighboring countries and for the region. Cooperation withother countries in the region and further improvement of customs efficiency is essential to

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achieving this goal. Lowering logistics costs to facilitate trade will especially benefit smallerfirms trying to enter export markets.

53. Considerable progress has already been made in reforming customs administration.Georgia began actively implementing trade reforms, including liberalizing trade restrictions andreforming custom services following the Rose Revolution. Tax and customs administrationswere merged and the revenue service was empowered to carry out responsibilities of bothagencies along with efforts to cut overlapping functions and streamline responsibilities. A newtax code was enacted in 2011, which unified tax and customs legislations into one. Forharmonization purposes, out of 12 departments of revenue service, seven are designed to performboth tax and customs administrative functions. Recently the focus of the authorities has shifted tofurther streamlining customs procedures to reduce the time require to trade across borders. Inaddition, internationally recognized success has been achieved in terms of eradicating corruptionand improving efficiency of customs services. Other achievements include state-of-the-artinfrastructure, a strongly client-oriented service, streamlined clearance, and successfulimplementation of integrated border management approaches, such as delegation of powersbetween agencies (customs and patrol police) and data sharing.

54. While the business environment has shown impressive improvements over the lastfive years, the cost of trading across borders remains relatively high. The area of thebusiness environment where Georgia exhibits relative weaknesses, according to recent DoingBusiness reports, is "Trading across Borders", due to the cost of exporting and importing. Theseare driven largely by transportation costs. However, improving logistics efficiency throughfurther streamlining of customs procedures will contribute as well. In particular, such measureswill benefit smaller firms for whom logistics costs are a higher proportion of sales and willthereby encourage self-selection into exports.

55. The Revenue Service proposes to allow the economic agent to finalize proceduresrelated to certifications and permissions in one customs control point. The prior applicationvia the official website will allow importers to obtain permits and certificates directly at BorderCrossing Points (BCP) or in Customs Clearance Zones (CZZ) specified in their electronicallysubmitted documents. This will save time that was previously needed to collect documentation indifferent places. The Revenue Service will be authorized to issue the following permits: export,import, re-export or transit of dual use goods, import or export of pharmaceuticals under specialcontrol, import of non-iodized salt, export, import, re-export and introduction from sea ofspecies, their parts and derivatives, prescribed in the Annexes to the "Convention onInternational Trade in Endangered Species of Wild Fauna and Flora" (CITES), import ofproducts of plant origin subject to phyto-sanitary control, import of products subject to veterinarycontrol, and transit of products subject to veterinary control. The Revenue service will also beauthorized to issue the following certificates: Certificate of Origin, Phyto-sanitary Certificate,Phyto-sanitary Certificate for Re-export, Veterinary Certificate, and Hygiene Certificate.

56. In the next phase, further streamlining of customs procedures is envisagedspecifically for transit traffic through the introduction of the automated selectivity moduleand, therefore, further strengthening of risk-based management. A risk-based managementsystem has been implemented since 2008. Full risk-based control is in place and facilitates thetimely and efficient processing of border trade. The introduction of the automated selectivitysystem during transit will further strengthen risk-based controls. This system will be supported

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by the installation of modern equipment. This initiative is very relevant given that Georgia is animportant transit country and is seen as a business hub for the region.

57. The Government also plans to strengthen the system of information exchangebetween traders and the customs administration. This strengthened integration will beimplemented electronically and will ensure time and cost savings from the consolidation ofpiecemeal individual transactions. The creation of a Common Trade Network will supportcoordination between traders, shipping and freight forwarding companies, and customs. Thesystem will support electronic filling of applications and electronic customs clearance ofmerchandise. Traders will be provided essential information regarding the movement andlocation of cargo.

Policy Actions to be supported

58. The first operation under the CG DPO series proposes to support the followingpolicy action:

* The Government of Georgia has authorized the revenue service to issue certificates oforigin and import, export and transit related permits at the border crossings.

59. The indicative triggers for DPO 2 and DPO 3 are proposed as follows:

* Strengthen the risks-based management of customs control by introducing theautomated selectivity for transit traffic.

* The Revenue Service implements enhanced software (tradenet) to integrate processesand simplify transactions.

Expected Outcomes

60. The expected medium term outcome of the actions under the trade facilitation componentof the three year program envisaged over the CG DPO series is an improvement in Georgia'sscore on the customs component of the Logistics Performance Index to 3.5 compared to the 2010baseline of 2.37.

B. STRENGTHENING THE INVESTMENT CLIMATE IN POWER

Context

61. Georgia has significant potential in sustainably exploiting renewable energy sources,specifically hydro-power. Over the last decade, the Government has successfully transformed aloss-making, heavily indebted state-owned national power sector on the verge of collapse into afast-growing and expanding sector. Currently, the government is pursuing two strategicobjectives: to ensure continued reliable domestic energy supply, and to facilitate and bolsterGeorgia's hydropower plants' participation in regional electricity trade. Georgia's hydro-powerresources are vast (about 3400 MW of additional capacity could realistically be developed overthe medium-term) and can address the country's growing domestic demand but also takeadvantage of the opportunities provided by the expanding regional power markets (Tradepotential especially with Turkey is estimated at 3-5 TWh by 2017 and 8-10 TWh by 2020).

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62. The government's efforts are following a two-track approach. The first track aims atbringing responsible investors to develop hydropower plants and other renewables following bestinternational environmental and social safeguards practices. The second track entails continuedimplementation, over the next three to five years, of a program of legislative and regulatoryapproximation to the EU to promote private investment and regional power trading and facilitatemarket integration.

63. Actions under the first track have paid off. Several small and mid-sized hydropowerprojects have attracted private financing, one of which (Paravani 78 MW) is supported by theIFC and EBRD. European investor is also developing an additional small-scale transmission linein the western part of the country. Additional Memoranda of Understanding have been signedwith interested investors, but implementation has not started yet. The government is alsoprepared to partially fund some projects. To this end they have established a Partnership Fundendowed with about equity from four SOEs (Georgian Railways, Georgian Oil and GasCorporation, Georgian State Electricity, and Electric System Commercial Operator). TheGeorgian Oil and Gas Corporation itself might also undertake investments in hydropower ifdeemed appropriate, but preference is being given to private investments without resort toinstruments that would affect the Government's balance sheet.

64. The Government is now prioritizing implementation of the second track. TheGovernment has already signed the Cross-Border Electricity Trading Agreement with Turkey,which is an initial step towards the establishment of a framework for regional power trade. Inaddition, regulatory reforms have been initiated with the preparation of important amendments tothe basic set of market rules aiming at ensuring transparent and non-discriminatory access tointerconnection transmission lines by new investors. The relevant decree will be enacted in thenear term after a thorough process of consultation with all stakeholders. Furthermore, plans areadvanced for the development of a transmission grid code to ensure that technical specificationsare established to help support system reliability. Finally, and with help from USAID, EBRD andthe EU, discussions are ongoing on a series of other aspects of the legislative framework, forexample the law on electricity and gas and transmission tariffs, that might also be needed to beimprove upon over the next few years depending on market demand. Finally, the Government isalso drafting a Law on Renewables in line with EU principles to support the use anddevelopment of renewable energy.

65. These regulatory and institutional reforms are expected to further encourageresponsible investment in hydropower projects and other renewables. Transparent regulationfor the allocation of transmission capacity and other measures supporting the efficientfunctioning of power markets are necessary to attract private investors with bankable projects,which is the ultimate objective of the Government. In addition to facilitating investment inhydros and other renewables, these measures will also support investment in transmission - bothdomestic and cross-border.

66. The CG DPO series supports the Government's reforms, which are viewed ascritical for realizing the potential of the renewable energy sector. The amendments to the

2 A draft of the new regulations (ENTSO-E Draft Network Code for Operational Planning and Scheduling accordingto Article 6 of Regulation (EC) No 714/2009 of the European Parliament and of the Council of 13. July 2009 onconditions for access to the network for cross-border exchanges in electricity and repealing Regulation (EC), No.1"> 11113) has been issued on May 14, 2012.

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market rules that are envisaged for DPO2 are needed to establish the framework within which allparticipants in the electricity market interact, and are an important initial step before otherreforms can be undertaken. The Law on Renewables (also a DPO2 action) will provide aframework for promoting the use and development of broader sources of renewable energy inGeorgia. Establishing a transmission grid code (DPO3) will improve the system's reliability byclearly specifying technical parameters and standards. Finally, review and revision of thelegislative and regulatory framework will be necessary given the expected expansion of capacityand projected growth in market demand. In this context for example, the Government may needto amend the Law on Electricity and Gas to introduce the key features of a more dynamicmarket.

Policy Actions to be supported

67. The following indicative triggers are proposed for DPO 2 and 3:

* The Ministry of Energy and Natural Resources of Georgia issues a decree withamended electricity (capacity) market rules to prioritize new hydropower projects andrenewable power production access to the grid with remaining congested transfercapacity allocated via transparent auctions.

* The Government of Georgia submitted to Parliament the Law on Renewablesadhering to EU principles.

* A grid code is issued to improve power system reliability and the Ministry of Energyand Natural Resources of Georgia revises as appropriate other relevant laws andregulations to address evolving market needs.

Expected Outcomes

68. The expected medium term outcome of the actions under the power component of thethree year program envisaged over the CG DPO series is that power exchanges will increasefrom the 2011 baseline of 1.5 TwH to 3TwH by 2015.

C. EDUCATION

Background

69. Education is recognized by the Government as a critical component of a successfulstrategy to improve competitiveness and create better employment opportunities. TheGovernment's program in education is grounded in the Strategy for the Development ofEducation in 2011-15 adopted by the Ministry of Education and Science in 2010. At the core ofthis strategy is increasing global competitiveness of Georgia's human capital through ensuringaccess to high quality education. While the strategy covers all levels of education, it particularlyemphasizes improvements in the quality of general education through the introduction andimplementation of a modernized curriculum, with emphasis on teaching of English andComputer Literacy, introduction of computer-based school leaving examinations, strengtheningteacher qualifications, national assessments to monitor student learning outcomes, and increased

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safety at the school level. Improving quality and relevance of education for creating betteremployment opportunities is a declared priority at the tertiary education level as well.

70. Georgia's education system has undergone rapid reforms over the last decade andseveral key policy measures have been implemented to enhance education efficiency.Particularly noteworthy are the reforms of finance and governance of educational institutionsresulting in the decentralized management of schools, elimination of corruption after theintroduction of transparent university entrance examinations, implementation of large-scaleinstitutional accreditation for processes at the higher education level and the introduction of perstudent financing system (through vouchers) both at both the general and higher education levels.Public spending on education has increased also improved and teacher salaries have doubledover the past few years. On the quality side, major efforts included development of a newnational curriculum and textbooks, administration of national assessments and the launch ofteacher certification. Investments were also made in the education infrastructure throughrehabilitation and reconstruction of schools, vocational education centers and higher educationinstitutions, and provision of new computers and modern laboratory facilities in schools. TheGovernment's reform has been supported through a network of newly created educationinstitutions, such as the Teachers Professional Development Center, National ExaminationCenter, National Center for Educational Quality Enhancement, National Agency for theDevelopment of Educational Infrastructure, National Science Foundation, and EducationManagement Information Systems.

71. However not all of these efforts have translated into tangible improvements in termsof learning outcomes as measured by international assessments. Georgia has participated inseveral international assessments over the last few years, including PIRLS 2006, TIMSS 2007,and PISA 2009 plus. There are still several critical challenges remaining in the sector. While thebulk of education spending goes to pay teacher salaries, introduction of voucher financing willallow efficiency enhancements through more funding for improving the content of education andstrengthening the school-learning environment.

72. The Government's policy program is directed at addressing the remainingchallenges. In particular, the Government is committed to continue the important educationreform efforts started in the past decade through better targeting education and training towardsthe evolving market needs, with a strong emphasis on innovation and competitiveness. Toaddress the remaining challenges, the DPO proposes to support the Government's reformstrategy targeted at improving learning outcomes. The two complementary objectives of theproposed support will be to (i) strengthen the quality of general education to supportcompetitiveness; and (ii) strengthen human resource policies.

i. Strengthen the quality of general education to support competitiveness:

Context

73. Improving the quality, relevance and coherence of education is an importantcomponent of the Government's agenda for competitiveness and social inclusion. Solidsecondary education is a pre-requisite for graduates from general secondary education to providethe basis for the training of high-quality professionals who can contribute to strengthening thecompetitiveness of the economy. The skills and competencies of the workforce are one of the

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most important inputs for economic innovation. Quality strengthening measures proposed in thisDPO in support of Georgia's general education will focus on added value to the ongoing effortsand build on results already achieved.

74. Innovations designed to modernize the national curriculum have been initiated. Thenew national curriculum for general education was initially developed and implemented acrossall schools in Georgia throughout 2006-2009. That was the first attempt to shift from inputsbased teaching and learning processes towards an outcome-based curriculum framework andphilosophy. Further changes and innovations were implemented in the national curriculumframework introduced in 2010 including introduction of new subjects and emphasis on teachingof foreign languages, exact and natural sciences, and information technology. It is important tosupport the Government in the implementation of the revised curriculum and monitoring theresults to inform policy and identify further needs for improvement and modification.

75. The Government has already taken important steps to build national assessmentcapacity and has also participated in international learning tests. Georgia participated in thelatest cycle of PIRLS, TIMSS and TEDS-M, and joined PISA in 2009. National assessmentswere administered in grades IV and IX in Georgian Language and Literature and Mathematicsthroughout 2009-2011. Results indicate that students in Georgia perform at comparatively lowproficiency levels compared to counterparts in the OECD countries. Reform outcomes need to beclosely and regularly monitored to adjust and fine-tune implementation so that desired outcomeswill be achieved.

76. Important steps have been taken to address these challenges. The national curriculumfor Grades I though XII is being modernized and is already being implemented for Grades Ithrough VI. Additionally, starting July 2011, the government expanded teacher certificationexaminations to include teachers in all remaining subjects (Biology, Geography, Physics,Chemistry, History and Civic Education). About 23,519 teachers took the examinations in 2011,out of which 15.4 percent were certified. The Teacher Professional Development Scheme forcertified teachers was also expanded in the same year. New teacher houses, equipped withmodem training facilities, were opened in Tbilisi and Kutaisi to provide opportunities forteachers' professional development. In parallel, school principal standards have also beendeveloped by the Government and examination content developed for the evaluation of schoolprincipals.

Policy Actions to Be Supported

77. The first operation under the CG DPO series proposes to support the followingpolicy action:

* The Ministry of Education and Science of Georgia has (a) issued Decree No. 36/ndated March 11, 2011, approving a new national curriculum for grades I through XIIeffective September 15, 2011, and (b) implemented the new national curriculum forgrades I through VI including the distribution of supporting materials.

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78. The indicative triggers for DPO2 and DPO3 are proposed as follows:

* The Ministry of Education and Science of Georgia approves a new nationalcurriculum for grades I through XII and operationalizes the new National Curriculumfor grades VI through XII, including distribution of supporting materials.

* Monitoring framework established and assessment of new national curriculumprepared.

ii. Strengthen Human Resource Policies:

Context

79. Georgia has instituted new policies and a revamped regulatory framework forimproving the quality of teaching. The government has established an autonomous agency, theTeachers Professional Development Center (TPDC), responsible for regulating the teachingprofession, has adopted teacher professional and subject standards, designed the teachercertification system and launched the first set of certification examinations in 2010. Despite theseimportant first steps, improving teacher quality and regulating the teaching profession remainsone of the main educational policy priorities in Georgia. As of today, only 6.4 percent of the totalteaching cohort has been certified.

80. The Government is strengthening professional development opportunities forteachers and principals. Currently teachers and school principals have access to trainingopportunities, which are mostly tailored to the needs of the ongoing certification process. In themedium and long term, expanding opportunities for teacher professional development beyondcertification and providing teachers with access to diverse needs-based professional developmentand career growth opportunities, as reflected in the recently adopted Teacher ProfessionalDevelopment Scheme, will be important. The envisaged certification of principals is part of theGovernment's strategy to improve overall school management.

Policy Actions to Be Supported

81. The first operation under the CG DPO series proposes to support the followingpolicy action:

* The Ministry of Education and Science of Georgia has issued Decree no. 16/n datedFebruary 18, 2011 amending Decree no. 1101 dated December 4, 2009 expandingteacher voluntary certification examinations to include teachers for all grades and inall subjects effective July 2, 2011.

82. The indicative triggers for DPO 2 and DPO 3 are proposed as follows:

* Launch certification of school principals and implement quality assessment systemfor their evaluation.

* Make Teacher Certification mandatory for all teachers.

* Operationalize quality assessment system for the evaluation of school principals.

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Expected Outcomes

83. The expected medium-term outcomes of the actions under the three year programenvisaged over the CG DPO series are improved learning outcomes across generaleducation. These learning outcomes are proposed to be measured by the national assessments inGeorgian Language and Literature and Mathematics for Grade 93. In the baseline year, 2009, 44percent of students (54 percent of girls and 35 percent of boys) had above average performancein Georgian. In the baseline year, 45 percent of students (46 percent of girls and 45 percent ofboys) had above average performance in mathematics. The Bank will continue to monitor scoreson a gender disaggregated basis.

PILLAR II: PUBLIC FINANCIAL MANAGEMENT

Background

84. To sustain economic growth while continuing with public expenditure consolidation,improvements in public financial management remain a policy priority for Georgia. Themain challenges that remain include the need to fully modernize accounting standards andstrengthen coverage of financial reporting and of the E-budget system. This will contribute totwo main objectives. First, it will ensure that public expenditures are contributing effectively toGeorgia's growth and poverty reduction priorities. Second, with the authorities committed tocontinued fiscal consolidation during 2012-15, efficiency improvements will ensure thatadjustments take place in a manner consistent with both social priorities and the objective ofencouraging the private sector to become the engine for growth.

85. Progress has already been made on performance budgeting. The previous DPO seriessupported the piloting of program based budgeting with a view to helping the Governmentachieve its objective of a greater results-focus in fiscal planning. The concept of program basedbudgeting was adopted in the 2009 Budget Code, and significant advances has been made sincethen, reaching all the way to the full adoption by the Parliament of the 2012 draft budget in theprogram format. All ministries have developed a set of performance indicators. The Governmentrecognizes the need for further improvements in the budget narrative and performance indicators.

86. Georgia has also advanced significantly in terms of budgetary and financialmanagement systems. The basic systems have been put in place for strategic budget planning,budget formulation and execution. Integrated budget management systems are also largely inplace, with about half the components already implemented and operational. These includeTreasury Operations (including E-Treasury), Budget Preparation, Payroll and External/InternalDebt Management modules introduced by the MoF Financial Analytical Service in January2012. The full launch of the system is expected by the end of 2013. The introduction ofinternational good practice in the budget cycle is well advanced, including the introduction ofrobust systems for budget preparation, adequate chart of accounts, reliable execution (includingaccounting and reporting), and sufficient controls.

87. The CG DPO series proposes to support reforms aiming to (i) strengthen theefficiency of treasury management; and (ii) improve coverage and transparency of the budget.

' While it is expected that the measures supported by the CG DPO will lead to significant improvement in learningoutcomes, predicting the improvement in quantitative terms would be difficult.

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Technical assistance to support the reform agenda in these areas and capacity building has beenprovided under the Public Sector Financial Management Reform Support (PSFMRSP) Projectfunded by the Bank and other development partners (closed on March 1, 2012).

i. Strengthen the efficiency of treasury management:

Context

88. The Treasury Service of the Ministry of Finance started an accounting reform in2009. The International Public Sector Accounting Standards (IPSAS) Implementation Plan wasendorsed by a Ministerial Decree issued in November 2009. A Board of Standards ofAccounting of the Public Sector of Georgia was established in February, 2010. The introductoryIPSAS training was delivered to the Treasury staff in November 2011 by a consultant financedunder the PSFMRS project. All materials from the introductory initial and detailed IPSAStraining and exams are being translated into Georgian and will be delivered through the MoFFinance Academy to public sector accountants throughout Georgia starting in 2013. The IPSASare also being translated into Georgian and will be published (along with the training materials)on the dedicated web-site currently under construction. Meanwhile, a modified cash-basis publicsector accounting standard based on IPSAS for the year ending December 31, 2011 was pilotedin eight budgetary organizations (both ministries and LEPLs). The pilot experience providedinputs to the new "Temporary regulation on financial reporting based on modified cash-basisstandards based on IPSAS" that will come in to force starting January 1, 2013 for all publicsector bodies for accounting periods starting January 1, 2012. The authorities are aiming to fullyadopt IPSAS by 2020, moving state accounts to full accrual accounting.

89. The MoF is working towards implementing an integrated information system of publicfinance management (PFMS) with core treasury modules as key elements. The web-based E-Treasury is already fully operational. It registers and monitors budget commitments and sendsthe related payment requests to the treasury system for execution of expenditures of nearly 550spending units. Preparation of the main Book of Accounts of the Treasury will start in 2013.This report will integrate transactions and notes/records related to all state finances as generatedby the unified system. This report will also include the full balance sheet of assets and liabilities.

Policy Action to Be Supported:

90. The first operation under the CG DPO series proposes to support the followingpolicy action:

* The Ministry of Finance of Georgia prepared financial reports of eight (8) pilotagencies in accordance with modified cash-basis accounting methods as part of thetransition to adopt the international public sector accounting standards (IPSAS).

91. The indicative triggers for DPO2 and DPO3 are proposed as follows:

* The Ministry of Finance of Georgia prepares the regulation on introduction ofmodified cash-basis IPSAS.

* The Ministry of Finance of Georgia prepares financial reports of all centralgovernment budgetary organizations in accordance with modified cash-basis IPSAS.

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ii. Improve coverage and transparency of the budget:

Context

92. Both coverage and transparency of the budget are being strengthened in severalways. The GoG is expanding coverage of the budget to Legal Entities of Public Law (LEPLs)while moving ahead to integrate accounts with the E-budget system. This will also facilitateefficient tracking of spending of LEPLs within the broader context of strengthened systems formanaging spending flows. This improved coverage and tracking of LEPLs' budgets is importantsince these entities' revenues are the equivalent of 9.4 percent of the total state budget.

93. The Government Decree of April 2011 identified the list of the LEPLs that arerequired to submit budget execution reports to the MoF. The list includes 141 legal entitiesof different profile and secondary and vocation training schools subordinated to the Ministry ofEducation and Science. These budget execution reports include information on financial flowscovering revenues and economic classification of expenditures. This information will beincluded in the state budget execution report as a separate chapter presenting both consolidatedas well as individual reports by each LEPL.

Policy Actions to Be Supported

94. The first operation under the CG DPO series proposes to support the followingpolicy action:

* The Government of Georgia has issued Decree No. 111 dated March 23, 2012requiring the inclusion of information pertaining to the financial flows of legalentities of public law in the annual budget execution report.

95. DPO 2 and DPO 3 propose to support the following actions:

* The Ministry of Finance of Georgia harmonizes E-budget (electronic budgetmanagement system) with the electronic treasury system (E-treasury).

* The Ministry of Finance of Georgia includes budgets of local self-governments andfive largest LEPLs in E-budget.

Expected Outcomes

96. The expected medium term outcome of the actions under the three-year programenvisaged over the CG DPO series is an improvement in the relevant PEFA indicator (PI-25)from a baseline of D+ (last available assessment was in November 2008) to C.

PILLAR III: EFFECTIVENESS OF SOCIAL SPENDING

Background

97. Health care and social safety nets are important elements of the Government'sstrategic development plan. A vision for the health sector was recently elaborated in the formof the Georgia National Health Care Strategy 2011-15 entitled "Affordable and Quality HealthCare". This strategy is based on seven key principles: (i) equal access; (ii) patient-focused health

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care system; (iii) affordable and efficient health care; (iv) public private partnerships andenhancing free competition; (v) transparency and public involvement; (vi) adequacy of resourcesrelative to needs; and (vii) an inter-sectoral approach. On social safety nets, the establishment ofa cash benefit program targeted to the extreme poor has been a consistent and long-standingpolicy priority.

98. Recent reform initiatives in the health sector have focused on partnership with theprivate sector to strengthen hospital infrastructure. A hospital construction program partiallyfinanced through government contracts with insurance companies under the Medical InsuranceProgram (MIP) for the poor is expected to result in about 150 fully-functioning, new orrefurbished hospitals with out-patient care clinics and ambulance services by the end of 2013.This has been accompanied by an extensive effort to establish a strong information technologyplatform to generate data flows from insurers and providers related to health care services andpayments under the MIP. Finally, there have been ongoing measures to improve the targetingand administration of the proxy means test used to determine eligibility for both MIP and for thetargeted social assistance (TSA) program.

99. Significant achievements notwithstanding, Georgia's health sector faces challenges.While a new hospital infrastructure is an important step forward, it will not be sufficient toguarantee high quality health care services. The need to improve quality of health care has beenlong recognized in Georgia. A recent study in 2009 found that the MIP program had not had asignificant impact on utilization rates among beneficiaries, with perceived low quality of care asone of the major obstacles. To address this challenge will require stronger inputs and incentiveson the human resource side.

100. An important challenge relates to coverage of the MIP and TSA programs. Whileboth programs are well-targeted to the poor by international standards, they still leave asignificant proportion of households of poor families without coverage. Due to the uncertainnature of health costs, even those households in the middle part of the consumption distributionface the possibility of high out-of-pocket (OOP) payments as a result of a health shock. Georgiahas one of the highest rates of OOP payments in the region. Further strengthening social safetynets in Georgia will require attention to these issues.

101. The Government is committed to follow up on the important health and social safetynet reforms undertaken in recent years. The DPO supports the Government's reforms to (i)improve accessibility and quality of health care services; and (ii) improve efficiency of targetedprograms (TSA and health insurance).

i. Improve accessibility and quality of health care services:

Context

102. The Government of Georgia is prioritizing reforms to strengthen the stewardship ofthe health sector to improve the quality of health care. Private insurers and providersreceived about GEL 120 million of public funds annually in exchange for their responsibility forimplementing the MIP program. The government has an interest in both providing the 'publicgoods' needed for promoting higher-quality care in the form of clinical protocols (specifyinghow to diagnose and treat specific diseases and conditions), as well as adopting measures that

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will enforce their application in clinical practice. A related process is to develop the standardsfor health facilities to ensure quality and patient safety.

103. The Government has launched an effort to develop improved standards in hospitals,laboratories, and outpatient care facilities. Amendments to the Law of Georgia on Licensingand Permits enacted in December 2010 defined rules for issuance of permits for healthcarefacilities and licenses for some of the medical activities. In accordance with this law, Decree no.383 of the Government of Georgia stipulates that upgraded standards for healthcare permits andlicenses be met effective January 2012. These upgraded standards, in accordance withinternational experience on quality and safety of medical care, ensure that hospital facilities meetrequirements for adequate staffing, safety of medical equipment, organization of healthcareservices (such as ensuring availability of necessary services and referral), infection control, andproper management of medical records. As a result, by May 2012, 331 hospitals have upgradedtheir hospital permits.

104. A detailed reporting system has also been established for monitoring adherence tostandards. This system will be fully operational by 2013 and is already being piloted. Thereporting system will be supplemented by spot physical checks and inspections.

105. In addition, the Government has undertaken a major expansion of publicly-fundedhealth insurance by extending coverage to all pensioners and children under six years ofage. Due to their health, pensioners are particularly vulnerable to high out-of-pocket payments.Beginning in September 2012 they will receive health insurance benefits similar to those underthe MIP, also to be administered through private insurers, as will children under six. Preparatorylegislation was issued in May 2012. These measures represent a major step forward towardsuniversal coverage in Georgia. There are also plans to expand health insurance to vulnerablegroups including persons with disabilities and university students next year.

Policy Actions to Be Supported

106. The first operation under the CG DPO series proposes to support the followingpolicy action:

* The Ministry of Labor, Health, and Social Affairs of Georgia has implemented theupgraded standards in all hospitals by issuing permits as of January 1, 2012 inaccordance with Decree No. 385 dated December 17, 2010 to improve safety andquality of healthcare services.

* The Government of Georgia has issued Decree No. 165 dated May 7, 2012 expandingmedical insurance plan to children below the age of six (6) and pensioners.

107. Indicative triggers for DPO2 and DPO3 are proposed as:

* Expand coverage of medical insurance plan to vulnerable groups, for examplepersons with disabilities and university students.

* The Ministry of Labor, Health, and Social Affairs of Georgia ensures implementationof upgraded standards for healthcare providers at outpatient level and for laboratoryservices in accordance with the decree of the Government of Georgia.

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Expected Outcomes

108. The expected medium-term outcomes of the health component of the social spendingpillar under the three year program envisaged over the CG DPO series are that (a) Percentage ofhospitals, outpatient facilities, and laboratories submitting detailed reports on compliance withupgraded standards is 100 percent (in the baseline year 2011, there was no such reportingsystem); and (b) the coverage of the population by the medical insurance plan increases from 21percent in 2011 to 35 percent in 2015, an increase of about 600,000 persons. Coverage of alltargeted programs will be monitored on a gender-disaggregated basis.

ii. Improve efficiency of targeted programs (TSA and Medical Insurance Plan):

Context

109. The major challenge related to Georgia's safety net programs (TSA and healthinsurance) relates to coverage. Shortcomings in program coverage are especially apparent inthe case of MIP. While 20 percent of the population is covered, and another 10-15 percent havecoverage through other programs (e.g., for military, police, teachers, or formal sectoremployees), at least 60 percent of Georgia's population does not have significant healthinsurance coverage. This results in vulnerabilities to the financial consequences of a healthshock. Even households covered by the MIP are at risk of high out-of-pocket payments becauseof minimal coverage of pharmaceuticals. The TSA program as well only covered about 39percent of households from the bottom decile in 2009. Preliminary evidence suggested this hadimproved somewhat by 2011, but this remains to be validated. Therefore, while the programperforms well in international comparisons on targeting effectiveness and adequacy (i.e., benefitper household), there is considerable room for expanding coverage of the very poor. A recentstudy by UNICEF on the barriers to access social services in Georgia suggests there arechallenges with respect to both outreach to certain vulnerable groups (including minorities), aswell as budget adequacy (many poor are applying but being rejected for eligibility, perhapsbecause the inclusion criteria are too strict). The government has started to operationalize thelessons of the barriers to access study by translating materials about the TSA program into Azeri,Armenian, and Russian, and through other outreach activities.

110. The establishment of the Social Information Management System (SIMS) will helpbeneficiaries access benefits faster. The time taken between application and actual receipt ofbenefits is a significant transactions cost to eligible beneficiaries. Reducing this cost is perceivedas critical to improving the cost efficiency of the TSA. This program is still under developmentand will be piloted next year. These measures will therefore be supported under DPO 2 and 3.

Policy Actions to Be Supported

111. The indicative triggers for DPO2 and DPO3 are proposed as follows:

* Pilot of all modules of SIMS introduced in Tbilisi and two other regions.

* Nationwide roll-out of SIMS.

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Expected Outcomes

112. The expected medium term outcome of the actions relating to targeted social programs asenvisaged over the CG DPO series is that the time taken for issuing first benefits after assessingbeneficiary eligibility will fall from 90 to 60 days for the TSA and from 120 to 60 days for theMIP.

VI. OPERATION IMPLEMENTATION

A. IMPLEMENTATION, MONITORING AND EVALUATION

113. The Ministry of Finance will act as the main coordinator for managing the overallimplementation of the DPO program. The Ministry also actively participates in implementingthe overall strategic goals of the Government's Ten Point Strategic Development Plan forGrowth and Employment. The primary implementing line agencies for the DPO program are:the Ministry of Finance, the Prime Minister's Office, The Ministry of Education and Science,and the Ministry of Labor, Health, and Social Affairs.

114. The monitoring of the reform program will be carried out through regular reviewsduring supervision of this operation. Progress in the implementation of policy measures willbe further monitored through other Bank financed projects, including those that complementactions supported under the DPO program. The monitoring of public sector reforms and publicexpenditures in social sectors is of particular importance to the Government.

B. POVERTY AND SOCIAL IMPACTS AND GENDER IMPACTS

Poverty and Social Impacts

115. Translating continued strong growth into sustained reductions in unemploymentand poverty is at the center of the reforms supported by the DPO. The prior actions in Pillar1 should help strengthen competitiveness for growth through enhanced market access, improvedcustoms efficiency, a better investment climate, and higher quality of education. In the mediumterm, reforms to sustain economic recovery are expected to be the driving force behind decreasedunemployment and improved living standards. The prior actions in Pillar II strengthen publicfinancial management by increasing the efficiency of treasury management, improving quality ofbudget spending, and increasing coverage and transparency of budget data. The actions underPillar II improve the overall functioning of the public sector and are expected to bedistributionally neutral. The anticipated fiscal consolidation could have adverse distributionaleffects, and careful monitoring is needed as the consolidation moves forward. This sectionfocuses on the prior action in Pillar III that aim to increase targeting and coverage of the basicsafety net programs (TSA and health insurance).

116. The TSA program is a cost effective policy instrument, and targets the poorest andmost vulnerable. The TSA program costs less than 1 percent of GDP (0.7 percent in 2009); andit has good targeting accuracy, with close to 45 percent of the transfers going to the poorest 10percent of the population. Since the program is means-tested, it presents the government with acost-effective policy instrument with which to combat extreme poverty and respond to crises. Forinstance, it only costs 1.25 Lari channeled through the TSA program to increase consumption ofthe average poor individual by 1 Lari. In response to the economic downturn, the TSA monthly

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distribution per additional family member was doubled from GEL 12 to GEL 24, resulting in asharp rise in expenditures in 2009. At the onset of the crisis, TSA coverage was also expanded,although more modestly, from about 400,000 beneficiaries in July 2008 to about 475,000 in July2009. According to survey data for 2009 (most recent available), the poverty headcount in 2009without TSA would have been almost two percentage points higher (27.5 percent versus 25.7percent), while the poverty gap would have been more than two percentage points higher (9.6versus 7.5 percent).

117. The expansion of the MIP program to pensioners and households with youngchildren is expected to contribute to a reduction in poverty incidence. Out-of-pocketexpenditures on health in Georgia are one of the highest in Europe. Less than a quarter ofGeorgia's population is covered by any kind of health insurance and the health insurance marketis underdeveloped. The current fully state-funded medical insurance plan program targeted topoor families covers about one-fifth of individuals in the poorest quintile (the poorest 20 percentof the population). High out-of-pocket expenditures serve both as a barrier to access healthservices and source of impoverishment for families, particularly in the case of a catastrophichealth shock. Approximately an additional 490,000 female and 235,000 male pensioners willbecome eligible after the expansion of the MIP program. Expanding coverage of this program topensioners and children under six is expected to improve the access to health services for thesevulnerable groups as well as contribute to a decrease in poverty among households that includepensioners and children under six.

Gender Impacts

118. Measures supported under Pillar III are likely to benefit women. Given the agingpattern in the population, the large gender wage gap and the high incidence of low pay amongfemale workers, women are particularly vulnerable to old age poverty and will be among themain beneficiaries of the expansion of the MIP program.

119. Teacher certification is likely to affect women more. The aim of the trainingopportunities offered in conjunction with the certification can lead to improvements in the skillsof certified teachers. The majority of teachers at the primary and secondary school levels arewomen (86 percent in both cases). The mandatory certification of teachers (an action in the thirdproposed DPO in this series) is therefore likely to impact women more than men. There is a riskthat some teachers do not meet certification requirements, which is mitigated by the expansion inteacher professional development programs. The overall effect on female employment in thissector of the actions supported by the CG DPO is likely to be small. Depending on theavailability of data, the team will monitor performance on the exam by age, gender, location,subject specialization, and so on to gather information on which groups are likely to be the mostaffected as the certification process becomes mandatory.

C. ENVIRONMENTAL ASPECTS

120. The policy actions supported by this DPO series are not likely to cause significanteffects on the natural environment of Georgia. The adoption of the Code on Food Safety,Veterinary and Plant Protection under the proposed programmatic operation may help decreasefuture environment pollution in agriculture, as improved practices of plant and animal farmingimply the application of higher standards in the use agrochemicals and pesticides. The reformssupported by the DPO series promote transparency of laws and regulations and alignment with

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international practices to attract reputable and responsible private investors to Georgia'shydropower sector. This operation will only support upstream functioning of electricitymarkets. The series will also support the Law on renewables, which is meant to facilitate theproduction and use of renewable energy.

D. FIDUCIARY ASPECTS

Public Financial Management System

121. The findings and conclusions of various assessments of the Georgian public financialmanagement system are an integral part of the design of the CG DPO series. Theseassessments include: the World Bank's 2007 Draft Country Procurement Assessment (CPA); the2003 Country Financial Accountability Assessment (CFAA); the IMF's 2003 Report on theObservance of Standards and Codes - Fiscal Transparency Module; the World Bank's 2009Country Procurement Assessment Report (CPAR); the World Bank's 2003 Public ExpenditureReview (PER), and the 2008 Joint World Bank-European Commission PEFA. The salient publicfinancial management issues of these assessments, as well as issues arising since the publicationof these assessments, have been summarized, and progress has been discussed and progress hasbeen assessed as adequate elsewhere in this Program Document.

122. As discussed in the PEFA report, significant progress was made in reforming thePFM system since the Rose Revolution and several areas were identified as priorities forfurther reform. The Budget System Law approved in January 2004 set in place principles ofcomprehensiveness, transparency and accountability for the budget system, and rules andprocedures for preparation, approval, execution, reporting, and audit of the budget. The newBudget Code approved in December 2009 further improves the legal framework in these areas.All extra-budgetary funds were closed and all State financial transactions were unified within aTreasury Single Account. Legislation defines the division of power between the Government,external control, and Parliament. The public sector accounting reform strategy, as well as thefinancial and performance requirements for Legal Entities of Public Law (LEPLs) havestrengthened the Treasury system and its financial accounting and reporting framework. The lawon local self government finances has defined the budget and financial control procedures forlocal self governments and established rules for formulation, control, audit, evaluation andexecution of local government budgets.

123. The Competition and State Procurement Agency has developed regulations forefficient procurement procedures and continues to improve transparency in publicprocurement processes by adopting international standards. The Law on State Procurementwas enacted in 2009 that provides a solid legal framework for second generation reforms,including introduction of the e-procurement system. Prior to March 2010 every public entityconducted paper-based procurement. After introduction of the Unified Electronic System,procurement under all state expenditure projects are conducted in electronic format onwww.spa.ge on a mandatory basis for all public entities. The system is completely open to civilsociety. Any kind of information concerning the procurement process can be easily obtainedthrough the portal without pre-registration - (number of bids, name of bidders, minutes ofmeetings, minutes of bid openings, contract, etc). The current system has reduced the volume ofpaperwork and has increased transparency. In addition, substantial savings were generatedfollowing the introduction of the e-procurement system. Currently the Bank is in process of

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finalizing an assessment of the current e-procurement system, prior to it being used for Bank-financed projects in Georgia.

124. An action plan was proposed in the last CPAR dated April 2009, withrecommendations and priority measures to improve public procurement system. Thisaction plan is based on the four main OECD/DAC pillars: (i) Legislative and regulatoryframework; (ii) Institutional framework and management capacity, (iii) Procurement operationand market practices, (iv) Integrity and Transparency of public procurement system. TheGovernment is making considerable progress towards implementation of these measures. Forexample, the Government has enacted the new law on state procurement and amended theimplementation regulation (Order No.9 dated 07 April 2011) to comply with the amended lawsand regulations for e-procurement. The Government has also introduced a user's manual knownto all bidders with clearly described selection procedures under different procurement methods.The system has been fully opened to civil society/NGOs to promote transparency in procurementpractices. Safe-keeping of records has been strengthened. However, several reforms are pending.For example, implementation regulations for pre-qualification procedures need to be established.The Government is still developing rolling multi-year budgeting linked directly to procurementplans. Currently, the level of competition in terms of number of bidders is not high, even thoughoverall improvements have led to effective, timely, and transparent procurement processes.Looking forward, a number of areas, including strategic budgeting, budget preparation andapproval, the internal control and external audit system, resource management, procurement, andaccounting and reporting, have been identified as priorities for continued reform to furtherstrengthen the effectiveness of the public finance management system.

Review of the Foreign Exchange Environment

125. The IMF conducted the latest safeguards assessment of the National Bank ofGeorgia (NBG) as part of the preparation of the new program approved in April, 2012.According to the latest report dated April 20, 2012, the foreign exchange environment in Georgiais assessed as adequate.

126. The NBG received an unmodified audit opinion on its latest published financialstatements from its auditors, for the year ended December 31, 2011. The NBG has adoptedIFRS and has been audited by internationally recognized auditing firms. Independent auditorshave consistently issued unmodified opinions on NBG financial statements for last several years.As a result the fiduciary risk for the operation is assessed as moderate.

E. DISBURSEMENT AND AUDITING

127. The proposed operation is an IDA Credit of US$60 million equivalent. The proceedsof the IDA Credit will be released in a single tranche upon effectiveness. The operation will besubject to ratification by Parliament before it becomes effective. The expected closing date ofthe proposed DPO is March 31, 2013.

128. The proposed DPO will be disbursed in US dollars into the Ministry of FinanceTreasury's Foreign Currency Account maintained at the NBG that forms part of thebudget management system. The disbursed proceeds of this development policy operation willform part of the country's official foreign reserves. The Recipient shall ensure that upon depositof the Credit proceeds into the said account, an equivalent amount in GEL at the officialexchange rate will be deposited within 30 days of disbursement in the Treasury Single Account

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in the NBG and accounted for in the Recipient's budget management system. The proceeds ofthe Credit deposited at the Treasury Single Account with NBG will be available to financebudget expenditures. The foreign exchange proceeds of the proposed first DPO will be sold bythe NBG or held in reserves, in accordance with the objectives of monetary policy.

129. The Ministry of Finance will be responsible for the operation's administration, forpreparing the withdrawal application, and for maintaining the Treasury Foreign CurrencyAccount at the NBG. The Ministry, with the assistance of the NBG, will maintain records of alltransactions under the CG DPO in accordance with sound accounting practices. The MoF willprovide to IDA a confirmation that the amount of the operation has been credited to an accountthat is available to finance budget expenditures (the format of the confirmation letter should beacceptable to IDA). This confirmation letter is required within 30 days of receipt of the amount.If, after the proceeds are deposited in the NBG account, the proceeds of the credit are used forineligible purposes as defined in the Financing Agreement, the Association will require theRecipient to promptly, upon notice from the Association, refund an amount equal to the amountof said payment to the Association. Amounts refunded to the Association upon such requestshall be cancelled.

130. Audits of the First and Second Poverty Reduction Support Operation (PRSO) wereunqualified and revealed no issues of concern. Given the progress in public financialmanagement reforms, the improvements recorded in the IMF safeguard assessments, unmodifiedaudit opinions issued on the NBG's recent years financial statements, and no audit requirementunder PRSO III and IV, and previous DPO series, no additional fiduciary arrangements includingaudit are required for the proposed DPO.

F. RISKS AND RISK MITIGATION

131. Georgia faces significant but manageable macroeconomic risks. The macroeconomicframework is vulnerable for several reasons. The global economic outlook remains uncertain,and there is vulnerability to contagion from a deepening Euro zone crisis. Downside externalrisks could negatively impact exports, remittances, inflows of FDI and other private capitalinflows, and therefore growth. Regional tensions could have an adverse impact on investor andconsumer confidence, which could constrain investment and growth of credit to the privatesector, and therefore growth. Pressures to increase social and investment spending may challengefiscal consolidation efforts, also considering the possibility of downside risks relating to the Eurozone crisis and the domestic political calendar.

132. There are also program-specific risks, including those to reform implementation.Several Government agencies will be involved in the implementation and monitoring of theprogram. Progress will depend on both the effort and capacity of these agencies, as well asendorsement from relevant stakeholders. For example, success in advancing trade-relatedreforms to help enhance access for Georgian products in European and other internationalmarkets depends not only on policy progress on the Georgian side, but also on decisions taken bytrading partners. At the same time, implementation capacity at the middle-level of the civilservice may be a constraint, including with respect to environmental safeguards.

133. Macroeconomic risks from the Euro zone crisis are partially mitigated; residualrisks remain that may have an adverse impact on growth and on the poor were they tomaterialize. Macroeconomic management in the context of a deepening Euro zone crisis

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scenario will require striking the appropriate balance between internal and external adjustment,with commitment to the envisaged fiscal adjustment, inflation targeting and flexible exchangerates providing important anchors in safeguarding overall macroeconomic and externalsustainability. However, significant downside risks remain in the event of a scenario in which theEuro zone crisis deepens further. These risks are being mitigated by several actions. The SBAand SCF with the Fund will provide contingent finance in the event that an adverse shock leadsto the realization of these risks. The Government also has large savings that provide back-upfinancing. Debt burden indicators remain within relevant prudential thresholds. The successfulEurobond issue in April, 2011 also suggests that Georgia has market access.

134. On mitigating regional tensions, some positive developments have occurred. Russia'saccession to the WTO may lead to improved economic ties with Georgia. In addition, Georgiaunilaterally waived visa requirements for Russian citizens, which is a step towards betterrelations. Domestically, political conditions remain stable with parliamentary and presidentialelections scheduled for 2012 and 2013, respectively.

135. The authorities' commitment to fiscal consolidation was reaffirmed by the recentagreement with the IMF under the new precautionary programs approved in April 2012.Spending pressures pose a risk to fiscal consolidation. The team will closely monitor fiscal andmacroeconomic developments.

136. Program-specific risks are mitigated by two main factors. While the reform programis challenging, implementation risks are mitigated to a large extent by strong Governmentownership and broad-based donor support on capacity building and technical assistance fordifferent components of the reform program. In particular, USAID, EBRD, and IFC have beencollaborating with the Government on the power sector reforms, while the EU has beenproviding technical assistance to support the legislative and regulatory measures required for theDCFTA. These two factors have been demonstrably important in the notable successes achievedby the previous DPO series.

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ANNEX 1: OPERATION POLICY MATRIXGeorgia: Programmatic Development Policy Operation

Indicative Triggers for Indicative Triggers for

Objective Prior Actions for the Competitiveness and Second Competitiveness Third Competitiveness and Outcome IndicatorsGrowth DPO (CG DPO) and Growth DPO (CG Growth DPO (CG DP03)

DPO2)

Pillar I. Competitiveness

1.1 Promote market * Georgia has enacted laws adopting trade- * Adopt secondary The legal provisions of Total trade with the EU increases toaccess with a view to related reforms which include the framework legislation as the DCFTA legislative 22 percent of GDP by 2015.enhancing exports and Laws No. 6155-Is on food/feed safety, appropriate in order to package to beforeign investment veterinary and plant protection; No. 6148-Is facilitate implemented and Baselie o tD i the1.

on free trade and competition; and No. 6157- implementation of the operationalized.Is on general product safety and liability dated DCFTA legislativeMay 8, 2012, needed to meet the requirements package.of the Deep and Comprehensive Free TradeAgreement (DCFTA) with the EuropeanUnion.

1.2 Improve customs * The Government of Georgia issued Decree no. * Strengthen the risks- * The Revenue Service * Score on the customs component ofefficiency to facilitate 357 on September 23, 2011, Decree no.426 on based management of implements enhanced the Logistics Performance Index istrade December 31, 2010, Decree no.366 on customs control by software (tradenet) to 3.5.

September 23, 2011, Decree no.3 54 on introducing the integrate processes and Baseline: In 20 10, the score wasSeptember, 23 2011, Decree no. 73 8 on automated selectivity simplifyi transactions. 2.37.November 17, 2011, Decree no.445 on for transit traffic.December 1, 2011, Decree no. 116 on March11, 2011, Decree no. 120 on March 11, 2011,Decree no. 425 on December 31, 2010, andDecree no. 428 on December 31, 2010,authorizing the revenue service to issuecertificates of origin and import, export andtransit related permits at the border crossings.

1.3 Enhance climate * The Ministry of * A grid code is issued to Power exchange increases to 3 TwH.for attracting Energy and Natural improve power system Baseline: In 2011, power exchangesinvestment in the Resources of Georgia reliability and theere oy 15 .power sector issues a decree Ministry of Energy and

amending electricity Natural Resources of*_Te_ovenmntof_eogiaisue Decree______ no. * (capacity) market rules Georgia revises as

42

Indicative Triggers for IniaveTgerfo.. Prior Actions for the Competitiveness and ScnCottivnerssr IdctveTigro

Objective Second Competitiveness Third Competitiveness and Outcome IndicatorsGrowth DPO (CG DPO) and Growth DPO (CG Growth DPO (CG DP03)

DPO2)

to prioritize new appropriate other relevanthydropower projects laws and regulations toand renewable power address evolving marketproduction access to needs.the grid withremaining congestedtransfer capacityallocated viatransparent auctions.

* The Government ofGeorgia submits toParliament the Law onRenewables adheringto EU principles.

I. 4 Strengthen the Ministry of Education and Science of Georgia * The Ministry of Monitoring framework Gender disaggregated learningquality of general has: (a) issued Decree No. 36/n dated March Education and Science established and outcomes as measured by nationaleducation to support 11, 2011, approving a new national of Georgia approves a assessment of new assessments of Grade 9 studentscompetitiveness curriculum for grades I through XII, effective new national national curriculum to be improve in Georgian language andthrough improved September 15, 2011; (b) implemented the new curriculum for grades I prepared. Mathematics.national curriculum national curriculum for grades I through VI through XII andand better human including the distribution of supporting operationalizes the M eacher ae e in ercn soe

Cuoreroiie.mteil .re iu o ga de for all teachers. percent of girls and 35 percent of* The Ministry of Education and Science of orrgiug * pei zq t boys). In the same year, 45 percent

Georgia has issued Decree no. 16/n dated Iclug dIIbutionamntlyse forlth scored above average inFebruary 18, 2011 amending Decree no.1101 mathematics (46 percent of girls anddated December 4, 2009 expanding teachers of supporting evaluation of school 45 percent of boys).voluntary certification examinations to include materials, principals.teachers for all grades and in all subjects i Launch certification ofeffective July 2, 2011. school principals and

implement qualityassessment system fortheir evaluation.

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Indicative Triggers for Indicative Triggers for

Objective Prior Actions for the Competitiveness and Second Competitiveness Third Competitiveness and Outcome IndicatorsGrowth DPO (CG DPO) and Growth DPO (CG Growth DPO (CG DP03)

DPO2)

Pillar II: Public financial management

11.1 Strengthen the * The Ministry of Finance of Georgia prepared * The Ministry of * The Ministry of Finance * The score under the relevant PEFAefficiency of treasury financial reports of 8 pilot agencies in Finance of Georgia of Georgia prepares indicator (PI-25) increases to C.management accordance with modified cash-basis prepares the regulation financial reports of all Baseline: In November 2008, the

accounting methods as part of the transition to on introduction of central governmentadopting IPSAS. modified cash-basis budgetary organizations score was D+.

IPSAS. in accordance withmodified cash-basisIPSAS.

11.2 Improve coverage * The Government of Georgia has issued * The Ministry of * The Ministry of Financeand transparency of Decree No. 111 dated March 23, 2012 Finance of Georgia of Georgia includesfinancial reporting requiring the inclusion of information harmonizes E-budget budgets of local self-

pertaining to the financial flows of Legal (electronic budget governments and fiveEntities of Public Law (LEPLs) in the annual management system) largest LEPLs in E-budget execution report. with the electronic budget.

treasury system (E-treasury).

Pillar III: Effectiveness of Social spending

111.1 Improve The Ministry of Labor, Health, and Social * Expand coverage of The Ministry of Labor, Percentage of hospitals, outpatientaccessibility, and Affairs of Georgia has implemented the medical insurance plan Health, and Social Affairs facilities, and laboratoriesquality of healthcare upgraded standards in all hospitals by issuing to vulnerable groups, of Georgia ensures submitting detailed reports onservices permits as of January 1, 2012 in accordance for example persons implementation of compliance with upgraded standards

with Decree No. 385 dated December 17, with disabilities, and upgraded standards for is 100 percent.2010 to improve safety and quality of university students. healthcare providers athealthcare services. outpatient level and for

* The Government of Georgia has issued laboratory services inDecree No. 165 dated May 7, 2012 expandingCoverage of the Government's

Dece no 1a e a y 7, 2012 expandin relevant decree of the Medical Insurance Plan increases tomgedoExicn in and pntoovgre Government of Georgia. approximately 35 percent of theageclofurnc (a)Hand pdSoianefir population, an increase of about

600,000 persons.

Baseline: In 2011,21 percent of the

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Indicative Triggers for Indicative Triggers forObjective Second Competitiveness Third Competitiveness and Outcome Indicators

Growth DPO (CG DPO) and Growth DPO (CG Growth DPO (CG DP03)DPO2)

population was covered by themedical insurance plan.

III. 2 Improve the * Pilot of all modules of * Nation-wide roll out of * The time taken for issuing firstefficiency of targeted the Social Information SIMS. benefits after assessing beneficiaryprograms Management System eligibility will fall to 60 days for the

(SIMS) in Tbilisi and TSA and for the MIP.two additional regions Baseline: In 2011, time taken forof Georgia. 1issuing first benefits after assessing

beneficiary eligibility took 90 daysfor the TSA and 120 days for theMIP.

45

ANNEX 2: MATRIX OF OUTCOMES AND MONITORING INDICATORS

DPO Area Key Monitoring Indicators Baseline (2011) Expected Outcome (2015)

D.

I. 1.1 Enhance market access * Total trade with EU. * Total trade with EU was 17 percent of * Total trade with EU reaches 22 percent of GDPCompetitiveness to promote exports and GDP.

foreign direct investment.

I. 2 Improve customs * Score on the customs component of * Score on the customs component of the * Score on the customs component of the Logisticsefficiency to facilitate the Logistics Performance Index Logistics Performance Index was 2.37 in Performance Index is 3.5.trade. 2010.

1.3 Enhance climate for * Power exchanges * Power exchanges are approximately 1.5 * Power exchanges increase to 3 TwH.attracting investment in TwH.the power sector.

I. 4 Strengthen the quality * Gender disaggregated learning * In 2009, 44 percent scored above * Improvement in learning outcomes is recordedof education to support outcomes measured by national average in Georgian (54 percent of girls (gender disaggregated).competitiveness. assessments of Grade 9 students in and 35 percent of boys) and 45 percent

Georgian language and literature scored above average in mathematicsand mathematics. (46 percent of girls and 45 percent of

boys).

II. Public II. 1 Strengthen the * Score on relevant PEFA indicator * Score on relevant PEFA indicator (PI- * Score on relevant PEFA indicator (PI-25) improvesfinancial efficiency of treasury (PI-25). 25) was D+ in November 2008. to C.management management.

11.2 Improve coverage andtransparency of financialreporting.

111. Effectiveness 111. 1 Improve *Reporting on compliance with *There was no such reporting system. *Percentage of hospitals, outpatient facilities, andof Social accessibility, and quality upgraded standards in hospitals, laboratories submitting detailed reports onspending of healthcare services, outpatient facilities, and Coverage of medical insurance plan is compliance with upgraded standards is 100 percent.

efficiency of targeted e Coverage of medical insurance plan The time taken for issuing first benefits Plan increased to 35 percent, an increase of aboutprograms. (gender disaggregated). after assessing beneficiary eligibility 600,000 persons.

was 90 days for the TSA and 120 days* Time taken for issuing first benefits for the MIP. The time taken for issuing first benefits after

after assessing beneficiary assessing beneficiary eligibility will fall to 60 dayseligibility, for the TSA and for the MIPa

46

ANNEX 3: IMF PUBLIC INFORMATION NOTICE

Press Release No. 12/131April 12, 2012

On April 11, 2012, the Executive Board of the International Monetary Fund (IMF)approved a 24-month Stand-By Arrangement (SBA) and Stand-By Credit Facility (SCF)for Georgia in support of the government's economic and financial program for 2012-13. The total access under the blend of SBA and SCF will be up to SDR 250 million (aboutUS$385.6 million), evenly divided between the two arrangements. The authorities intend totreat the arrangements as precautionary. The approved SBA and SCF follow the successfulcompletion of the 33-month SBA that expired on June 14, 2011 (see Press ReleaseNo.11/224).

Following the Executive Board discussion on Georgia, Mr. Min Zhu, Deputy ManagingDirector and Acting Chair, said:

"Georgia largely achieved the objectives of the previous Fund-supported program. Economicperformance in 2011 was stronger than envisaged, inflation dropped to single digits,government debt declined, and international reserves increased. However, the unsettled globaleconomic and financial conditions have increased risks.

"The authorities' economic program, supported by the precautionary Stand-By Arrangementand Stand-By Credit Facility, aims at completing the macroeconomic adjustment processinitiated under the last program. The program seeks to rebuild fiscal buffers, promote externaladjustment, strengthen market confidence, and catalyze continued official financial support.

"The authorities' commitment to pursue fiscal consolidation during the 2012-13 electionperiod and their intention to focus these efforts on expenditure containment are welcome. TheEconomic Liberty Act reinforces the fiscal policy framework by providing the governmentwith additional flexibility to introduce revenue-enhancing measures and by anchoring policiesto medium-term sustainability objectives.

"The progress made in enhancing the monetary policy toolkit will help consolidate the gainsmade in price stability. Exchange rate flexibility will continue to be a critical element of theauthorities' economic strategy.

"Continued structural reforms to strengthen competitiveness are essential to sustain high andinclusive growth and create employment. The newly established Partnership Fund can play auseful role in attracting private investment, but it will be important to strengthen itsinstitutional framework so as to limit the accumulation of contingent fiscal liabilities andensure that public resources are optimally allocated.

"The banking sector is well capitalized and has adequate liquidity. The authorities' efforts tostrengthen the prudential and supervisory framework ahead of a possible new credit cycle are

47

welcome, as is the development of new tools to better assess and counter potential systemicrisks."

Background and Program Summary

Georgia's economic performance in 2011 was stronger than originally envisaged, with growthreaching 7 percent, inflation converging to the low single digits, government debt falling to 34percent of GDP, and international reserves increasing to US$2.8 billion.

Despite these achievements, the unsettled external environment has increased external risks.At this juncture, the economic outlook for 2012 remains relatively favorable, with growthprojected to slow to 6 percent and inflation remaining subdued. However, access to IMFresources would become available under the program in the event of a significant worseningof external economic and financial conditions.

The program's objectives are to rebuild fiscal buffers, promote external adjustment,strengthen market confidence, and catalyze continued official financial support. Fiscaladjustment, a flexible exchange rate, and monetary policy dedicated to price stability will bethe key macro policy underpinnings of the program. The fiscal deficit is targeted to decline to3.5 percent of GDP in 2012 and to 3 percent in 2013, consistent with a steady reduction of thegovernment debt ratio.

Medium-term challenges remain, notably in terms of lowering the current account deficit(11.8 percent of GDP in 2011) and reducing unemployment (16.3 percent in 2010). Toaddress these challenges, sound macroeconomic policies and strong business environmentpolicies will be complemented with sector policies to encourage private investment andeducation and training reforms to improve labor-market skills.

48

ANNEX 4: COUNTRY AT A GLANCE

Georgia at a glance 12

Europe& LowerKey Development Indicators Central middle

Georgia Asia income Age distribution, 2010

72011) Male Female

Population,mid-year(millions) 44 405 2,519 7579Surface area (thousand sq. km) 70 23,614 23,579Population growth (%) -0.5 04 1.5 60-64

Urban population (%of total population) 53 64 39 45-49

GNI (Atlas method, US$ billions) 12.8 2,047 4,078 3-4

GNI per capita (Atlas method, US$) 2,900 7,272 1,619 15-19

GNI percapita (PPP,international$) 4,990 13,396 3,632 0-4 a

GDP growth (%) 7.0 5.7 6.9 percent of total populationGDP per capita growth (%) 7.5 5.3 5.3

(most recent estimate, 2005-2011)

Poverty headcount ratio at $1.25 a day(PPP, %) 15 0Poverty headcount ratio at $2.00 a day (P PP, %) 32 2 Under-5 mortality rate (per 1,000)

Life expectancy at birth (years) 71 71 65Infant mortality(per 1,000 live births) 39 19 50 soChild malnutrition(%of children under5) .. 2 25 50

40Adult literacy, male (%of ages 15 and older) 100 99 80Adult literacy,female (%of ages 15 and older) 100 97 62 30Gross primary enrollment, male (%of age group) 100 99 110 20Gross primaryenrollment, female (%of age group) 98 98 104 10

Accessto an improvedwatersource(%of population) 99 96 87 0 1990 1995 2000 2010Access to improved sanitation facilities (%of population) 93 84 47

Net Aid Flows 1980 1990 2000 2011 a

(US$ millions)Net ODA and official aid .. 0 169 626 Growth of GDP and GDP per capita (%)Top 3 donors (in 2010):United States .. 0 75 202 20European Union Institutions .. 0 14 155 10Germany .. 0 19 82 o

-10Aid(%ofGNI) .. 0.0 5.3 5.5 -20Aid per capita (US$) .. 0 38 141 -30

-40

Long-Term Economic Trends -095 05

Consumerprices (annual%change) .. 3.3 4.1 8.5GDP implicit deflator(annual%change) 1.0 224 4.7 9.2

Exchange rate (annual average, local per US$) .. 0.0 2.0 1.7Terms of trade index(2000=100) .. .. 100 124

1980-90 1990-2000 2000-11(average annual gro wth %)

Population,mid-year(millions) 5.1 5.5 44 4.4 0.7 -2.1 0.0GDP (US$ millions) .. 7,738 3,057 14,367 0.4 -7.1 6.6

(%ofGDP)

Agriculture 24.3 31.5 219 9.3 .. .. 0.3Industry 35.6 33.5 224 23.2 .. .. 8.3

Manufacturing 27.9 24.2 9.1 13.2 .. .. 10.0Services 40.1 35.0 55.7 66.2 .. .. 8.0

Householdfinalconsumptionexpenditure 55.8 64.8 90.5 74.2 .. 23.1 5.9General gov't final consumption expenditure 13.0 10.2 8.5 18.3 .. 32.1 17.6Gross capital formation 29.1 30.7 26.6 25.6 .. 210 3.0

Exportsofgoodsandservices .. 39.9 23.0 36.5 .. 17.6 9.6Imports of goods and services .. 45.7 39.7 55.1 .. 14.2 10.1Gross savings .. .. 9.2 14.5

Note: Figures in italics are for years other than those specified. 2011data are preliminary. .. indicates data are not available.'a.Aid data arefor 2010.

Development Economics, Development Data Group (DECDG).

49

Georgia

Balance of Payments and Trade 2000 2011

(US$millons)Governance indicators, 2000 and 2010(US$ millions)Total merchandise exports (fob) 459 3,254Total merchandise imports (cif) 971 6,663 Voice and accountabilityNet trade in goods and services -521 -2,682 Politcal stablity and

absence of violenceCurrent account balance -269 -1,682asa%ofGDP -8.8 -11.7 Regulatoryquality

Workers' remittances and Rule of lawcompensation of employees (receipts) 274 806 Control of corruption

Reserves, including gold 109 2,818 0 25 50 75 100

Central Government Finance 2012000o Country's perceneale rank (0-100)higher altaibilyityer atan

(%Rl of GlP)Current revenue (including grants) 15.4 28.4 Source: Woldwide Goveeance Indicators (wwwgovindicators.org)

Tax revenue 14.6 25.3Current expenditure 16.7 23.1

Technology and Infrastructure 2000 2010Overall surplus/deficit -1.7 -3.6

Paved roads (%of total) 93.4 94.1Highest marginal tax rate (%) Fixed line and mobile phone

Individual .. .. subscribers (per 100 people) 16 114Corporate .. .. High technologyexports

(%of manufactured exports) 10.9 1.8External Debt and Resource Flows

Environment(US$ millions)Total debt outstanding and disbursed 1638 8,770 Agricultural land (%of land area) 43 36Total debt service 118 364 Forest area (%of land area) 39.7 39.7Debt relief (HIPC, M DRI) - - Terrestrial protected areas (%of land area) 3.7 3.7

Total debt (%of GDP) 53.6 61.0 Freshwater resources per capita (cu. meters) 13,342 13,179Total debt service (%of exports) 12.5 5.5 Freshwater withdrawal (billion cubic meters)

Foreign direct investment (net inflows) 131 981 C02 emissions percapita (mt) 10 12Portfolio equity (net inflows) 0 0

GDP per unit of energy use(2005 PPP $ per kg of oil equivalent) 3.8 6.0

Composition of total external debt, 2011Energy use percapita (kg of oil equivalent) 650 723

Short-ter, 330 IBSRA??6217

World Bank Group portfolio 2000 2010

MF, 989 (US$ millions)

~ate w IIBRD

Ptivate, 4,808 Otherrnulti-ORte., 531 Total debt outstanding and disbursed 0 216Disbursements 0 116

Bilateral, 619 Principal repayments 0 0Interest payments 0 3

US$ millions IDATotal debt outstanding and disbursed 347 1218Disbursements 18 80

Private Sector Development 2000 2011 Total debt service 3 23

Time required to start a business (days) - 2 IFC (fiscalyear)Cost to start a business (%of GNI per capita) - 5.0 Total disbursed and outstanding portfolio 20 252Time required to register property(days) - 2 of which IFC own account 20 252

Disbursements for IFC own account 16 51Ranked as a major constraint to business 2000 2010 Portfolio sales, prepayments and

(%of managers surveyed who agreed) repayments for IFC own account 0 43P Economic and regulatory policy uncertainty .. 44.7r Anticompetitiveorinformalpractices .. 38.2 MIGA

Gross exposure 2 9Stock market capitalization (%of GDP) 0.8 9.1 Newguarantees 0 9Bank capital to asset ratio (%) 30.5 16.9

Note: Figures in italics are for years other than those specified. 2011data are preliminary. 5/1112.. indicates data are not available. - indicates observation is not applicable.

Development Economics, Development Data Group (DECDG).:)u

Millennium Development Goals Georgia

With selected targets to achieve between 1990 and 2015(estimate closest to date shown, -- 2 years) Georgia

Goal 1: halve the rates for extreme poverty and malnutrition 1990 1995 2000 2010Povertyheadcount ratio at$ 1.25 a day (PPP, %of population) 15.7 19.3 15.3Poverty headcount ratio at national poverty line (%of population) 52.1 213Share of income or consumption to the poorest qunitile (%).Prevalence of malnutrition (%of children under 5) 3.1.

Goal 2: ensure that children are able to complete primary schoolingPrimary school enrollment (net, %) 97 150 94Primary completion rate (%of relevant age group) 84 98 116Secondaryschool enrollment (gross, %) 95 77 79 86Youth literacyrate (%of people ages 15-24) 100 .. 10.

Goal 3: eliminate gender disparity in education and empower womenRatio of girls to boys in primary and secondary education (%) 98 99 98Women employed in the nonagricultural sector(%of nonagricultural employment) 45 45 41 47Proportion of seats held by women in national parliament (%) .. 7 7 6

Goal 4: reduce under-5 mortality by two-thirdsUnder-5 mortality rate (per 1,000) 47 45 45 42Infant mortality rate (per 1,000 live births) 43 41 41 39Measles immunization (proportion of one-year olds immunized, %) 16 61 73 97

Goal 5: reduce maternal mortality by three-fourthsMaternal mortality ratio (modeled estimate, per 100,000 live births) 32 30Births attended byskilled health staff (%oftotal) 96Contraceptive prevalence (%ofwomen ages 15-49) .. .. 41

Goal 6: halt and begin to reverse the spread of HIVIAIDS and other major diseasesPrevalenceof HIV(%of population ages 15-49) 0.1 0.1 0.1 0.1Incidence of tuberculosis (per 10,000 people) 38 .. *. 84Tuberculosis case detection rate (%, all forms) 26 30 87 100

Goal 7: halve the proportion of people without sustainable access to basic needsAccess to an improved water source (%of population) .. .. 76 99Access to improved sanitation facilities (%of population) .. .. 83 93Forest area (%of land area) .. .. 39.7 39.7Terrestrial protected areas (%of land area) 2.8 2.8 3.7 3.7C02 emissions (metric tons per capita) 3.1 0.5 1.0 1.2GDP per unit of energy use (constant 2005 PPP $ per kg of oil equivalent) 2.4 2.2 3.8 6.0

Goal 8: develop a global partnership for developmentTelephone mainlines (per 10 people) 11.2 11.7 11.5 24.8Mobile phone subscribers (per 150 people) 0.0 0.0 4.4 89.4Internet users (per 100 people) 0.0 0.0 0.5 26.3Computerusers (per 100people)

Education indicators (%) Measles immunization (% of 1-year ICT indicators (per 100 people)olds)

125 100 120

100- 39:99R== 75 .100

75- 80

50 50 60

25 4025

0. 20.2000 2005 2010 25 20

1990 1995 2000 2010 2000 2005 2010

-im ry netenroll ntra

Ratoogirlsboys,in primary&seco.ndaryedc INGeogi. O.rape. etl i A@ ed+mble.ubscrber A,, rneusr

Note: Figures in italics are for years other than those specified. ..indicates data are not available. 5/11/12

Development Economics, Development Data Group (DECDG).

51

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