How Could the Status of Neutrality Affect the Economy of Georgia?

Over the past decades, Georgia has often been perceived as a success story. In many ways, this is true: Georgia has made impressive progress in implementing institutional reforms. In 2019, Georgia ranked 7th in the world, according to Ease of Doing Business and 16th in the Index of Economic Freedom. Institutional development is key to economic success. Georgian case, however, does not reveal this connection. Georgia still lags behind its own performance in Soviet times and performs poorer than some of its neighbors.

Political reasons are deep rooted in Georgia’s economic decline

Let’s consider the macroeconomic and institutional indicators of some countries in one table.

Table 1. Economic and institutional indicators of the countries of the Black Sea-Caspian region

Macroeconomic indicators Institutional indicators
Nominal GDP per capita, 2019 GDP growth rate, 2000-19 GDP growth rate, 2015-9 Real GDP, 1985=100 Index of economic freedom (Heritage) Ease of Doing Business (WB) Control of corruption (WGI / WB)
Unit USD % % % Percentile rank, 0 (worst) – 100 (best)
Armenia 4,579* 6.44 4.65 121.1*** 67.7 74.5 42.79
Azerbaijan 4,841* 8.83 0.23 197.0 65.4 76.7 21.63
Bulgaria 9,518 3.65 3.60 137.3 69.0 72.0 50.96
Georgia 4,304* 5.31 4.05 87.6 75.9 83.7 76.44
Iran 5,506 2.48 -0.21 270.4 51.1 58.5 15.87
Kazakhstan 9,139 6.43 2.85 216.8 65.4 79.6 36.06
Moldova 4,539** 4.43 3.24 84.6 59.1 74.4 25.96
Romania 12,483 3.99 4.75 154.1 68.6 73.3 52.40
Russia 11,163 3.60 0.59 121.0 58.9 78.2 21.15
Turkey 8,958 4.78 3.93 377.4 64.6 76.8 43.75
Ukraine 3,592 2.22 0.16 62.9 52.3 70.2 18.27

Sources: IMF World Economic Outlook Database 2019/02, World Bank World Development Indicators Database, Conference Board Total Economic Database, National Statistical Services of the states, Heritage Foundation, World Bank Group, World Bank Worldwide Governance Indicators, author’s calculations.

Notes: *For most cases IMF 2019 forecast was used; estimates on Georgia, Armenia and Azerbaijan were recalculated based on current growth rates (January-September 2019); **Moldovan GDP per capita was recalculated based on new official population estimates; ***Armenia’s growth rate was recalculated based on author’s estimate due to exaggeration of growth rates by the official statistics in 1990s.

As we can see, the successes of the Georgian reforms do not transform into sustainable economic growth that would exceed the growth rates of other countries in the region, also, Georgia is characterized by a lower level of economic development compared to most countries in the region and is ahead of only Ukraine in terms of per capita GDP. Given that with a high probability the population of Ukraine is overstated, and the population of Georgia is underestimated[1], it cannot be ruled out that Georgia is possibly behind Ukraine and, thus, Georgia would have the lowest GDP per capita in the entire Black sea – Caspian sea region.

Georgia’s geographic location plays in favor of economic growth. Georgia is one of the first in the world in the transparent policymaking and has high level of economic freedom. In 2013, Georgia signed an Association Agreement with the European Union. Given its location, country serves a transit function for neighboring countries that do not have access to the world ocean, including the transit of Caspian oil to the West. Finally, Georgia is one of the major recipients of Western aid. However, if in 2000s it were mainly the United States, now it is the EU. How, with such a combination of favorable factors, Georgia’s economic results are so weak, it may seem a mystery and needs to be explained.

There is an explanation; however, it is primarily in the field of politics. One of the reasons is the critical issue with the political continuity. A power transit in Georgia each time was very dramatic, and usually the total revision of the past follows immediately after. The whole legacy of the predecessors was mostly destroyed in 1990, 1992, 2003 and 2012. Each time, this leads to a complete change of leadership, and often the whole staff, institutional memory was interrupted, and everything was starting from the scratch. The second reason is connected to the territorial conflicts. The severity of interethnic relations in Georgia in the late Soviet period was manifested in the number of potential confrontation and two military conflicts. In 2008, the violence resumed and Russia intervened. Ultimately, Georgia lost 18% of its territory, received more than 200 thousand refugees, and by 2014, 5.1% of the country’s population were refugees from the conflict areas. Finally, the third reason is Georgia’s unilateral foreign policy: in terms of foreign politics country was developing exclusively towards closer cooperation with the West, while economically it was built up on the close cooperation within the Russian Empire and later – the USSR. Foreign markets for Georgian goods are in its neighborhood, while political aspirations of Georgia are in the North Atlantic. This would not turn into a major issue if Russia would not consider its economic and political relations as closely interconnected. After all, Georgia was deprived of the opportunity to develop harmoniously for several decades.

All the above-mentioned problems are closely related to each other and arise from each other. Only a politically stable government can seriously discuss issues of foreign policy and conflicts, and only in the event of a settlement of conflicts can a full-fledged stabilization of the situation in the region be expected. At the same time, without normalizing relations with Russia, it’s hard to expect neither settlement, nor just stabilization of the conflicts in northern Georgia. If Georgia accepts neutrality in foreign policy, it will have big impact over relations with Russia and ultimately – in its economy.

This article attempts to calculate this effect based on the available data and current trends in the economy of Georgia and the region. It should be borne in mind that these calculations are based on a number of political and technical assumptions. Changing these parameters can seriously affect the results. In addition, the very possibility of Georgian foreign policy neutrality is only theoretical. Therefore, these calculations are hypothetical in nature. Nevertheless, they may be of interest to policy makers as an alternative scenario that would significantly affect the economic situation of not only Georgia, but also its neighbors.

The parameters of foreign policy neutrality in the case of Georgia

The first direct effect of Georgian neutrality, that is, the refusal to join NATO, will be an improvement in relations with Russia and the abolition of all sanctions and restrictive measures taken by Russia against Georgia, including the restoration of flights, visa-free regime, removal of trade barriers and expansion of investment. If desired, Georgia will have the opportunity to join the CISFTA and thus increase trade with other CISFTA member countries. For this, it is not necessary to be a member of the Eurasian Union. The Moldovan case shows that you can simultaneously be a member of CEFTA and CISFTA. However, for this, Georgia will need to return to the CIS, so this possibility should be considered purely theoretical.

Georgian transport and logistics infrastructure will require expansion, which will lead to an increase in foreign direct investment in Georgian infrastructure. Different players may show interest in this, including those that are not active players in the South Caucasus region.

The neutral status and, as a result, the expansion of contacts with Russia, will significantly increase Georgia’s transit opportunities in the North-South direction, as well as North-West. Georgia can become a transit region for the southern regions of Russia in the direction of Turkey, South Europe and the Middle East. Far East countries, including China and Japan, are already interested in the transit potential of Georgia, but in the case of Georgian neutrality, this interest will grow. Since not only Armenia and Azerbaijan will use Georgian transit potential, but also the south of Russia and the north of Turkey, a scale effect will appear to increase the volume of cargo transportation by two or more times. At the same time, Georgian transit will no longer be a risky destination. Now some of the major roads in the Shida Kartli region, run along the de facto border with South Ossetia within the range of 5-15 km and there are still incidents occurring on the line. The neutrality of Georgia can lead to the demilitarization of the territory and make this direction safe.

Georgia’s potential neutrality can also reduce security risks for the country and thus decrease future uncertainties. Today Georgia is trying to ensure its security by joining NATO, but it will require a lot of time: Georgia still does not have a Membership Action Plan (MAP), and even having that would require additional 8-10 years. Process of joining NATO, until it’s completed is by itself creating additional risks. Neutrality can be an alternative way to ensure the security of Georgia, and thus lead to decrease of future external shocks to the economy.

At the same time, Georgia needs to consider the risks that arise in the event of an abandoning of a neutral status if it was once accepted. Such a special policy designed to stabilize relations with a large neighbor (like Finland during the Cold War or Singapore since the mid-1950s) and even earn on the special nature of these relations might attract international players to participate in projects that will become possible by neutral status. But it also carries risks of serious losses in case of abolition of the neutral status without major changes in geopolitical context. In this case, the country may lose most of its gains obtained through the neutral status. On one hand it is in the hands of government, on the other, governments might change and so their foreign policy priorities.

Estimating economic outcomes of Georgia’s potential neutrality

As already shown, the economic losses of Georgia from political uncertainties and conflicts are quite significant. Slowdown in the economic activity caused by political factors has multi-dimensional effect. Therefore, to assess the impact of potential neutrality on the Georgian economy, one should consider as many factors as possible.

Most of these factors will directly affect the external sector of Georgia: its foreign trade, tourism, revenues from transport and transit services, foreign direct investment and the budget deficit. Education services provided by Georgia might also be more attractive for foreigners in the future if Georgia increases its transit role and level of economic development. It will still have negative balance and will not be able to compensate for the costs of education of Georgian citizens studying abroad, but it will put Georgia on the regional map of education services providers.

Below are the results of calculations of the impact of potential neutrality on the external sector of Georgia in a 10-year timeframe. The calculations are based on the gravity model, existing growth rates, IMF forecasts and author’s estimates. In addition to the political assumptions presented in the previous chapter, the technical assumptions are also included in the calculations. In particular, it is assumed that the policy of neutrality will be adopted from the very beginning of 2020, and the effects of neutrality will gradually increase over the course of ten years. After ten years, in some fields the potential will be fully unfolded, while in other fields it will only continue to increase for a longer period.

Table 2. The effect of potential neutrality on the balance of payments of Georgia in a 10-year perspective, $ millions, constant 2019 prices

Baseline scenario Alternative scenario The effect of neutrality
Net inflow of private transfers from Russia through banking system
2020 347 354 7
2025 355 406 51
2030 360 458 98
Net income from tourism (divergent influence on the flows from different countries)
2020 3,140 3,568 428
2025 5,731 6,036 305
2030 7,314 7,528 214
Transport services, net
2020 -369 -363 6
2025 -536 -385 151
2030 -590 110 700
Foreign trade in goods, net
2020 -5,146 -5,099 47
2025 -6,266 -5,813 453
2030 -8,134 -6,920 1,214
Education services, net
2020 -144 -144 0
2025 -284 -265 19
2030 -398 -288 110
All above mentioned, net
2020 -2,172 -1,684 487
2025 -958 -21 1,422
2030 -1,448 888 2,336
Inflow of Foreign Direct Investment
2020 900 920 20
2025 1,176 1,558 383
2030 1,725 2,398 672
Decrease of budget deficit
2020 0
2025 100
2030 244

The countries of East Asia – China and Japan both can be considered as the main potential investors in Georgia. Georgia, which has attracted significant investments by regional standards for its economy over the past 15 years, has recently faced the threat of this stream running out. Foreign investment in the mid-2000s were caused by large-scale privatization by the Georgian government. This source of potential investment has already been exhausted. The next group of drivers of FDI inflows were the mining industry, transport infrastructure and telecommunications. In all three directions, the potential decreased markedly. Communications linking Turkey and Azerbaijan have already been constructed, the telecom sector is quite developed, and other sectors attract fewer investors. Neutrality will make investments in Georgia more attractive for a number of players, primarily China.

In addition to influence on the external sector, the degree of influence of Georgia’s potential neutrality on the financial sector should be considered. It is very difficult to assess its impact on the finances of organizations, while an assessment of the impact on public finances can be tried. It should be noted that this estimate is less accurate than in the case of the external sector, since it is more difficult to forecast. According to the estimates in Table 3, from 2030, Georgia will have approximately $700 million of available funds annually due to both a reduction in expenses and an increase in budget revenues, primarily due to the growth of the economy.

Table 3. Components of change in the state budget of Georgia in case of potential neutrality, $ millions, constant 2019 prices

2020 2025 2030
Increase of the government revenues due to GDP growth 124 465 812
Change in grant incomes, estimate -40 -50 -60
Decrease in military expenditures -9 14 60
Reduction in public debt service cost due to lower interest rates (higher credit ratings) and less borrowing 0 27 145
Decrease in borrowing 0 100 244
Change of all incomes of state budget 84 315 508
Reduction in the state budget expenses[2] -9 41 205

Finally, let’s consider the macroeconomic effect that can be exerted on the Georgian economy if Georgia is neutral, subject to the prerequisites presented in sections 2 and 3. GDP growth will accelerate by about 1.2% per year. At first glance, this is not very impressive, but by 2030, Georgia’s GDP may be 3-3.7 billion more than in the absence of neutrality.

Table 4. The effect of potential neutrality of Georgia on the dynamics of gross domestic product, by 2030

Indicator Results by 2030
Annual acceleration of GDP growth rate 1.1% – 1.3%
Cumulative GDP increase 3.0 – 3.7 bn USD
Cumulative GDP increase, % over baseline scenario 12.3% – 15.3%

Limitations of the study

All effects of potential neutrality are evaluated based on the difference with the baseline scenario, with the given political contexts. Their implementation in its pure form is almost impossible, as these are ideal models. For example, softening the foreign policy context around Georgia may lead to the realization of a part of the effects of neutrality. On the contrary, the aggravation of the foreign policy situation will lead to the fact that the potential effect will become even more pronounced. Finally, it is possible to predict accurately future dynamics only with a certain degree of assumption: to predict global and regional trends and crises is also very difficult. Political effects of neutrality on Georgia are outside of the scope of this study.

In addition to the direct economic effects, neutrality can create a number of indirect ones, opening up those opportunities that today are not visible. The fact that Georgia can regain dynamism in the economy will lead to the restoration of agriculture and manufacturing. Thanks to this, Georgia will be able to restore a number of sectors of the economy that almost completely disappeared in the post-Soviet era. This, of course, will lead to a marked reduction in unemployment, both among women and among men. In the first case, this will positively affect equality in family and social relations; the second is to reduce the prevalence of social vices such as drug addiction, alcoholism and crime. However, assessing the impact of these indirect and effects remains outside the scope of this study.

Georgian citizens will be able to effectively conduct business not only in Georgia, where there are all conditions for this except for a sufficiently large market, but also in neighboring countries, restoring the experience of transborder cooperation and bringing new technologies to the country.

Also, this will lead to the stabilization of the Georgian economy in a number of areas. Currently, national currency is gradually devaluating over the past several years due to negative net balance of payments. This leads to devaluing the savings of Georgian citizens and increasing their debt burden (loans are often taken in foreign currency). Stabilization of financial and macroeconomic environment will lead to the stabilization of Georgian currency and in the future, all these effects will lead to a decrease in the number of overdue loans. This is also an indirect effect; it has not only economic but also social dimension.

[1] The last census was conducted In Ukraine in 2001. Since then, several million people have emigrated from the country, and as a result of the war Ukraine has lost territories with a population of about 3 million people. Recalculation based on voter lists puts estimated Ukrainian population at 33 million instead of 42 million, which it is according to the officially published statistics.

In Georgia, the census was conducted in 2014. It revealed decrease of population size by 20% – from 4.5 to 3.7 million people, although there were several publications in the press regarding the incomplete coverage of the population by the census.

It is worth considering that most post-socialist countries distort the size of their own population, both intentionally and accidentally (given the inability to accurately account for migration). At the same time, countries use different methodology for calculating GDP, so that certain deviations from the data presented in Table 1 are possible in one direction or another, but it should not radically affect the results.

[2] Actually, the state budget spending on infrastructure and social budget items will increase. The reduction, which is indicated in Table 3, is connected precisely with the potential neutrality of Georgia