Georgia hikes rate 2nd time, inflation pressure intense

     Georgia's central bank raised its key interest rate for the second month due to above-target inflation and "intensified" inflationary pressures - the third monetary authority in Central Asia to raise its rate this week - and said further monetary tightening would depend on inflation expectations.
     The National Bank of Georgia (NBG) raised its refinancing rate by 100 basis points to 9.50 percent and has now raised it 150 points this year following last month's 50-point hike.

      In an effort to lower the high level of dollarization - estimated at over 60 percent in 2019 in Georgia compared with less than 20 percent of average in other developing countries - the central bank will begin to levy reserve requirements on a sliding scale that is based on each individual bank's dollar deposits.

      This year's two hikes by NBG takes the rate back to its level in October 2019 when the bank was in the midst of monetary tightening cycle that began in September 2019 when the rate was raised twice that month to ward off pressure on the lari's exchange rate.

     But the arrival of the COVID-19 pandemic forced NBG - like other central banks - to change course and the rate was cut three times in 2020 (April, June and August) by a total of 100 basis points.
     With the global economy recovering and commodity prices worldwide accelerating, inflationary pressures are rising and central banks are now beginning to unwind some of the extraordinary monetary stimulus unleashed last year and normalize their policy stance.
      Georgia is among 13 central banks worldwide, mainly in smaller and more inflation-sensitive nations, to have raised their key interest rates so far this year. 

     But three larger emerging market countries (Turkey, Brazil and Russia) have also raised rates and Canada last week became the first developed economy to begin rolling back some of its stimulus by trimming asset purchases.

      Today's rate hike comes as a surprise as NBG in March said there was "no apparent need of additional policy tightening over the course of the year" despite raising its inflation forecast.

     But circumstances had changed since that meeting, the bank said, raising its inflation forecast again.

    NBG now expects inflation to average around 6.5 percent this year, up from the March forecast of 4.0 to 4.5 percent and the February forecast of 4.0 percent.

     As last month, NBG still expects inflation to gradually approach its 3.0 percent target.

     "A possible further tightening of monetary policy will depend on inflation expectations and the dynamics of factors affecting it," NBG said.

     Inflation in Georgia jumped to 7.2 percent in March from 3.6 percent in February, mainly due to the scheduled end of subsidies of utility fees. The central bank noted the subsidiary will also have a base effect and upward impact on inflation in December this year and in January-February 2022.

     But upward pressure on inflation is also coming from three other sources.

     Commodity prices, including oil and food, are putting upward pressure on inflation and production costs remain high after due to the closure of many facilities during the pandemic.

     Thirdly, the exchange rate of Georgia's lari has continued to weaken since June last year, with the high dollarization in the country adding further fuel to the fire. 

     With the prospects for tourism still uncertain, there is less foreign exchange coming in and the central bank said domestic demand is recovering - supported by fiscal spending - and this is boosting imports.

     "Based on the aforementioned factors, it is clear that the pressure on inflation coming from high dollarization and the exchange rate is still strong," NBG said.

     As other currencies, Georgia's lari plunged in March last year but then after rebounding to early June, it has steadily weakened. Although it rose slightly today, it was trading at 3.45 to the U.S. dollar, down 5.2 percent this year and down 17 percent since the start of 2020.

     In addition to limiting the effect of monetary policy, dollarization can also impact financial stability and NBG said from July it would set minimum reserve requirements for banks' foreign currency deposits on an individual basis.

      If dollarization exceeds 40 percent of deposits with a maturity of up to one year, the reserve requirement will be lowered to 10 percent from 25 percent. But if dollarization is 70 percent or more, it will remain 25 percent. Between those two levels, the requirement will decline as the amount of dollars is lowered.

     For foreign currency deposits with maturity of 1 to 2 years, the reserve requirement will be lowered to 10 percent from 15 percent.

     "This change will help to intensify competition in the GEL deposit market, gradually increase the demand for GEL and ease the pressure in the foreign exchange market," the bank said.

     The National Bank of Georgia issued the following statement:

d"The Monetary Policy Committee (MPC) of the National Bank of Georgia (NBG) met on April 28, 2021, and decided to raise the refinancing rate by 1 percentage point to 9.50 percent.

Annual inflation stood at 7.2 percent in March. The reduction of inflation since last December was related to the subsidization of utility fees, which was of a temporary nature. The end of this subsidy in March 2021 was reflected in the upward shift of inflation. It is noteworthy that the subsidy will also have a base effect with a significant upward impact on the annual inflation rate in December 2021 and January-February 2022. Given the changed circumstances since the previous meeting, according to the updated forecast, other things being equal, inflation will average around 6.5 percent in 2021 and then gradually approach the target. The forecast for economic growth is about 4 percent in the baseline scenario.

Inflation pressures, coming from rising prices on international commodity markets, persists, being reflected in the increased prices for oil products and selected food items. At the same time, on the back of a big drop in output due to the pandemic, the average production costs are still high, being another source for the upward pressure on inflation. The Committee also took into account that the recent developments in the trading partner economies have, to some extent, also been transferred to the local foreign exchange market. Given the high dollarization of the economy, this puts even more pressure on prices. Moreover, there is high uncertainty remaining about the prospects of the tourism industry in Georgia as well as globally. Amid deteriorating epidemiological conditions, the fiscal deficit remains at high level, pushing domestic demand up. As for the lending, despite the recent slowdown, as a result of maintaining adequate buffers of liquidity in the financial sector, it continues to grow fairly. Overall, the increase in domestic demand boosts imports. In view of prolonged deviation of inflation from its target and intensified inflationary pressures, the Committee decided to increase the monetary policy rate by 1 percentage point. A possible further tightening of monetary policy will depend on inflation expectations and the dynamics of factors affecting it.

According to the preliminary data, there are signs of recovery in the aggregate demand. Based on rapid estimates, economic activity fell by 5.1 percent year-on-year in February, while, amid easing of restrictions since the start of the year, a gradual recovery of economic activity is expected from March, the main driver of which will be domestic demand. In contrast, external demand remains significantly reduced compared to the pre-pandemic situation. As for the current indicators, exports of goods increased by 31 percent in March, which is partly due to the base effect. At the same time, revenues from international travelers is down by 60 percent year-on-year in March, while the drop since the same period in 2019 amounts to 88 percent. As for imports of goods, an annual growth of 18 percent was recorded in March.

Based on the abovementioned factors, it is clear that the pressure on inflation coming from high dollarization and the exchange rate is still strong. In addition to limiting the efficiency of monetary policy, dollarization also carries risks of financial stability, and thus its gradual reduction remains a long-term priority of the NBG. For this purpose, starting from July, the minimum reserve requirements for funds attracted in foreign currency will be determined individually, for each commercial bank, according to the deposit dollarization of each bank. In particular, unless the deposit dollarization rate exceeds 40 percent, the reserve requirement norm will be reduced from 25 to 10 percent for funds borrowed in a foreign currency and with a remaining maturity of up to 1 year. If the deposit dollarization is 70 percent or above, reserve requirements will still be 25 percent. Finally, for the deposit dollarization in the range of 40-70 percent, the reserve requirement norm will decrease linearly from 25 to 10 percent along with a decrease in the deposit dollarization. Similarly, the reserve requirement will be reduced from 15 to 10 percent for foreign currency-denominated funds with a remaining maturity of 1 to 2 years. This change will help to intensify competition in the GEL deposit market, gradually increase the demand for GEL and ease the pressure on the foreign exchange market.

The NBG continuously monitors the developments in the economy and financial markets and will use all available tools to ensure price stability.

The next meeting of the Monetary Policy Committee will be held on June 23, 2021."

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