The Georgian economy faces many challenges, not least of which is access to finance and the extremely high cost of financing private enterprises. With the cost of borrowing (real interest rate) reaching 17.3% on average in April 2013, businesses find it very difficult to function, let alone invest in innovative technologies, long-term growth, and development. These challenges can be directly traced to issues raised in one of the ISET Economist blogs: the Georgian financial industry is still very far from being a well-developed, efficiently functioning system. In one of the recent blogs, financial literacy among the general population was named as one of the culprits for the low levels of financial development.  Yet financial literacy remains only one of the many pieces of the development puzzle. What are the other structural obstacles to financial sector development? Here is a partial list of potential problems leading to financial sector inefficiencies and a high cost of finance:

1. Small market size and low real sector penetration prevent economies of scale for Georgian banks.
2. Moderate country ratings on international markets and a reliance on external sources of funding for commercial banks. Short funding maturities for commercial banks lead to short-term lending.
3. Low financial reporting standards among Georgian companies. Low levels of financial literacy among the general population.
4. Long-term lending is done almost exclusively in foreign currencies, which creates an FX credit risk.

Let us examine each of these problems in turn.

1. Economies of scale refer to the cost efficiencies (lowering of average costs) the firm's industry might realize if the scale of its operations increases. Since the fixed costs associated with operating a commercial bank are quite high (operating branches, loan monitoring departments, etc.), the profitability of the banking sector, in particular, suffers from the relatively small market size in which banks operate. In Georgia, this problem is reflected in the total country GDP and the asset size of the commercial banks.

For example, according to the World Bank, the average private credit-to-GDP ratio in Georgia (2008-2010) was 30.5%,  which suggests a low level of financial depth relative to developed economies (as a comparison, the private credit-to-GDP ratio in Germany and France is about 109%). In addition, the loan-to-GDP and deposits-to-GDP ratios are equal to 42.5% and 39.6% (by the end of 2012 Q3) respectively. However, this does not imply the low indebtedness of the population, as individual borrowers exhibit quite high debt-to-income ratios stemming from short-term lending.

The problem of the economies of scale is further exacerbated by the fact that the industrial base of Georgia is largely underdeveloped, which prevents banks from diversifying their risk across different industries and regions. The situation results in a vicious circle of low diversification, high cost of finance, and, consequently, low industrial development.

This is an example of a situation where private markets are unable to efficiently resolve the problem. Consequently, government involvement might be in order. For example, clear policies to increase and diversify the country’s industrial base could help commercial banks better assess the future direction of industrial development and increase private lending.

2. The level of domestic savings in Georgia is very low relative to the financing needs of the country. As a result, Georgian banks have to rely on external (international) financing to satisfy these needs. Besides the high costs of borrowing internationally for a small developing country such as Georgia, the reliance on external finance poses certain risks (capital flow reversals), especially in times of global crises. Thus far, Georgia’s banking system has managed to secure sufficient financing from abroad, but the luxury of foreign financing comes at a price. Georgian banks can only borrow at relatively short maturities on international markets, which translates into high financing costs and short loan maturities for domestic borrowers. As per the NBG’s data, the average maturity of loans is 15.8 months, while the average lending interest rate is 17.3%. The total loan amount is 5.2 billion USD as of the end of April 2013.

The lengthening of credit maturity and decreasing interest rates would undoubtedly have a significant positive impact on the indebtedness of borrowers and the cost of debt services. For instance, increasing the average maturity to three years and freezing the interest rate at the same level would decrease an average borrower’s monthly payments by 50%. However, only decreasing the interest rates would have a much more moderate impact. For example, decreasing the average interest rate to 16% would lower monthly payments only by 1 %.

Payment per Month with Changing Maturity

 Source: own calculations

Payment per Month with Changing Interest Rate

 Source: own calculations

Improving the maturity structure of private lending seems to be the most effective path for banking sector development. However, lengthening the maturity of private sector loans is a challenging task that would require overcoming informational as well as institutional hurdles.

3. In the economic literature, the maturity structure of bank credit depends on the institutional and political characteristics of a country. And yet, the quality of the information coming from firms and the ability of the banks to effectively monitor their borrowers are seen as one of the crucial determinants (see, for example, Ortiz-Molina, Hernan, and Maria Fabiana Penas. "Lending to small businesses: The role of loan maturity in addressing information problems." Small Business Economics 30.4 (2008): 361-383; and Coleman, Anthony D. F., Neil Esho and Ian G. Sharpe. "Does bank monitoring influence loan contract terms?" Journal of Financial Services Research 30.2 (2006): 177-198.). Substandard financial reporting significantly complicates loan evaluation for commercial banks, leading to higher administrative costs and lower asset quality. In this environment, the development of a stock exchange is unfeasible.

In Georgia, overcoming informational hurdles may play a decisive role in lengthening the maturity structure of bank credit and thus promoting long-term lending.

4. Finally, due to the lack of domestic savings in GEL, as well as the inability to borrow in GEL on foreign markets, the long-term loans of Georgian banks are almost exclusively foreign-currency denominated. This exposes the country’s banking sector to the foreign currency induced credit risk (for example in the event of a sharp devaluation of the Georgian lari, businesses whose revenues are mostly GEL denominated, would suddenly become insolvent, unable to pay back their euro-denominated loans. Such situations are by no means uncommon in developing countries, and the experience of Eastern European countries in 2008 bears witness to this type of risk).

While there is no easy, short-term solution to this problem, it is worth mentioning that higher levels of financial literacy can actually help increase the amount of domestic savings in the banks, thus increasing the pool of loanable funds in the domestic currency.

In conclusion, although one may say that the Georgian banking sector faces many challenges, it also has the possibility to tap into many growth opportunities by, amongst other things, increasing domestic saving, adopting well defined industrial policies, shortening loan maturities, standardizing financial reporting for companies, and improving the financial literacy of the population. A well-designed policy mix, aimed at increasing financial literacy and informational transparency; promoting a platform for direct financing (a stock exchange) and a diversified industrial base; and improving the maturity structure of bank loans to the private sector, could all significantly improve the growth prospects of the Georgian banking sector. This would mean greater efficiency and decreased interest rates, which would result in benefits for the Georgian economy as a whole.