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How The Lifting Of The Russian Trade Embargo Will Benefit Georgia

Primary Credit Analyst: Ana Jelenkovic, London (44) 20-7176-7116; ana.jelenkovic@standardandpoors.com Secondary Contacts: Trevor Cullinan, Dubai (971) 4372-7113; trevor.cullinan@standardandpoors.com Kai Stukenbrock, Frankfurt (49) 69-33-999-247; kai.stukenbrock@standardandpoors.com

Table Of Contents
Geographic And Segment Diversification Of Wine And Mineral Water Exports Post-Embargo External Vulnerabilities Are Driven By A Large Current Account Deficit Improved Relations With Russia Could Support Investment Inflows And Tourism Diplomatic Ties Are Likely To Take Time To Re-Establish Conclusion Related Criteria And Research

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How The Lifting Of The Russian Trade Embargo Will Benefit Georgia
Earlier this year, Russia lifted its seven-year import ban on Georgian wine, mineral water, and other agricultural products. The first batch of wine from Georgia was officially allowed back into Russia in early June. However, although the lifting of the embargo should be a net positive for Georgia's external accounts, Standard & Poor's Ratings Services believes it will be insufficient to significantly improve the country's high external vulnerabilities, which stem from its large gross external financing needs and net external debtor position. We do not expect these developments to have a tangible bearing on Georgia's creditworthiness in the near term. But they could lead to improvements in key economic and external indicators over the medium to longer term. Besides benefitting the external accounts, the lifting of the embargo, announced in March of this year, should moderately improve Georgia's economic and political risks. Prior to the embargo--imposed in 2006 by Russia's consumer watchdog, ostensibly on health grounds, amid heightening tensions between the two countries--Russia accounted for more than 80% of Georgian wine exports and 70% of Georgian mineral water exports. It remains to be seen how great a share of the Russian market can be recovered, and at what price. Agriculture accounts for only about 10% of Georgia's GDP and we do not expect any significant improvement in productivity in the agricultural sector in the near term. Overview • Georgia is resuming the export of its wine and mineral water to Russia after the latter lifted its seven-year de facto trade embargo on wine, mineral water, and other products. • While this resumption of trade with its largest neighbor is in our view a net positive for Georgia's external accounts, the extent of the benefit is unlikely to be significant in the short term. • In our view, the improvement in relations between Russia and Georgia is likely to focus on discrete, commercial goals. But the two countries' foreign policy agendas are likely to remain incompatible.

In our view, the decision by Moscow to lift the import ban signals that relations between Georgia and Russia, at least on a commercial level, are improving. The move also marks a key achievement for the new Georgian Prime Minister Bidzina Ivanishvili, who has set the rebuilding of relations with Russia as a key policy goal. However, we do not anticipate a significant improvement in relations between Russia and Georgia following the resumption in trade. We expect relations to remain complicated and tense given mutually-exclusive policy agendas vis-à-vis the separatist republics of South Ossetia and Abkhazia, as well as opposing foreign policy goals for the region.

Geographic And Segment Diversification Of Wine And Mineral Water Exports Post-Embargo
When Russia imposed its de-facto trade embargo in 2006 it was Georgia's largest trading partner, accounting for 18% of Georgia's total exports in 2005. In 2006, this figure dropped to 8%, and in 2012 fell to just 2%.

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How The Lifting Of The Russian Trade Embargo Will Benefit Georgia

Interestingly, the embargo had only a temporary effect on Georgia's export growth. Nominal growth of exports averaged 36% per year between 2003 and 2005. It subsequently dropped to 8% in 2006, but picked up to more than 30% in 2007. Following the introduction of the embargo, dozens of wine producers and some mineral water producers went out of business. However, both industries subsequently became more efficient and cost-effective. At the same time, the Georgian government actively sought to diversify exports away from Russia in order to reduce the country's dependence on its large neighbor as relations deteriorated. The government supported exporters in targeting other neighboring countries as well as niche markets in the U.S., Canada, and Europe. For example, Azerbaijan, which accounted for 10% of Georgia's total exports in 2005, now accounts for more than 20%, while the U.S. now accounts for 10% of Georgia's total exports, up from 3% in 2005. Efforts to diversify away from Russia are most evident in wine and mineral water, which suffered the largest loss of market share through the embargo. It took Georgia until 2010 to reach pre-embargo export levels of mineral water, but there is still some way to go to reach the pre-embargo level of wine exports (see charts 1 and 2). In 2012, Ukraine, Kazakhstan, Lithuania, Belarus, and Azerbaijan accounted for the bulk of mineral water exports. Exports of mineral water to Ukraine increased from 15% of the total in 2005, to nearly 50% in 2012.
Chart 1

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How The Lifting Of The Russian Trade Embargo Will Benefit Georgia

Chart 2

In terms of wine exports, Georgia has significantly diversified its markets since 2006. Exports to neighboring countries such as Ukraine, Kazakhstan, Belarus, and Azerbaijan have leapt by 270% since in nominal terms and 180% in volume terms. Ukraine, for instance, now accounts for more than 40% of Georgia's wine exports, while China accounts for 10%. Along with diversification of export markets, Georgian wine and mineral water producers have moved into niche market segments. This was an important contribution to reaching pre-embargo export levels in dollar terms for mineral water producers. And even though the volume of mineral water exports in 2012 remained only 70% of the pre-embargo level, price increases more than compensated for the loss of the Russian market (see chart 3).

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How The Lifting Of The Russian Trade Embargo Will Benefit Georgia

Chart 3

Georgia has also been able to significantly increase the price per ton of its wine exports as the quality of its wines has improved. The price per ton of Georgia's wine exports nearly tripled to $3,200 in 2012 from $1,250 in 2005 (see chart 4). As previously indicated, wine exports have yet to recover to their pre-embargo volume level. Unlike mineral water, export market diversification and higher added value have not been sufficient to bring Georgian wine exports back to pre-embargo levels. The value of wine exports in 2012 was 80% of what it was in 2005, and only 31% of the volume. This indicates to us that there may be significant room to increase production.

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How The Lifting Of The Russian Trade Embargo Will Benefit Georgia

Chart 4

External Vulnerabilities Are Driven By A Large Current Account Deficit
Georgia's weak external accounts remain a key ratings vulnerability, in our view. The country's net external liability position remains significantly higher than before 2008. Large current account deficits are driven by persistently high trade deficits, which are a function of Georgia's heavy dependence on imported goods ranging from food to investment needs. The trade deficit has narrowed somewhat since 2008, but we still expect it to remain above 20% of GDP over the next three years. As a result, we expect gross external financing needs to average more than 120% of current account receipts and usable reserves. We understand that that brand recognition remains relatively strong in Russia for Georgian products and that re-establishing transportation and distribution channels will not be an overly difficult task. That said, the producers in these industries indicate that they are not willing to increase exports to Russia at the cost of the gains made to any of their new markets and that exports to Russia will come from increased production. Moreover, the Russian market has changed since 2005, and we are not certain how easy it will be for Georgian producers to reclaim a significant share of that market. In 2005, the Russian wine market was dominated by Moldovan and Georgian wines, which accounted for 35% of the market. In 2012, French wines made up 26% of the market, followed by Italian, Spanish, and Ukrainian

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How The Lifting Of The Russian Trade Embargo Will Benefit Georgia

wines. Yet, even a sharp increase in wine and mineral water exports back to 2005 volume levels, and at current prices, is in our view unlikely to lead to a noteworthy reduction in Georgia's external vulnerabilities. In volume terms this would mean more than tripling current export levels to Russia, resulting in an 8% increase in total exports. We estimate that this increase in exports would translate into a reduction of the trade deficit of 1% of GDP. While the lifting of the embargo is in our view a net positive for Georgia's external accounts, the extent of the benefit is unlikely to be significant in the short term. It remains to be seen how great of a share of the Russian market can be regained by Georgian wines and how quickly, seven years since they were last available there, and at what price.

Improved Relations With Russia Could Support Investment Inflows And Tourism
The trade embargo did not preclude Russian companies from operating in Georgia. These companies include RAO UES, which controls electricity distribution in Tbilisi; VTB Bank JSC; and mobile operator Vimpel-Communications OJSC. Still, the rebuilding of relations between the two countries could potentially lead to increased investment from Russian businesses--including in Georgia's tourism sector, which has emerged in recent years as an important source of external funding. Ahead of the public indications that the trade ban would be lifted, Russia's Alfa Group bought a stake in Georgia-based mineral water company Borjomi. Looking ahead, an improved geopolitical environment could support both Russian and non-Russian foreign domestic investment (FDI) if investor sentiment picks up as the political environment stabilizes. Net FDI inflows, averaging 6% of GDP between 2009 and 2011, supported by Georgia's investment-friendly policies, remain a crucial source of funding the government's sizable current account deficit. In 2005, Russia accounted for 10% of Georgia's total FDI. Since then, that share has declined to less than 5%. Georgia's tourism sector could also benefit further from improved relations with Russia. The sector's importance to Georgia has been growing rapidly in recent years, with tourism export receipts reaching 6% of GDP in 2012, according to the government. In 2011, visitors from Russia increased by 40% after Georgia lifted visa requirements for Russian citizens.

Diplomatic Ties Are Likely To Take Time To Re-Establish
Tensions between Russia and Georgia began increasing following the 2003 Rose Revolution in Georgia that brought President Mikheil Saakashvili to power. In 2006, Russia's consumer watchdog imposed the ban. Relations continued to deteriorate, eventually culminating in a brief war between Georgia and Russia in 2008. Through international mediation, the parties reached a ceasefire agreement five days after the conflict started. As a consequence of the political unrest, we lowered our long-term sovereign credit ratings on the Government of Georgia to 'B' from 'B+' during the conflict and the outlook on the foreign- and local-currency ratings was revised to stable from positive in May 2008.

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Political and diplomatic relations between Georgia and Russia have remained tense since the war, although there has been a slow normalization in relations and a reduction in hostile rhetoric. Notably, the geopolitical environment established by the war has become the new status quo. Russia has increased control over the separatist regions, recognizing them as independent and continuing to deploy its forces there, contrary to the terms of the ceasefire agreement. The new status quo has led to some stability in geopolitical tension, allowing Georgia's economy to recover and supporting our decision in April 2010 to upgrade the sovereign ratings to 'B+' from 'B'. Relatively strong growth prospects and a stabilizing political climate underpinned our decision in November 2011 to further upgrade Georgia's long-term foreign- and local-currency ratings of Georgia to 'BB-' from 'B+'. We note that the decision to lift the trade embargo followed both a change in government in Georgia, as well as Russia's entry into the World Trade Organization in 2012 (Georgia became a member in 2000). These moves afforded Russia the opportunity to engage with a non-Saakasvhili administration and to establish trade norms with a fellow WTO member. In October 2012, the Georgian Dream (GD) coalition won a surprise victory at the parliamentary elections, Georgia's first democratic handover of power within the bounds of the post-Rose Revolution institutions. Domestically, we expect tension between the GD and the United National Movement (UNM), now the main opposition party, to remain high until the end of President Saakashvilli's term in October 2013. Prime Minister Ivanishvili has made improving relations with Russia a priority, appointing Georgia's former ambassador to Russia as a special envoy. Russia and Georgia first held direct talks in mid-December 2012, the first time the two sides had met since the August 2008 war. In early 2013, Russia agreed in principle to lift the import ban on Georgian products, which was followed by a site visit from Russia's consumer watchdog and the announcement in June that 36 Georgian winemakers and four mineral water producers were ostensibly cleared to resume exports to Russia. We expect political and diplomatic relations between Georgia and Russia to remain complicated. In our view, the improvement in relations between Russia and Georgia is likely to focus on discrete, commercial goals, such as the lifting of the trade embargo. We also anticipate an improvement in border relations and transport links such as railway traffic. But the two countries' foreign policy agendas and policies toward the separatist republics are likely to remain incompatible.

Conclusion
The lifting of Russia's trade embargo on Georgian agricultural goods, including wine and mineral water, marks an important improvement in relations between the two countries. In our view, however, the direct economic effect--the potential recovery in net exports of wine and mineral water to Russia--is unlikely to be significant relative to the weakness of Georgia's external accounts. Eventually, though, we believe accelerated investment inflows and a higher number of Russian tourists could arise through the strengthening of relations between Georgia and Russia.

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Related Criteria And Research
The articles listed below are available on RatingsDirect. • Supplementary Analysis: Georgia (Government of), July 22, 2013 • Government of Georgia 'BB-/B' Ratings Affirmed On Prudent Fiscal Policy And Commitment To Reforms; Outlook Stable, June 14, 2013 • Lack Of Reform And Inefficient Energy Industries Constrain Growth For CIS Sovereign, May 15, 2013
Additional Contact: SovereignEurope; SovereignEurope@standardandpoors.com

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