Outlook for 2011-12

The Economist Intelligence Unit expects Mikheil Saakashvili, who was re-elected president in January 2008, to remain in power in 2011-12. Mr Saakashvili's popularity waned following his failed attempt in August 2008 to regain the breakaway province of South Ossetia by force, which led to a brief but damaging conflict with Russia. However, divisions among the opposition will continue to limit its ability to mount a credible challenge to Mr Saakashvili. Real GDP is estimated to have expanded by 6.1% in 2010, following a contraction of 3.8% in 2009. Although growth is expected to slow to 4.3% in 2011 as external conditions weaken modestly, an improvement in 2012 will result in growth of 5.2% in that year. The current-account deficit will continue to narrow over the forecast period, to 8.3% of GDP in 2012.

The political scene

Although the opposition remains discontented with Mr Saakashvili, the failure of the main opposition parties to form an umbrella group prevents them from posing a genuine threat to Mr Saakashvili's United National Movement (UNM). Support for protests organised by the radical opposition remains weak, indicating that the electorate are growing tired of the instability brought by street protests, and that a calmer political climate lies ahead. Tension between Georgia and its breakaway territories is still elevated, but has not worsened.

Economic policy

In a state of the nation address in February Mr Saakashvili announced a wide range of measures that the government plans to implement to support the economy over the forecast period. These included extra funding to support agricultural production and the construction of a further 17 hydropower stations.

The domestic economy

Real GDP expanded by 6.5% year on year in the first three quarters of 2010, compared with a contraction of 5.2% year on year in the year-earlier period. Manufacturing, trade and transport expanded the most rapidly in this period. Year-on-year growth began to slow in the third quarter as the impact of base-period effects subsided. We estimate that real GDP expanded by 6.1% in 2010.

Foreign trade and payments

The current-account deficit narrowed to US$833.5m in the first three quarters of 2010, from US$916.3m in the year-earlier period. The expansion of the trade deficit in January-September 2010 compared with the year-earlier period was partly offset by a higher surplus on current transfers. We estimate a current-account deficit equivalent to 10.6% of GDP in 2010.

Land area

69,700 sq km

Population

4.44m (January 1st 2010)

Main towns

Population in '000 (2010 National Statistics Office)

Tbilisi (capital): 1,153

Kutaisi: 193

Zugdidi: 175

Batumi: 124

Climate

Western Georgia has a humid, subtropical climate. The climate in the east varies from subtropical to temperate. The average temperature ranges from 2°C in January to 24°C in August

Language

Georgian is the state language; Russian is spoken in the towns; Armenian, Azeri, Abkhaz and Ossetian are also spoken

Measures

Metric system

Currency

The lari was introduced on September 25th 1995, replacing the Georgian coupon

Time

Four hours ahead of GMT

Public holidays

January 1st (New Year); January 7th (Christmas); January 19th (Epiphany); Easter Monday (April 25th in 2011); May 26th (Independence Day of the 1918 Georgian Republic); August 28th (Assumption of the Virgin); October 14th (Svetitskhovloba); November 23rd (St George's Day)

Official name

Georgia

Form of state

Georgia was an independent republic between 1918 and 1921, but in 1922 it was incorporated into the Soviet Union, from which it declared its independence in April 1991. The Abkhaz and South Ossetian autonomous territories, created in 1922, have both declared their independence from Georgia. Russia recognised the independence of the two territories in August 2008. A new constitution was approved in Georgia in August 1995, which reinforced the presidential-democratic form of government, providing for a strong executive branch and a unicameral, 235-seat parliament. A constitutional court met for the first time in late 1996. The constitution does not address the status of Abkhazia or South Ossetia, but grants autonomous status to Adjara, another separatist region until its reintegration in May 2004

National legislature

The Parliament of Georgia; from 2008, with 150 members: 75 elected by party list and 75 by single-member districts

National elections

January 5th 2008 (presidential); May 21st 2008 (legislative); next elections 2012 (parliamentary) and 2013 (presidential)

National government

The president appoints the cabinet, subject to individual approval by the legislature

Head of state

President, currently Mikheil Saakashvili

Main political parties

United National Movement (UNM); New Rights; Our Georgia-Free Democrats; the Republican Party; Georgia's Way; Labour Party; Conservative Party; Christian Democratic Movement; People's Party; Democratic Movement-United Georgia; Movement for Fair Georgia; National Forum; Freedom Party; Georgian Party

Council of ministers

President: Mikheil Saakashvili

Prime minister: Nika Gilauri

First deputy prime minister & state minister for regional policies & infrastructure: Ramaz Nikolaishvili

Deputy prime minister & state minister for Euro-Atlantic integration: Giorgi Baramidze

Deputy prime minister & state minister for reintegration: Eka Tkeshelashvili

Chair of parliament: David Bakradze

Head of the presidential administration: Davit Tkeshelashvili

Key ministers

Agriculture & food: Bakur Kvezereli

Culture: Nika Rurua

Defence: Bacho Akhalaia

Economic development: Vera Kobalia

Education & science: Dimitri Shashkin

Energy: Aleksander Khetaguri

Environment: Goga Khachidze

Finance: Kakha Baindurashvili

Foreign affairs: Grigol Vashadze

Internal affairs: Vano Merabishvili

Justice: Zurab Adeishvili

Labour, health & social welfare: Andria Urushadze

Central bank president

Giorgi Kadagidze

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The president, Mikheil Saakashvili, will remain in power in 2011-12. Threats to his leadership have continued to ease after opposition protests, which began in April 2009 and were aimed at forcing the president's resignation, petered out in July of that year. Entrenched divisions among the various opposition groups resurfaced over tactics, and over whether to negotiate with the authorities, sapping momentum from the protests. Since then, the domestic political situation has gradually improved, and it has remained more stable than at any point since before the large anti-government demonstrations in 2007.

Mr Saakashvili and his party, the United National Movement (UNM), will benefit from the wide divisions in the opposition camp. Although protests organised by the opposition continue to be held in Georgia on a sporadic basis, they do not pose a threat to political stability at the moment, as the opposition remains weak and divided, and unable to present a credible alternative to the leadership of Mr Saakashvili and the UNM. The poor turnout for protests in recent months indicates that the electorate have tired of the disruptions brought by street protests, and want the political elite to focus on policymaking and implementation.

Mr Saakashvili will continue to attempt to co-opt the opposition by offering some a greater say in political decisions. Parts of the opposition, particularly the National Council bloc (comprising the Conservative Party, the People's Party and the Movement for Fair Georgia), will resist the president's overtures, and will sustain demands for his resignation. Our Georgia-Free Democrats-led by Irakli Alasania, a former envoy to the UN-will continue to pursue a more conciliatory approach, possibly working with the authorities on issues such as electoral and judicial reform. Although some high-profile figures formed a new party, the Georgian Party, in October 2010, the longevity of the group is questionable, as there is a considerable divergence of political views. Mr Saakashvili will seek to exploit the divisions among the opposition, hoping to weaken their campaign against the presidential administration.

Prospects for the reintegration into Georgia of the breakaway provinces of Abkhazia and South Ossetia, which were already remote before the conflict with Russia in 2008, have vanished. In August 2008, shortly after hostilities ended, Russia recognised the independence of Abkhazia and South Ossetia. Although so far Nicaragua, Venezuela and Nauru are the only other countries to have recognised the two provinces' independence, Russia's decision appears to be irrevocable. Russia will accelerate the process of integration of the provinces' military, economic and administrative structures, especially those of South Ossetia, with its own. Georgia is trying to counteract Russian influence in these areas, and has launched a state strategy aimed at providing social assistance and improving economic links between Georgia and the breakaway provinces. However, the government's poor relations with the de facto authorities in the territories will make implementing the plan difficult. The government will also continue to lobby the international community to help to restore Georgian territorial integrity. Tensions between the breakaway provinces and Georgia will remain high through the forecast period.

The next parliamentary election is scheduled for 2012, and the presidential election for the start of 2013. The constitution prevents Mr Saakashvili from standing for a third term in the election in 2013. Currently, the most likely candidate from the ruling UNM is Gigi Ugulava, the mayor of the capital, Tbilisi, who won the mayoral election in May 2010 with just over 55% of the vote. Although not our main scenario, there is a possibility that Mr Alasania, from the more moderate wing of the extra-parliamentary opposition, could win the presidential election. However, support for his party is weak outside urban areas. Mr Alasania was Mr Ugulava's nearest rival in the mayoral election, receiving 19.1% of the vote.

The UNM will remain the largest party in parliament following the parliamentary election in 2012. Changes to the constitution in October 2010 will significantly reduce the powers of the president. The opposition has speculated that the decision to increase the powers of parliament was designed to allow Mr Saakashvili to retain a controlling influence over the political scene by assuming the post of prime minister once his term as president comes to an end. The opposition's ability to increase its share of seats in parliament will depend on its capability to reduce divisions among the main groups within the opposition and to propose a political programme that appeals more broadly to the concerns of Georgian voters-an approach that it has struggled to pursue in the past. There is a risk of protests in the run-up to, and the aftermath of, both elections. However, as the political scene is more stable than at any point in recent years, the risk that either election is brought forward has lessened.

Relations with Russia plummeted to a post-Soviet low in August 2008 as the two countries fought a brief but intense conflict, and full diplomatic ties have been suspended ever since. Bilateral relations with Russia will continue to dominate the foreign policy agenda, and ties between the two will remain difficult as long as Mr Saakashvili is in power. The "reset" in Russia-US relations could have implications for Georgian-Russian relations. Georgia has indicated that it may not block Russia's accession to the World Trade Organisation (WTO), which is expected to occur within the forecast period, as long as Russia lifts its blockade on Georgian goods, and customs control is established at the internationally recognised border. Nonetheless, this will be difficult to achieve, as Russia does not acknowledge the border, recognising South Ossetia and Abkhazia as sovereign states.

The desire to join NATO, already high on Georgia's foreign policy agenda, has intensified following the conflict with Russia. However, divisions within NATO with regard to Georgian membership have hardened, and Georgia is unlikely to be granted a Membership Action Plan (MAP, the last formal step on the way to possible future membership) in 2011-12. Most west European countries are even more ambivalent about Georgia's NATO aspirations after the events of August 2008. These countries would block or postpone prospects for Georgian NATO membership, both to avoid alienating Russia, with whom they have burgeoning commercial ties, and to avoid the risk of going to war for Georgia, particularly if this was the result of a renewed attempt to recover the breakaway provinces.

US-Georgian relations were cemented by the large amount of financial aid pledged by the US in the wake of the Russia-Georgia conflict. However, US officials have described Georgia's recourse to military action as unwise, and in time the US may come to view with favour the replacement of Mr Saakashvili with a less impetuous figure. The Georgian leadership will seek to further its long-term ambition of achieving closer relations with the EU. However, ongoing enlargement fatigue, and especially reservations about expanding into the post-Soviet space, means that the EU is unlikely to offer Georgia a clear prospect of eventual membership.

The war in August 2008 caused substantial damage to infrastructure, as well as an inflow of several thousand internally displaced persons (IDPs) from the conflict areas. Public funds, supplemented by a large amount of foreign aid, are being used to provide humanitarian assistance to IDPs, and to rebuild military and civilian infrastructure. As the effects of the global economic recession fade in 2011-12, economic policy will again focus on efforts to reform the legislative, financial, energy and healthcare sectors. However, these efforts will be tempered by the need to make the reforms more palatable to the population, in order to avoid a repeat of the domestic turmoil seen in late 2007. Slower budget revenue growth over the forecast period compared with 2004-08 is likely to weigh on the reform process, as will concern about the potential for political tensions, which could damage investor sentiment towards the country.

The consolidated budget deficit, according to IMF methodology, is estimated to have narrowed to 6.3% of GDP in 2010 from 9.2% of GDP in 2009. A return to economic growth in 2010 supported an increase in tax revenue. The government kept expenditure on social benefits and education in 2010 close to 2009 levels, although cuts were made in other areas. Maintenance of spending on social welfare was important in 2010 to offset the negative effects of higher unemployment and increased poverty.

The government's 2011 state budget targets revenue of Lari5.95bn (US$3.3bn) and expenditure of Lari5.73bn. The government plans to keep social spending in line with 2010 levels in order to provide support to the more vulnerable sections of the population as the effects of the global economic recession of 2009 continue to be felt. The government will increase spending on infrastructure in 2011, and further improvements in this area will continue to be supported by loans from multilateral organisations and foreign investment. We forecast that the consolidated budget deficit will narrow to 4.4% of GDP. It will shrink to 3.1% of GDP in 2012 as the government begins to tighten its fiscal policy further, and as an improvement in economic conditions provides support to revenue inflows.

The National Bank of Georgia (NBG, the central bank) lowered the refinancing rate from 12% in mid-2008 to 5% in November, and kept it at that level until June 2010 in a bid to stimulate the economy. Since then, the NBG has raised the refinancing rate by a cumulative 300 basis points, to 8% in February 2011. The central bank has said that its decision to raise the refinancing rate was motivated by concerns over a resurgence in inflationary pressures, which have been driven by an increase in global food prices. Faster than expected GDP growth in the first half of 2010 and a decision to support the lari have also been factors behind the rate increase.

As the stability of the economy improves, the NBG will continue to gradually tighten policy, and to resume working towards setting up an inflation-targeting regime. Issuance of certificates of deposit (CDs) and open-market operations should eventually facilitate this process. Nevertheless, the development of liquid domestic securities markets, which is essential for the smooth conduct of monetary policy, will take time, as investor risk appetite towards Georgian assets will remain weak in 2011 owing to post-conflict concerns, before gradually increasing through 2012. Tension will remain between the competing policy objectives of improving external competitiveness and achieving domestic price stability.

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In the first three quarters of 2010 GDP expanded by a robust 6.5% year on year. The increase contrasts with the 3.8% full-year contraction in 2009 as economic activity was negatively affected by the global economic recession, reinforced by the effect on economic activity of the war with Russia in 2008. In the first three quarters of 2010 all the main sectors expanded year on year, except agriculture, which contracted by 0.7%. We have revised our 2010 real GDP estimate to 6.1% from 5.3%, to take account of the robust performance in the third quarter. Nonetheless, we expect that real GDP growth will slow in the final quarter as the impact of base-period effects is reduced.

Real GDP growth will slow modestly in 2011, to 4.3%, as external demand dips. An improvement in external conditions in 2012 will result in an expansion in real GDP of 5.2% in that year. The rate of expansion in the forecast period will be slower than the average of 9.3% in 2004-07. Higher prices for base metals in 2011-12 than in 2009 will support export volumes and revenue. Annual average expansion of 4.4% of Russian real GDP in 2011-12, following a severe recession in 2009, will continue to have a positive impact on inflows of workers' remittances, supporting domestic demand. Private investment will increase more robustly in 2012 than in 2010-11, owing to the loosening of liquidity constraints, although private investment is not likely to return to the levels seen before 2008.

Annual average inflation rose to 7.1% in 2010 from 1.7% in 2009. The ongoing recovery in domestic demand growth, as well as an increase in global commodity prices, resulted in a return of inflationary pressures in 2010. Consumer prices rose sharply in the final months of 2010 owing to a sharp upward trend in food prices. Higher global prices for soft commodities (particularly cereals and sugar), along with the increase in global oil prices, have been the main factor behind recent consumer price increases in Georgia. The authorities target an annual inflation rate of 6% for 2011-12. However, we forecast an annual average inflation rate of 8.4% in 2011, owing to higher food and oil prices in the first half of 2011, as well as the ongoing recovery in domestic demand. Inflationary pressures will remain prevalent in 2012; however, lower commodity prices will reduce annual average inflation to a forecast 5%.

The authorities adopted a more flexible exchange rate policy in mid-2009, moving away from the daily fixing of exchange rates through the Tbilisi Interbank Currency Exchange and instead adopting weekly foreign-exchange auctions. Downward pressure on the lari picked up in the second quarter of 2010 and it depreciated to Lari1.89:US$1 in mid-June 2010. A stronger US dollar, lower than expected foreign direct investment (FDI) inflows and signs of a widening trade deficit in the second quarter were the main pressures on the lari. In a bid to prevent a further fall of the lari against the US dollar, the NBG increased the volume and the frequency of auctions to support the currency, and raised the refinancing rate by 300 basis points in June 2010 until February 2011. As a result of the NBG's intervention, pressure on the lari has eased. We forecast that the lari will gradually appreciate over the forecast period to average Lari1.72:US$1 in 2012.

The current-account deficit is estimated to have widened to 10.6% of GDP in 2010 from 11.7% in 2009. As in 2010, over the forecast period the widening of the trade deficit will partly be offset by an increase in the current transfers and services surpluses. Barring another military conflict, services credits over the forecast period will benefit from an increase in hydrocarbons transiting Georgia. The current-account deficit will therefore remain broadly stable in nominal US dollar terms, although as the economic outlook for the economy improves in 2012, this will result in a shrinking of the current-account deficit to 8.3% of GDP. In the first half of 2010 net FDI totalled US$270.9m, substantially below the US$1.1bn recorded in the first half of 2008. The outlook for net FDI will remain weak in 2011 as investors remain risk averse. However, as global economic prospects and constraints on credit ease in 2012, net FDI inflows will pick up.

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The president, Mikheil Saakashvili, delivered his annual state of the nation address to parliament on February 11th. In his speech Mr Saakashvili outlined a list of development targets to be achieved by 2015, leading to further speculation that he intends to remain in power after his constitutional mandate as president expires in 2013, in order to see these targets met. There has been much speculation that Mr Saakashvili plans to switch to the position of prime minister in 2013 in order to prolong his leadership. Constitutional amendments will enter into force in 2013 that will significantly increase the powers of the prime minister (December 2010, The political scene). However, in a televised phone-in session on January 25th, Mr Saakashvili insisted that the new constitutional arrangement was not modelled on individuals, and that from 2013 Georgia would experience collective governance. He went on to claim that his main interest was where the country would be, not the position that he would hold as an individual after 2013.

In terms of foreign policy, Mr Saakashvili insisted that he wants a dialogue with Russia, but that Georgia would not tolerate the disintegration and occupation of the country. The president added that Georgia's progress towards EU and NATO integration was unwavering and that Russia had been unable to isolate Georgia.

In response to the address, Giorgi Targamadze, the leader of the Christian Democratic Movement (the largest parliamentary opposition party), criticised Mr Saakashvili for undermining the independence of the media and the judiciary, and claimed that the president was on the top of a pyramid of corruption that sought to hide how public money was spent. The Christian Democratic Movement, seen by many opponents of the government as a "tame" opposition, has stepped up its criticism of the president and his government in recent months. In late November Mr Targamadze accused the government of "violence" towards the business community. As a parliamentary election in 2012 approaches, the Christian Democratic Movement is keen to highlight the difference in its policies compared with those of the government.

In February parliament began discussions on a draft national security concept that will replace the one adopted in July 2005. The draft concept states that the main geopolitical threat that Georgia faces comes from the Russian occupation of parts of its territory and the risk of renewed military aggression by Russia. The draft also claims that Russia's aim is to derail Georgia's Euro-Atlantic aspiration and "forcibly return Georgia back into the Russian orbit". It goes on to say that the long-term aim of the Russian military intervention in 2008 was to end Georgian co-operation with the West and bring Georgia back into the Russian sphere of influence. In contrast, the concept of 2005 stated that there was little risk of open military aggression against Georgia, despite a threat of crossborder aggression from state and non-state actors. The new draft focuses on Georgia's relationship with the West, emphasising Georgian citizens' "firm will" to integrate into Euro-Atlantic structures, as well as the eventual goal of NATO and EU membership. It also describes Turkey as Georgia's leading regional partner. Finally, the draft concept mentions specifically the North Caucasian republics in Russia, stating that the establishment of an "atmosphere of co-operation and peace" in the North Caucasus is of special importance for Georgia. No timeframe has been set for the adoption of the new concept.

However, Georgia's approach to the North Caucasus has been criticised in a report by the US director of national intelligence, James Clapper. The report, published on February 16th, stated that Georgia's public efforts to engage with various ethnic groups in the Russian North Caucasus may have contributed to tensions in the region. This can be interpreted as criticism of a decision by the Georgian government in October 2010 to grant visa-free travel to all residents of the North Caucasian republics in Russia. The Russian Ministry of Foreign Affairs had described the move as provocative and an attempt to destabilise the situation in the region (December 2010, The political scene).

On November 23rd, in an address to the European Parliament, Mr Saakashvili said that the Georgian government unilaterally declared that Georgia will never use force to roll back the Russian occupation and to restore its control over the occupied areas. He stressed that even if Russia failed to withdraw its forces from Abkhazia and South Ossetia, Georgia would only retain the right to self-defence in the case of new attacks on other parts of Georgian territory. Mr Saakashvili's declaration was immediately welcomed by the EU's high representative for foreign affairs and security policy, Catherine Ashton, who described the decision as a "constructive step and positive contribution to ongoing efforts towards a peaceful and lasting solution to the conflict".

The de facto leaders of the breakaway entities of Abkhazia and South Ossetia-Sergei Bagapsh and Eduard Kokoity, respectively-made similar pledges on the non-use of force in response to Mr Saakashvili's declaration. The Russian foreign ministry was initially cautious about the Georgian move, stating that the declaration would only be taken seriously when it is put on paper and becomes legally binding, but went on to say that the parallel pledges by Mr Saakashvili, Mr Bagapsh and Mr Kokoity created a new situation in the region. Russia has long been pushing for non-use-of-force treaties between Georgia and the de facto authorities of its breakaway enclaves. Until now, however, Georgia had insisted that Russia must also be a signatory to any such pledge-a demand that Russia has so far refused.

An explosion at a coal mine near Tkibuli in the western province of Imereti on January 21st killed one miner and injured four. This was the third such explosion at this mine in less than a year; in March 2010, four miners were killed and one injured after a similar explosion, and a second explosion killed another four miners and injured six in August. Another miner was killed in December 2009, when a protective barrier collapsed. In response to the latest explosion, the miners-with the support of the Trade Union of Metallurgy, Mining and Chemical Industry Workers-began a strike in support of a package of demands including permanent employment contracts, pay rises in line with inflation, paid holidays of 40 days per year, and payment of overtime. Their demands also included the improvement of working conditions through the provision of modern safety systems along with protective clothing and equipment, and the introduction of pension and compensation systems for the families of those killed or injured. On February 3rd the miners ended their strike, claiming that most of their demands had been met. As a result of the incident, two members of the mine's management team were arrested, and Mr Saakashvili harshly criticised the owners of the mine for ignoring safety norms.

The mine is operated by Saknakhshiri, which is part of the Georgian Industrial Group (GIG), a business conglomerate founded by an influential member of parliament (MP), Davit Bezhuashvili of the ruling United National Movement (UNM). Mr Bezhuashvili is also believed to be one of the main financial backers of the UNM. GIG incorporates a wide range of other businesses, including the import and distribution of natural gas, and owns shares in the private television channels Mze and Rustavi2. Mr Bezhuashvili's brother, Gela Bezhuashvili, is the head of the intelligence service and was previously foreign minister. Shortly after the incident, it was announced that Gela Bezhuashvili had taken temporary leave of absence for training in the US, leading to press speculation that the Georgian authorities were distancing themselves from the Bezhuashvili brothers.

On January 25th the Russian-language satellite news channel of the Georgian Public Broadcaster (GPB), First Caucasus News, was relaunched after being off air for one year. During a two-week period in January 2010 the channel had been operated by Eutelsat Communications (France), but was terminated at the end of a trial period. Eutelsat claimed that it had halted transmission because the channel was a pilot project and that a contract with Georgia had not been signed. In response, the Georgian authorities accused Eutelsat of bowing to Russian pressure, given that the company had a lucrative contract with Intersputnik, a Russian firm that provides broadcasts for a media unit of the Russian state-owned energy company, Gazprom (March 2010, The political scene). The GPB had attempted to sue the satellite operator for breach of contract, but the court, in Paris, ruled in favour of Eutelsat in July 2010. In the same month GPB handed over the channel's management rights to a private company called Key One, which was co-founded by a veteran BBC correspondent, Robert Parsons, and the head of the First Caucasus News newsroom, Ekaterina Kotrikadze. Responding to allegations by critics in Russia and Georgia that the channel may become a mouthpiece for the Georgian authorities, Mr Parsons has insisted that the new channel would not use propaganda.

On January 3rd police broke up a sit-in at the memorial in the centre of the capital, Tbilisi, to Georgian soldiers killed in the conflicts in Abkhazia and South Ossetia. The demonstrators were mainly veterans of the armed conflicts in the breakaway provinces, and had been staging a hunger strike at the memorial since December 27th in protest against social hardships and the "undignified" attitude shown towards them by the authorities. Eleven demonstrators were arrested and later fined Lari400 (around US$230).

Opposition and advocacy groups strongly condemned what they claimed was a heavy-handed intervention by the police, who allegedly punched peaceful protesters. The Georgian Young Lawyers' Association (GYLA) issued a statement claiming that police's use of excessive force constituted an illegal violation of the constitutionally guaranteed right of assembly. The police action also provoked a response by the US ambassador, John Bass, who claimed that he was disturbed by the reports of police violence and stated that such violence does not have a place in democratic societies. In a statement on January 4th, the Georgian public defender, Giorgi Tugushi, who was elected to the post with the support of lawmakers from the UNM, also criticised the police action as illegal. However, in a televised phone-in session on January 25th, Mr Saakashvili dismissed the criticism, claiming that the protesters had been urinating on the memorial.

The government submitted a package of legislative amendments to parliament on February 23rd, which detailed the potential downsizing of the Ministry of Environment Protection and Natural Resources. According to the plans, most of the ministry's functions will be transferred to the Ministry of Energy, the Ministry of the Economy and Sustainable Development, the Ministry of Agriculture, the Ministry of Justice, and the Ministry of Regional Development and Infrastructure. The decision to restructure the environment ministry came after Mr Saakashvili said in December 2010 that there was "systemic corruption" in the organisation, especially in its forestry department, and that the ministry needed to be reorganised. The government requested that parliament treat the package as a matter of urgency, and the parliamentary vice-speaker from the UNM, Mikheil Machavariani, suggested that it could be approved on its second reading as early as March 9th.

However, the proposals met opposition from environmental groups. In a joint statement, 29 non-governmental organisations (NGOs) urged the government to postpone the plans and instead initiate broad public consultations on the matter. The NGOs were particularly critical of a proposal within the package to subordinate the Agency of Protected Areas to the economy ministry, which they believe would undermine its ability to ensure biodiversity, conservation and the protection of the ecosystem, and would instead subject protected areas to the demands of the tourist industry. Some MPs from the UNM also criticised the plan. The chair of the parliamentary committee on European integration, Davit Darchiashvili, reiterated the NGOs' concerns about the plan to move the Agency of Protected Areas, and argued that issues relating to radioactive substances should remain the remit of the environment ministry, rather than being transferred to the energy ministry as proposed by the government. In response to the criticism, the government announced on February 25th that it had dropped its earlier plans to transfer the Agency of Protected Areas to the economy ministry, in what amounted to a significant climbdown. The remaining amendments will be discussed during a second reading of the bill, which is expected to occur by March 9th.

Georgia ranks as a hybrid regime

Georgia's score in the Economist Intelligence Unit's 2010 Democracy Index improves marginally, to 4.59 (out of 10). Georgia is ranked 103rd out of 167 countries, an improvement on its previous rank of 104th, placing it among the 33 countries classified as hybrid regimes. Other members of the former Soviet Union in this classification are Armenia, Russia and the Kyrgyz Republic.

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The potential for unrest will rise in the run-up to the elections

Georgia's poorest score is for the category of government functioning, reflecting the fact that the government's authority does not extend over the whole country, with South Ossetia and Abkhazia both having declared their independence in 2008. Factors such as corruption and low public confidence in the government also detract from the score, as does the lack of accountability of the government, and the absence of a properly functioning system of checks and balances. Georgia scores relatively poorly for the categories assessing political culture and political participation, reflecting factors such as low public involvement in political parties.

Its scores for civil liberties and electoral process, however, are much higher. Observance of civil rights is higher than in other countries in the former Soviet Union, and electoral procedures have improved since the "Rose Revolution" of 2003. The mayoral election in the capital, Tbilisi, in 2010 showed progress in this area compared with the presidential and parliamentary elections in 2008.

The global economic and financial crisis affected Georgia through falling remittances, which led to a downturn in domestic demand. The economy was also affected by much weaker external demand for its main exports, especially goods such as ferrous metals. After contracting by 3.8% in 2009, real GDP returned to growth in 2010, expanding by an estimated 6.1%. Sectors such as construction and transport, which were affected by the war with Russia in August 2008, have started to show signs of robust recovery. Despite the improvement in the economic outlook, and the increased stability of the political scene compared with recent years, there is a possibility that social unrest will rise in the run-up to the parliamentary election, which is scheduled to be held in 2012, and ahead of the presidential election due in 2013. The potential for public protests to turn violent cannot be excluded, particularly if the authorities decide to use force to break up demonstrations.

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Democracy index 2010: Democracy in retreat, a free white paper containing the full index and detailed methodology, can be downloaded from www.eiu.com/DemocracyIndex2010.

Note on methodology

There is no consensus on how to measure democracy and definitions of democracy are contested. Having free and fair competitive elections, and satisfying related aspects of political freedom, is the sine qua non of all definitions. However, our index is based on the view that measures of democracy that reflect the state of political freedom and civil liberties are not "thick" enough: they do not encompass sufficiently some crucial features that determine the quality and substance of democracy. Thus, our index also includes measures of political participation, political culture and functioning of government, which are, at best, marginalised by other measures.

Our index of democracy covers 167 countries and territories. The index, on a 0 to 10 scale, is based on the ratings for 60 indicators grouped in five categories: electoral process and pluralism; civil liberties; the functioning of government; political participation; and political culture. The five categories are inter-related and form a coherent conceptual whole. Each category has a rating on a 0 to 10 scale, and the overall index of democracy is the simple average of the five category indexes.

The category indexes are based on the sum of the indicator scores in the category, converted to a 0 to 10 scale. Adjustments to the category scores are made if countries fall short in the following critical areas for democracy:

• whether national elections are free and fair;
• the security of voters;
• the influence of foreign powers on government; and
• the capability of the civil service to implement policies.

The index values are used to place countries within one of four types of regimes:

• full democracies-scores of 8 to 10;
• flawed democracies-score of 6 to 7.9;
• hybrid regimes-scores of 4 to 5.9;
• authoritarian regimes-scores below 4.

State revenue reached Lari5.42bn (US$3.04bn) in 2010 as economic recovery boosted taxable income. (The data in the Economist Intelligence Unit's annual tables refer to the consolidated government budget.) This represents a 10.3% increase compared with Lari4.92bn in 2009. Total tax revenue also rose by 10.3% in 2010. Receipts from taxes on goods and services, which accounted for over 60% of total tax revenue, grew by 10.8%. Revenue from income tax increased by 7.9%. Grants totalled Lari471m (US$266m), up from Lari387.7m in 2009. However, this figure remained much lower than the Lari617m recorded in 2008, when the country received Lari526m of grants in the fourth quarter alone in the aftermath of the war in August (March 2009, Economic policy).

State budget expenditure rose modestly in 2010, by 1.9%, to Lari5.47bn. Social spending, which accounted for over 27% of total spending, rose by 4.3%, to Lari1.48bn. The second-largest component, compensation of employees, rose by 5.5%, to Lari993.5m. The state budget recorded a small deficit, of Lari45m, well below the Lari450m deficit in 2009. The deficit narrowed more sharply in the second half of 2010 as the authorities tightened fiscal spending.

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The 2011 state budget, which parliament approved on December 17th, targets a surplus of just over Lari220m as fiscal constraints continue. The government plans state revenue at Lari5.95bn, of which it expects Lari5.3bn to come from tax revenue and Lari150m in receipts from privatisation. Expenditure has been set at Lari5.73bn. The government has increased the amount allocated to the Ministry of Regional Development and Infrastructure to Lari864m in 2011 from Lari689m in 2010, but has reduced spending in other spheres, most notably the defence budget, which fell to Lari661m from Lari749m in 2009.

On December 15th parliament passed on the third and final reading a constitutional amendment that will require a referendum to be held if the government decides to increase taxes (although local taxes and excise duties are excluded). However, the amendment has been modified significantly since it was first conceived by the president, Mikheil Saakashvili, in October 2009 (December 2009, Economic policy). Unlike the original draft, the adopted version will specify a set of circumstances under which the government will be able to increase taxes without calling a referendum. In addition, specific deficit and debt limits will be set up. The toning down of approved legislation reflects concerns by domestic and multilateral organisation, such as the IMF. Concerns were raised that by restricting its own capacity to raise taxes, the government risked depriving itself of an important tool to plug the fiscal deficit. Moreover, the amendment will only become law when other new constitutional provisions enter into force in 2013.

In a report published in January 2011, the IMF stated that the Georgian authorities had expressed interest in securing a successor arrangement with the Fund after the current stand-by arrangement (which was agreed in the aftermath of the war with Russia in August 2008) expires in June 2011. The Georgian authorities' desire for a loan is probably linked to their repayment obligations to the IMF and to the need to repay the five-year US$500m Eurobond issued in 2008. The IMF expects Georgia's debt-to-GDP ratio to peak at 43.6% in 2011, before declining to 35.9% by 2015, but the Fund has warned that sharp reductions in salaries for public-sector workers and benefits for social security beneficiaries may lead to social pressures for a more relaxed fiscal policy, which would result in higher levels of expenditure and public debt. According to the IMF, the World Bank has been exploring ways to better target social spending during the period of fiscal tightening. On January 13th the IMF approved the allocation of the seventh tranche of the stand-by arrangement, worth US$153m. The funds will be used to maintain the reserves of the National Bank of Georgia (NBG, the central bank).

On December 3rd, in an address at the opening ceremony of the Lilo Customs Clearance Zone on the outskirts of the capital, Tbilisi, Mr Saakashvili announced that a new economic course would be adopted. The plan is designed to improve the business environment and to provide a boost to small and medium-sized enterprises (SMEs). Mr Saakashvili acknowledged that the state still had a number of shortcomings in its relationship with business.

Mr Saakashvili clarified some of the authorities' future economic priorities in his annual state of the nation address on February 11th. He announced that the government would allocate an extra Lari150m to the agricultural sector over the coming years, with the aim of doubling agricultural production by 2015. Agriculture has experienced sluggish growth in recent years, and most agriculture has remained subsistence-based. The president also stressed the need to create new agricultural processing enterprises. In 2007 the government pledged to create 100 new agricultural processing plants (September 2007, Economic policy). However, these plans stalled after the war with Russia and the subsequent economic downturn.

Among other targets for 2015, Mr Saakashvili pledged to halve the current level of unemployment, increase average salaries by 50%, increase the annual number of foreign visitors to Georgia to 5m and build 17 new hydropower plants. In a related development, on January 12th, after a meeting between the parliamentary chair, Davit Bakradze, and representatives from the Business Association of Georgia, it was announced that a Business Council would be established to improve communication between parliament, the government and businesses.

In line with Mr Saakashvili's pledge to increase the number of foreign visitors to Georgia, on December 24th he called on businessmen to invest in the construction of hotels in Mestia, the main provincial town of the mountainous region of Svaneti, which is one of the country's main tourist attractions. Mr Saakashvili said that the government would offer investors a plot of land for the symbolic sum of Lari1 (about 60 US cents) in exchange for building hotels in the region. Mr Saakashvili expressed the hope that the region would host at least 500,000 tourists in four years. However, during 2010 there was some resistance from residents of Svaneti, who claim that the government has been ignoring traditional property rights in a bid to build hotels and attract tourists.

After maintaining the refinancing rate at 7.5% for three consecutive months, the NBG raised the rate by 50 basis points, to 8%, on February 16th. The increase in the refinancing rate was in response to the surge in inflation, which picked up from August 2010, but has risen more steeply in year-on-year terms in recent months. Although the NBG insisted that the current high rate of inflation is caused by exogenous rather than domestic factors (most notably a sharp increase in world food prices) and that the growth in the money supply is under control, it decided to increase the rate as a result of fears that the growth in food prices may create high inflation expectations.

The lari faced little pressure during the fourth quarter of 2010. The NBG sold a total of US$197m worth of foreign currency in the second quarter of 2010, but bought US$21m of foreign currency in the third quarter and US$95m in the fourth quarter, which helped to boost foreign-currency reserves to an all-time high of US$2.26bn at the end of 2010, compared with US$1.87bn at the end of the first half of the year. The losses to foreign-currency reserves that occurred in the aftermath of the war with Russia have been reversed, although this is partly the result of IMF support.

At the end of February 2011 the exchange rate was Lari1.76:US$1, essentially unchanged from Lari1.77:US$1 at the end of December 2010. The real exchange rate against the US dollar strengthened in the final quarter of 2010, rising by 5.2% year on year at the end of January 2011, following losses earlier in the year. However, the lari depreciated against the euro from Lari2.3:EUR1 at the end of November 2010 to Lari2.42:EUR1 at the end of February 2011. The lari's real effective exchange rate (REER), calculated by the NBG from data on trade with Georgia's 12 main trading partners, appreciated by 4.1% year on year at the end of January 2011.

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According to data from the National Statistics Office, real GDP expanded by 6.7% year on year in the third quarter of 2010 (the latest data available), marking a modest slowdown from the 8.7% year-on-year growth rate recorded in the second quarter. The slowdown in the third quarter can primarily be put down to base effects. In the second quarter of 2009 real GDP contracted by a sharp 9% year on year, compared with a less steep 1.5% year-on-year contraction in the third quarter.

Over the first three quarters real GDP expanded by 6.5% year on year. Manufacturing, which accounted for just under 11% of total GDP in the first three quarters, grew by a robust 18.5% year on year in January-September. Transport recorded the second-fastest year-on-year growth over the first three quarters, of 14.8%. Construction and financial intermediation also performed strongly, expanding by 7.3% and 10.1% year on year, respectively, in January-September. However, the large agricultural sector recorded a 0.7% year-on-year contraction in the first three quarters. Given that agricultural production slows in the final quarter, the full-year figure is likely to show a steeper contraction.

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The economy has performed better than expected. The IMF has raised its real GDP estimate for 2010 to 6.3%, from an earlier forecast of 4.5%. It also raised its growth forecast for 2011 to 4.5% from 4%. This is based on expectations of higher private demand and private investment in the Georgian economy. The IMF's 2011 forecast is in line with that of the finance minister, Kakha Baindurashvili, who also predicted that the economy would expand by 4.5%.

During the third quarter of 2010 (the latest data available), the average nominal wage was Lari609.5 (US$340) per month, an increase of around 7% year on year, according to figures from the National Statistics Office. At 9.1% year on year, growth in average wages for women outpaced the 6% growth recorded for men's salaries. In the third quarter salaries grew particularly sharply year on year in mining and manufacturing-by 13.6% and 13%, respectively. However, both of these rates were slower than the 24.1% and 17% expansions recorded for mining and manufacturing, respectively, in the second quarter, which probably reflected the feed-through effects of the demand for Georgian metals abroad (December 2010, The domestic economy).

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Since then, the increase in nominal wages is likely to have been outpaced by a sharper rise in inflation. According to data from the National Statistics Office, year-on-year inflation rose by 12.3% in January 2011, compared with 9.8% in October and 3.6% in June. The rise in consumer prices in January 2011 was the greatest increase since August 2006. The increase in year-on-year inflation has primarily been fuelled by higher food and oil prices. In January 2011 prices of food and non-alcoholic beverages grew by 25.2% year on year, compared with 1% in June 2010.

Food prices have risen in recent months owing to higher global prices for a number of foodstuffs, particularly cereal, sugar and vegetable oil. Highlighting the steep rise in prices in January, the Food Price Index-an indicator devised by the UN's Food and Agriculture Organisation (FAO), which measures the wholesale price of basic foodstuffs worldwide-reached the highest level since records began in 1990. Adverse weather conditions in several parts of the world reduced the supply of food at the same time as demand for food increased in emerging economies such as China and India. Georgia's vulnerability to rises in global food prices is accentuated by the underdevelopment of its agricultural sector and hence its need to import food.

The prices of clothing, footwear, alcoholic beverages and tobacco also rose a little during between November 2010 and January 2011. The prices of most other commodities remained more or less constant. In a bid to reduce the impact of the recent spike in inflation, on February 10th the government paid a one-off Lari20 allowance to each family to pay electricity bills. In addition, in his state of the nation address on February 11th, the president, Mikheil Saakashvili, announced that the government would also provide each family with Lari30 worth of food coupons. The authorities aim to bring inflation back to around 6% by the end of 2011, if necessary by tightening monetary policy, although the success of this aim also depends on the development of global prices.

Despite the high inflation rate, growth of monetary aggregates has been relatively modest, underlining the fact that the recent spike in inflation has been owing to external factors rather than the domestic economy overheating. Growth in reserve money expanded by 11% year on year in December 2010, slightly above the rate of 7% in September. Broad money (M3) grew more rapidly, registering a year-on-year growth of 35% in December, well above the rate of 8% at the end of 2009, but below the rate of 41% in September 2010. The National Bank of Georgia (NBG, the central bank) has set a target growth rate for broad money of 20-25% for 2011.

Total deposits in national and foreign currencies grew by 43% year on year at the end of 2010. The recent stabilisation of the lari has not dramatically influenced depositors' preference for keeping their savings in foreign currency. Foreign-currency deposits comprised 72.1% of total deposits at the end of 2010, only marginally down from 73.4% recorded at the end of 2009.

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In 2010 the banking sector recovered strongly and recovered the losses accrued in 2009. During 2010 the commercial banking sector recorded a net profit of Lari156.3m (US$87.8m), compared with a net overall loss of Lari65.3m in 2009. The recovery in the banking sector gathered pace towards the end of the year; a net profit of Lari37.3m was recorded in January-June, whereas in July-December the figure was Lari119m. After a slight slowdown in the pace of lending during the third quarter of 2010, growth accelerated again in the fourth quarter. On January 1st 2011 total loans (including overdue loans) from commercial banks stood at Lari6.33bn (US$3.56bn), compared with Lari5.25bn on January 1st 2010. There are signs that debtors are again able to repay their loans to commercial banks. The volume of overdue loans stood at Lari174m on January 1st 2011, compared with Lari202m on October 1st 2010. Despite higher interest rates, private-sector borrowing accelerated in the fourth quarter of 2010 after a slight slowdown in the third quarter (December 2010, The domestic economy); private-sector loans rose by 21% year on year at the end of January 2011, up from 12% year on year at the end of October 2010. The combined assets of commercial banks grew strongly throughout 2010, to stand at Lari10.6bn at the end of December 2010, up by 7% quarter on quarter and 27% year on year.

Exports grew by 40% in 2010, to US$1.58bn, aided by a surge in external demand for Georgian goods in the final quarter. This compares with a 24% contraction in 2009. The return to export growth in 2010 was buoyed by robust external demand for Georgian products, particularly ferro-alloys, as the ongoing global recovery, following the global recession in 2009, continued. Despite the substantial increase, imports continued to dwarf exports, although imports grew more slowly. According to data from the National Statistics Office, imports totalled US$5.1bn, a rise of 17%, compared with a 31% contraction in 2009. The trade deficit expanded to US$3.51bn from US$3.23bn in 2009. The relative gap between exports and imports narrowed, as coverage of the import base by exports increased to 31.1% in 2010 from 26% in 2009.

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Exports of ferrous metals grew robustly throughout 2010 as demand for Georgian iron and steel recovered. This followed a steep slump in demand for these products in 2009 as buyers in the US substantially reduced their purchases from Georgia and elsewhere (September 2010, Foreign trade and payments). Ferrous metals were Georgia's main export in 2010, comprising 16.7% of total exports, up from 11.5% in 2009, with growth of over 100%. Exports of cars increased sharply in 2010, by 190%, to total US$227.3m. However, this figure disguises the fact that Georgia does not produce its own cars, but instead buys them and resells them to other countries, most notably Azerbaijan. Electricity exports rose by 82% and comprised 2.3% of total exports as Georgia increased its electricity exports to Turkey and Russia (December 2010, Foreign trade and payments). Exports of gold fell by around 26%, owing to falling demand for Georgian gold in Canada, which is the only buyer of this commodity. Exports of nuts also fell significantly in 2010.

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The composition of imports changed little in 2010 compared with 2009. Petroleum and crude oil was the main import commodity, comprising 13.6% of total imports, up from 12.7% in 2009. Natural gas imports comprised 2.6% of total imports in 2010, down from 3.5% in 2009. Wheat imports rose to US$171.7m in 2010, equivalent to 3.4% of total imports, up from 2.4% in 2009. This is likely to reflect higher world prices for wheat during the second half of 2010, rather than a substantial increase in the amount of wheat imported (December 2010, Foreign trade and payments).

Turkey remained Georgia's most important trading partner in 2010, accounting for 16.5% of total trade, although this was down from the 18.4% share in 2009. Turkey absorbed 13.6% of Georgian exports in 2010, a share smaller than the 19.9% in 2009. The main reason for the reduction in exports to Turkey is Turkey purchasing a smaller share of Georgian exports of ferrous metals. In 2010 Turkey bought only 9% of this commodity, compared with 63% in 2009. In 2010 the US regained its position as the main buyer of Georgian exports of ferrous metals. Turkey continued to buy a wide variety of other products from Georgia; its most significant purchase was ferrous waste and scrap-the country accounted for 81% of Georgia's exports of this product in 2010. Turkey was the main source of imports for Georgia, selling a vast range of products including medicines, cement and domestic appliances.

Azerbaijan was Georgia's second most important trading partner in 2010, accounting for 10.6% of total trade (US$708.1m). Azerbaijan bought US$244m worth of Georgian exports, the highest figure for several years, or 15.4% of the total value. However, this figure is slightly misleading, as 43% of Georgian exports to Azerbaijan consisted of cars bought by Georgia and then resold. In addition to cars, Azerbaijan bought aircraft parts, iron bars and cattle. Azerbaijan provided Georgia with 43% of its imports of crude oil and petroleum products in 2010, and 58% of gas imports. Ukraine was Georgia's third most important trading partner. In 2010 Ukraine bought 47% of Georgian exports of ethyl alcohol and spirits, 46% of wine exports and 53% of mineral water exports. Ukraine sold Georgia a variety of goods, most importantly cigarettes, iron bars and sunflower seed oil.

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According to data from the IMF, the current-account deficit widened to US$279m in the third quarter of 2010 from US$214.2m in the year-earlier period. The expansion was primarily driven by the widening of the trade deficit to US$657.6m in July-September 2010 from US$572.6m a year earlier. The widening of the trade deficit was partially offset by a rise in the services surplus to US$200.2m from US$132.4m a year earlier.

In the first three quarters the current transfers surplus rose to US$698.1m from US$586.9m in the year-earlier period. The current transfers surplus has been boosted by an increase in remittance inflows from Georgians working abroad. Remittance inflows have risen owing to an improvement in the economic conditions in the destinations for Georgian workers abroad, particularly Russia, which is the main source of remittance inflows.

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Foreign direct investment (FDI) remained weak in the first three quarters of 2010, as investor risk appetite towards Georgia remains poor. According to preliminary IMF estimates, net FDI totalled US$428m during the first nine months of 2010, down sharply from the US$2.48bn in January-September 2008. The Netherlands was the most important investor during the first three quarters of 2010, investing US$113m, followed by the US (US$63m). The IMF warned that if net FDI remains at such a low level over the medium term, this could harm the development of the private sector, leading to a slowdown in economic growth.