Economic Freedom in the Southern Caucasus: How to Generate Sustainable High Economic Growth

Kapan_Southern_Armenia-1024x638
Gregor Samsa via flickr || Creative Commons

The nations of the Southern Caucasus region – Armenia, Azerbaijan and Georgia – were among the most private entrepreneurial republics even during the last decades of the Soviet Union (the SU). Underground economy started flourishing already in 1960s. This reflected the entrepreneurial spirits of the people in these republics.

Economies of the three nations have suffered the most since the collapse of the SU and gaining back independence – GDP per capita of Armenia and Azerbaijan had decreased by half and of Georgia by three quarters mostly because of the slow pace of privatization and vulnerability of the post-Soviet economy, that was fully dependent on the ex-Soviet economic ties for supply and demand. In the 1990s all three of them needed to change the attitudes towards private sector, convert their countries into market economies, establish supportive business environment and legislation.

In Armenia and Georgia restoration came very late while Azerbaijan succeeded more, mostly due to the re-start of oil and natural gas industries. The economy of Georgia failed the most – it shrunk by almost four times and recovered to the levels of 1980s only after 2000s. It recovered and made its fastest development only after starting free market reforms, achieving higher economic freedoms. This helped Georgia to stabilize the economy and continue to grow even during the global financial crisis of 2008-2010 – the economic growth of Georgia between 2004 and 2014 amounted on average to 5.8 per cent. It was similar with Armenia. Azerbaijan was more successful – if in the case of Georgia’s economy it hardly reached the per capita (by $8K PPP) level of the last years of the Soviet Union, Azerbaijan quickly regained and doubled that level ($16K). Armenia improved twice if compared to the level at the end of 1980s.

Interesting is what role of improvement of economic freedoms could be applied to the economic recovery of the Southern Caucasus nations. The Study of Economic Freedom of the World by Canadian Fraser Institute started evaluation of the three countries only after 2006 by the initiative of the New Economic School of Georgia and with the support of the Fraser Institute scholars and Friedrich Naumann Foundation. Since that time Georgia’s EFW rate improved the most – almost by one point: from 6.96 to 7.87; while Azerbaijan went up only by 0.12 point; and Armenia, which led the group from the beginning with 7.34, increased its EFW to 7.7. It is obvious that success of Azerbaijan was mainly guaranteed by increase of the oil and natural gas industrial output – some sources estimate the share of these industries as almost a half of GDP, in some years 87 per cent of total exports and 70 per cent of the revenues. It is difficult to imagine what would be other sources of economic welfare in this country without these revenues.

At the same time, the source Armenia’s and Georgia’s recovery can be attributed mostly to the economic freedom policies they maintained – openness, lower tax burden, more limited regulations and investment attractiveness. Georgia (12th) and Armenia (18th) are the world leaders of economic freedom in the firmerly communist region (according to EFW 2013) but Azerbaijan is one of the outsiders (118th out of 157 nations studied). It is visible that the improvement of economic freedoms is not a highest priority of the government in Azerbaijan that can be explained by easy revenues; something similar could be implied for remittances in Armenia and Georgia, though they never shared more than 20 per cent of their GDP.

Both Oil/Natural Gas and remittances went through an examination during the last two-three years after the fall of energy prices – Azerbaijan lost its economic growth, while Armenia and Georgia also grew much slower than during the 10-15 previous years. That puts the economic policies of these nations under a strong question mark – if they can continue without further advancing the economic freedoms.

The State of Economic Freedom in the Southern Caucasus Countries

The Past

Countries of the Southern Caucasus have been forcefully incorporated into the Soviet Union in 1921. Before, these nations were a part of the Russian Empire until 1918 but remained independent for these three years. Many different aspects of the life in the Southern Caucasus show these societies were based on a strong private property ethics and experience.

Soviet Union abolished private ownership of the means of production in the first decades after its establishement. This was the harshest time of repressions – the mass-murder of millions of property owners but also demolishing of the economic system. The Soviets, who promised land to the farmers and factories to the workers, changed their ideological direction towards public ownership which immediately destroyed any economic opportunities. The central planning system eliminated any economic actions since then – instead of the power of competition and incentives, the Soviets executed permanent terror and political propaganda making people fulfilling their artificial economic 5-year plans.

The economic system was managed from the central bureaucratic institutions, commercial pricing was forbidden, private initiatives too. This made life very difficult: deficits, corruption, illegal economic activities, waste and stealing of resources became normal. The tragedy of commons impacted in its highest capacities. The only source of the Soviet economic sustainability for decades was unlimited exploitation of natural resources; the quality of produced goods was so bad that it would not interest any foreign customers. A closed nature of the economy left Soviet citizens out of reach of any good quality goods but also further limited competition and chances of quality improvement, including labor force. The latter, famous with highest literacy rates, was far behind to compete with foreign/Western producers of cars, TVs, refrigerators, or any production of customer goods.

The collapse of the Soviet Union became inevitable; changes of global political situation and a drop in the oil prices pushed the Soviet economy further below and forced the Soviet leadership to start reforms which then ended with total collapse of the economic system.

Transitional Period

Ex-Soviet nations started independent life with many wrong attitudes and inability of compete in global markets. They did not have any experience in trade, they had no partners, and commercialization and privatization went slowly in most of their economies. Russian energy blockades and a bad quality of goods (i.e. labor) made most of the economic activities impossible to continue.

The Soviet people who abandoned socialist planning economic system were still unprepared for entrepreneurial life. They needed to establish new economic environment based on private property and competition. All of the newly born nations rushed to copy the legislation of developed nations, especially of Western Europe; many advisers came to recommend certain regulations, monetary rules, etc.

Some of the nations of the former SU were more successful and were faster advancing their economies, especially because of higher attention from the Western partners; their security was better protected, their neighbors injected big volumes of investments. The Baltic nations along with some of Central-Eastern Europeans succeeded more in changing the environment – both at formal and informal levels – towards more pragmatic, market-oriented decisions. But the others suffered from the very slow change in their attitudes and were caught by deep politicization of economic decision-making.

Business Environment in the Southern Caucasus in 21st Century

The Southern Caucasus countries were included in the study of Economic Freedom of the Fraser Institute (since 2004). The New Economic School – Georgia with active support of Friedrich Naumann Foundation organized the Network of Economic Freedom of Southern Caucasus to promote and support the study. Therefore, the data of economic freedom for the Southern Caucasus countries is only available for the period of 2004-2014.

The following graph illustrates the dynamics of the rates of three nations’ economic freedom for the period of 2004-2013:

1Figure 1. Economic Freedom of the World results of the Southern Caucasus Nations, Fraser Institute, 2004-20131

While Georgia and Armenia have performed successfully and improved their rates quite significantly and almost reached 8 points level, Azerbaijan stayed at the same level of 6 points out of 10.

Armenia was most stabile in keeping the EFW rate at almost the same level during the 10 years (between 7 and 8 points), although some of the components such as Size of Government have been characterized with fluctuations in a range of one point. Its best performance component has been Sound Money – kept over 9 points for almost whole period of the EFW study.

2Figure 2. EFW Components, Armenia, 2004-20132

Meanwhile, Georgia’s scores in almost all components have improved during the period. Only Sound Money component remained stabile as this policy is strictly monitored by the International Monetary Fund.

3Figure 3. EFW Components, Georgia, 2004-20133

Azerbaijan made some upgrade of the components (Regulation, Freedom to Trade Internationally) but simultaneously downgraded in two others (Sound Money, Size of Government).

4Figure 4. EFW Components, Azerbaijan, 2004-20134

Azerbaijan’s best performing EFW component has been Regulation, which at the end of the observed period has reached the level of 7 points.

All the three nations of the Southern Caucasus failed the most in the component of Legal System and Property Rights and have stayed at the level of 6 points. The improvements of the Judiciary System did not make enough influence on its impartiality and independence of the Courts – these subcomponents of the EFW study remained below 5 points. It is important to note that this component is the lowest rated for almost all former communist nations in Europe and Asia – the average score of the measured 28 nations is 5.7. Even more problematic situation can be found in the (measured) countries of the former SU (excluding the three EU member states). Their average score in the same component of the EFW is 5.4. This situation can be explained with a more difficult transition in this sphere than in others, from the no-private-property to private-property economies – the oldest Soviet nations existed without private property two decades longer than others.

In the other components Armenia and Georgia scored above the World Average and the two nations firmly occupied their places among the Economically Free nations – Georgia 12th and Armenia 18th in the world (2013).

Economic Performance of the SC region and its Connection to the Scores of the EWF

The South Caucasus countries, especially Armenia and even more Georgia, suffered the most after the collapse of the Soviet Union. Only Moldova’s and Tajikistan’s economies went below their levels. According to the World Bank data, Georgia’s economy – one of the best in the Soviert Union with GDP per capita – shrank by almost 70 per cent during the first years of independence in 1990s. The following Chart is showing this situation in GDP per capita PPP, Current International Dollar:

5Figure 5. GDP Per Capita, PPP, Current International $, Southern Caucasus Countries5

More interesting is to compare the economic growth figures (measured in the same WB International Dollar, Per Capita, PPP). The average growth during the period of EFW measure in the Southern Caucasus, Azerbaijan grew faster by 14 per cent per year in average, Georgia’s economy was the second with slightly better result than Armenia – 10 and 9 percent, accordingly.

The best outcomes of Azerbaijan’s economy can be related to the large inflows of revenues from the Oil and Natural Gas industries, which several times increased their capacities after launching the Baku-Ceihan (Oil, operating since 20066) and Shah-Deniz (Natural Gas, operating since 20067) pipelines. The share of the Oil Rents (difference between production costs and the market prices of Oil or Gas) in the Azerbaijan’s GDP during 2004-2013 was 47 per cent8; plus around 5 per cent for Natural Gas9 – the revenues from these two sources on average reached 52 per cent of all the nation’s GDP (WB data). It is possible that this guaranteed source of revenues decreased the practical needs of improvement of the business environment. Though during the two last years the share of the Oil and Natural Gas rents in Azerbaijan decreased to the level of 30 per cent and resulted in the Government Budget deficits and bad performance of the Manat.

Quite important role in Armenia and Georgia (just like the oil and gas revenues in Azerbaijan) could be attributed to the Remittances to their citizens from abroad (from relatives and friends). The average share of remittances in the GDP of Armenia during the observed period was 17 per cent – and 9 per cent in Georgia (during the reforms of 2004-2012, the volume of remittances from Georgia also doubled over USD 200m10). It is also worth to mention that the same proportion for Azerbaijan was above 3 per cent11.

It seems obvious that when comparing the EFW scores and economic performance of the three nations, the major source for Armenia’s and especially Georgia’s economic growth during the observed period was the improvement of economic freedom conditions. Georgia, having no significant revenues from either oil or remittances, has attempted the best economic reforms in the region and the world.

The changes of the business environment and governance in Georgia were also highly evaluated by other surveys as Doing Business (WB, 24th place in the world)12, Economic Freedom Index (Heritage Foundation, 23rd place)13, Corruption Perception Index (Transparency International, 48th)14. The country became an example for orienting the developing countries towards advancing their business climates; the lack of issues when starting business and registering property became a model to many even developed nations. During the reforms Georgia:

1. Decreased the number of taxes from 22 to 6; cut the corporation tax from 20 to 15 per cent; eliminated social security tax and contributions; minimized all customs duties and fees; made income tax flat at the level of 20 per cent; digitalized the whole tax process;

2. Eliminated more than 800 regulations (permissions and licenses);

3. Eliminated several uncessary public agencies, decreased the number of public employees by more than 25 per cent;

4. Made openning of a business in Georgia possible via Internet in two hours;

Simultaneously, Georgia has an open doors policy for goods and labor. More than 90 nationalities are not required to have visa to enter and stay in the country, and most of them do not even need passports. Foreign citizens also do not need formal permits to work in the country. Shops, including pharmacies, are allowed to work 24 hours, air companies enjoy an open space, etc.

The following information is also an evidence of the economic changes that occurred in Georgia during the free market reforms:

  • average monthly reimbursment in the private sector increased from 168 Georgian lari in 2004 to 760 in 201315;

  • the total volume of bank deposits increased from 971 m lari in 2004 to 9,664 m lari in 201316;

  • external trade of Georgia from 2,491 m lari in 2004 increased to 10,933 m lari in 201317;

  • the total government tax revenues increased from 1,530 m lari in 2004 to 6,659 m lari in 2013 (a supply-side economic effect)18.

Armenia, traditionally good in trade (it has the lowest rates of customs duties on agrarian goods; still, the best policies Armenia has in the monetary sphere). In comparison, during 2014-2016 period Georgian lari lost its power towards US dollar by 30 per cent; Azerbaijan Manat – by 50 per cent, but the Armenian Dram by only 15 per cent. This was the additional factor of the success of this quite vulnerable economy19.

Recommendations

It is obvious that Armenia and Georgia, instead of relying on revenues from natural resources (like in Azerbaijan), improved their economic freedoms with better skills than the latter. This helped the two nations to attract investments, diversify their economies and perform better during the global crises. Azerbaijan, getting easy revenues for a decade, faced the demand for and energy price decline unprepared. Moreover, having oil and gas industries in the government ownership, the country had no flexibility to diversify its economy quickly; consequently, it slowed its speed of growth, and even economic capacities (foreign reserves).

It is visible that the economies of Armenia and Georgia became more sustainable as having comparatively more open and free environment – it is mostly the market that decides where the resources can go. The big size of a government in Azerbaijan – the government’s budget and non-budgetary funds – means automatically less flexibility of use of resources and underperformance. The lesser dependence on the natural resources or any other sources (like remittances) made Georgia looking for pragmatic solutions.

The Economic Freedom of the World study gives nations a very good tool to see in which areas their countries’ economies have week sots, why investors are not attracted to what they offer and why individuals avoid hard work. The governments can be advised to find which components their countries need more concentrate on to speed up their economic growth, increase employment rates and revenues of the population.

In the case of the Southern Caucasus countries the following directions of changes can be further developed:

  • Azerbaijan needs better scores in all components of the EFW. More attention can be directed to fiscal system, systematically decreasing the role of the government in the economy. As Azerbaijan is willing to be a member of the World Trade Organization, it is also very important that it launches comprehensive reforms in this direction. Free trade in the Southern Caucasus is not only necessary for economic development but it can be also a good starting point for sustainable peace.

  • Armenia still needs very strong efforts to eliminate any political influence over the economy, especially strengthening of the independence of the Judiciary and protecting property rights. Since Armenia is not anymore applying for the Free Trade Agreement with the EU, it can further de-regulate its economy. Simultaneously, it needs a careful estimation of the prospective benefits of being a member of the Eurasian Economic Union.

  • Georgia, after signing the Deep and Comprehensive Free Trade Agreement, now attempts to achieve more trade agreements with other nations in the world. The DCFTA obliged the government to take certain steps to approximate its regulatory legislation to the EU standards. This puts the country under a political and economic pressure since the benefits of this privilege can come later than the costs. Therefore the Georgian government must be very careful when adopting new legislation – it can employ the best examples from the EU countries with the most liberalized environment in each sector. It certainly needs to gain benefits earlier from the DCFTA.

The EFW study and its components are the best way to measure and to look for limits of the government interventionism. The governments of the three nations (or any others in the World) can use the EFW criteria as a measure for a new legislation or a spending authorization – if they increase or decrease the score of the country. This can be added to the bylaws of the legislative bodies as the criteria of justifying of the drafts of legislation. Economists, the media and politicians should pay more attention to the EFW and control the state power.

If we are to compare the costs and the benefits of investing in the Southern Caucasus countries (comparing them with other nations in a larger region or the world), we can see that they need further improvement of economic freedoms to be more attractive and invite investments to substitute the developed, better educated and peaceful countries. Higher EFW scores can help increase the region’s economic capacities, cooperation and growth.

1 www.freetheworld.org

2 Ibid.

3 Ibid

4 Ibid

5 http://data.worldbank.org/indicator/NY.GDP.PCAP.PP.CD?locations=AM-AZ-GE

6 https://en.wikipedia.org/wiki/Shah_Deniz_gas_field

7 https://en.wikipedia.org/wiki/South_Caucasus_Pipeline

8 http://data.worldbank.org/indicator/NY.GDP.PETR.RT.ZS?locations=AZ

9 http://data.worldbank.org/indicator/NY.GDP.NGAS.RT.ZS?locations=AZ

10 https://www.nbg.gov.ge/index.php?m=304&lng=eng

11 http://data.worldbank.org/indicator/BX.TRF.PWKR.DT.GD.ZS?locations=AM-AZ-GE

12 http://www.doingbusiness.org/data/exploreeconomies/georgia

13 http://www.heritage.org/index/country/georgia

14 http://www.transparency.org/country#GEO

15 http://geostat.ge/index.php?action=page&p_id=212&lang=eng

16 http://geostat.ge/index.php?action=page&p_id=317&lang=eng

17 http://geostat.ge/index.php?action=page&p_id=134&lang=eng

18 http://geostat.ge/index.php?action=page&p_id=314&lang=eng

19 Monetary statistics by Forex and IMF

Gia Jandieri
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