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Rule of Law and Property Rights, the Economics Perspective

Rule of Law and Property Rights, the Economics Perspective

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By 2012, riskes associated with weak protection of property rights have become the binding constraint for Georgia’s economic growth. These risks translated in extremely real lending interest rates (8th highest in the world in 2011) and very low availability of domestic credit to the private sector.

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“Don’t rush to judgment on Georgia” was the title of a recent article by Michael Cecire in Foreign Policy (FP). Written in an apparent reaction to “Georgian Dream shows its dark side” (FP, November 29), and “Georgia’s wrong turn” (Washington Post, November 28), Cecire’s piece attempts to provide a more objective account of the situation. According to Cecire, “the Western outcry has been much too hasty. Ultimately, it's not the arrests [of senior UNM officials] themselves that will test the new government's commitment to democratic ideals and the rule of law so much as the Georgian judiciary's commitment to transparency and due process. On that count, issuing harsh judgments now would be premature, and could aggravate already raw feelings in Tbilisi, where many feel that the West was much too close to the UNM and often too passive to its excesses.”

A similar note is struck by Anna Dolidze and Thomas de Waal in “A Truth Commission for Georgia” (Carnegie Endowment for International Piece, December 5) who shrewdly point out that the furor around the recent arrests of UNM officials, “both in support of and in opposition to them, reflects that the rule of law is probably the most critical problem for present-day Georgia. In fact failings of the rule of law could be called the “dark side” of the 2003 Rose Revolution, which unfortunately—and despite the efforts of nongovernmental organizations such as the Georgian Young Lawyers’ Association and Human Rights Watch—received less attention than the government’s anticorruption and economic reforms.” Dolidze and de Waal focus on the need to bolster the rule of law in Georgia and recommend that the new government take a “transitional justice” approach by forming an objective “truth commission” to deal with the past.

There are many reasons for Georgia and its friends around the world to be concerned with the strength of its fledgling democratic institutions. For one thing, rule of law and property rights are, indeed, key elements of a free democratic polity. What I would like to emphasize here, however, is that there are also very important economic reasons for Georgia to worry about rule of law and property rights. In particular, a recent study by the ISET Policy Institute (Michael Fuenfzig and Yaroslava Babych, June 2012) identified weak property rights as the binding constraint for investment and Georgia’s future economic growth. Incidentally, this study contradicts the main findings of a similar “constraints analysis” exercise that has been previously undertaken by the Georgian Prime Minister’s office at the time.

Fuenfzig and Babych argue that as a result of reforms enacted after the Rose Revolution, Georgia did very well in almost all indices concerned with the formal aspects of “doing business”, such as the number of days it takes to register business, the tax and customs procedures, the lack of petty corruption, etc. Exceptions were indices that measure property rights protection and political stability, broadly interpreted. As they explain “Property rights and political stability do not only encompass laws designed to guarantee and protect property rights, but also the ability and willingness of the government to evenly enforce and to respect these laws; the stability of the government itself; the stability of institutions, and the absence of  potential internal or external conflicts.“

The risks associated with weak property rights are reflected in data concerning Georgia’s financial sector. For instance, Figure 1 compares the average real interest rates among a group of transition economies, including Georgia, for the period between 2000 and 2011. Among the developing countries of Europe and Central Asia, Georgia has had one of the highest real lending interest rates. In 2011 the real lending interest rate was 15.3 percent – up from 14.4 percent in the previous year.

Georgia’s real lending interest rate was not only high compared to other developing countries in Europe and Central Asia, but also compared to all countries in the world. According to the World Bank, in 2011 the Georgian real lending interest rate was the eighth-highest in the world, only below the real lending interest rates of the Uganda, Papua New Guinea, Gambia, Kyrgyzstan, D.R. Congo, Brazil, and Madagascar. This is particularly striking given that real lending interest rates in the major economies were at record low levels. It is also not an aberration given that already in 2007 Georgia had the eighteenth highest real lending interest rate in the world.

As shown in Figure 2, the availability of domestic credit to the private sector was also significantly below the regional average. While the share of domestic credit to the private sector in GDP was only 32.8 percent in Georgia in 2011, the comparable number is 47.4% percent for a group of developing European and Central Asian economies. Credit to the private sector as a share of GDP has been increasing since 2003, but it came to a stop in the aftermath of the global financial crisis. Although GDP growth has since then recovered, credit to the private sector has remained stagnant.

With this data in mind, one can have a clearer appreciation of the damage inflicted on Georgia by the negative press it has been receiving in recent weeks. Right or wrong, perceptions of reform reversals and poor protection of property rights would be a major impediment for Georgia’s continued economic revival and growth. As Babych and Fuenfzig put it “firms and entrepreneurs will be less likely to invest, and if they will, their investment will be of the high-risk-high-return type. Banks will charge higher real lending rates, will be more likely to require collaterals, and will shorten the maturity of the loan.”

The new government thus has a task that is both easy and difficult. To boost growth it needs to ensure continuity. At the same time it has to break with the past as far as property rights and the rule of law are concerned. Foreign and domestic investors have to be convinced that the new administration is doing everything in its power to adhere to the rule of law and, indeed, make this issue a top priority for future reforms.

The The Growth Diagnostics study for Georgia is made possible by the generous support of the American people through the United States Agency for International Development (USAID). The contents are the responsibility of Eric Livny and do not necessarily reflect the view of USAID, the United States Government, or  EWMI.


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