The Importance of the Heavy Manufacturing Sector

Heavy manufacturing industry is one of the most important sectors in terms of value added, exports and employment. It is also one of the few areas where there are large companies with immediate opportunity for dramatic expansion. Growth in this sector, therefore, offers huge potential for providing broad economic growth, reducing unemployment, increasing tax receipts and improving balance of payments situation.

However, the sector as a whole has received very limited attention from subsequent governments. Discussions of economic development, have focused on tourism, energy and (recently) agriculture, with a range of other sectors like transport and logistics, finance, food-processing and textiles gaining partial consideration depending upon where the discussion is taking place.

These three sectors have been supported by the government in a range of ways. In tourism whole towns have been renovated, airport have been built and even skiing infrastructure has been paid for at public expense. In energy, new electricity transmission lines have been built by the government, and the government has financed renovation of power infrastructure more broadly. In agriculture, the government has set up numerous state-run businesses to improve input supply, provided grants to farmers and subsidised loans to agribusinesses. All three sectors have been able to look for financing through the government‟s Partnership Fund.

Perhaps more importantly these sector have been the focus of the Georgian Government‟s PR efforts and have been promoted as opportunities for investment in government supported road-shows, presentations and visits around the world.

By comparison, in spite of its significance in terms of GDP, employment and exports, there has been little consideration of the heavy industry sector in the public discourse about economic development. As a result, the government has not supported growth in the sector and elements of the infrastructure that support the sector have continued to degrade. Equally importantly, the government has not promoted the sector in their investment promotion efforts and, as a result, opportunities for investment and growth have undoubtedly been missed.

This is unfortunate. Manufacturing industry dwarfs tourism and energy in terms of value added to the economy. It is worth 10% of GDP, 16% of formal employment and around 30% of exports. Only the „trade‟ (mostly small retail shops) sector is larger. Agriculture is smaller as a proportion of GDP and exports and while agriculture „employs‟ more people, these people are very unproductive, and have incomes around 20% that of salaried employees.

If one looks at the sub-sectors, the numbers are similarly impressive. „Metal and metal products‟ is worth 2.5% of GDP. „Chemical and non-metal mineral products‟ (mostly fertilisers and cement) is worth 2.3% of GDP. This makes both of these subsectors roughly the same size as the entire telecommunications sector (worth 3% of GDP) or banking (worth 2.8%) and makes both sub-sectors far more valuable than the entire restaurant and catering sector (worth 1.9%) or the hotel sector (worth 0.6%). Another manufacturing sector, that of „transport and manufacturing equipment‟ (worth 0.9% of GDP) is somewhat smaller but roughly the same size as manufacturing of alcoholic beverages- including wine (also 0.9%).

Of all of the sub-sectors a few are particularly important; manganese, steel, fertiliser, cement, trains, airplane parts, electrical wire and other metal products stand out. These sectors generally gain their comparative advantage from a combination of existing plant infrastructure and/or available local inputs. The plants are often old but would be enormously expensive to replace and are often extremely well connected in terms of transportation infrastructure, physical buildings and electricity transmission provision. They also depend on the utilisation of locally available resources, whether that is manganese, scrap metal, lime, aggregates, or relatively inexpensive electricity.

All of these sectors also have the characteristics that Georgian growth needs if it is to be inclusive and sustainable. While the reforms of the UNM government, after 2004, brought high growth, they did not reduce unemployment and they left Georgia with a unsustainable balance of trade deficit.

To correct for these problems Georgia needs to encourage growth in high-employment export-oriented sectors. As manufacturing goods are all tradeable, the manufacturing sectors are all export-oriented or potentially so. Export orientation is particularly important because export-oriented growth is not constrained by local demand growth and because increase in exports is needed to fix Georgia‟s balance of trade deficit.

As a high-employing sector, growth in manufacturing industry will bring jobs and have large regional employment multiplier effects.

The fact that governments should promote growth in sectors that can act as „growth engines‟, has become fairly well accepted in recent years, as a necessary component of economic development policy. Economists from Harvard and Cambridge have explained that dramatic and structural growth requires government support.

The form of the support is the proper subject of discussion between businesses, government and the wider public. It may include direct support, like protections from foreign competition, in the short term, or guarantees of low transport and energy prices. But more than anything, what investment development will need is an on-going dialogue with the government on public policy reforms. It will also need the sectors full inclusion in the platform of economic opportunities elaborated by the Georgian Government in business- fairs, meetings and speeches across the world.

This paper will elaborate the importance of the heavy manufacturing sector, the opportunities for growth and the benefits that such growth would bring. It will also argue that, in line with most of the rest of the world‟s successful developing countries, encouraging this growth will require Georgia to adopt a pro-active stance to developing the sector. The analysis will end with a detailed description of the circumstances and opportunities facing Rustavi Steel as a case study for the kind of support that could be useful and what investments and growth that support could bring.

The exact form that a pro-active involvement should take, will not be elaborated here. Such a policy needs to be promoted over time and in discussion between the business community and the government. However, the analysis below should at least leave no doubt that this sector is crucial to Georgia‟s development and deserves to be part of any discussions about the country‟s future.

1 The current importance of manufacturing industry to the local economy

At 10% of gross value added, manufacturing remains one of the largest sectors of the Georgian economy.

Figure 1: Breakdown of GDP by Gross Value Added (2012)

Ref: GeoStat (2013), Gross Domestic Product at Current Prices

As one can see, only „trade‟ (mostly small retail or import businesses) and public administration (provided by the government) is larger in value-added terms, while agriculture, transport and construction are smaller.

Manufacturing industries have been amongst largest exports for many years. In 2011, if one excludes cars, then the composition of exports is as follows:

Figure 2: Breakdown of Exports (excluding cars) (2012)2

As one can see, the combination of ferroalloys, fertilisers, steel and cement is already 28% of total exports, and that does not include aircraft parts, railway carriages, steel pipe, plastic products and many manufacturing subcategories that are not big enough individually to be included in the separate categories.

In terms of employment and poverty alleviation, the sector is also vital.

Figure 3: Sectoral Breakdown of Employment (from 1⁄2 million people employed in registered and active businesses) (2011)

Manufacturing industry is responsible for 16% of formal private sector employment, or around 80,000 jobs. 3 If we assume that each of these jobs is supporting an average-size Georgian household of around 4 people, then this sector could be directly supporting 320,000 people or 8% of the population. If we furthermore assume that the cash salaries have significant regional multiplier effects on the local economy, the overall impact of manufacturing could be far higher.

2 Current composition of heavy manufacturing industry

It is hard to gain a clear national picture of the importance of heavy manufacturing because, generally, GeoStat does not publish data that is disaggregated in sufficient detail to see the value added of each sub- sectors. Below is a breakdown of the main sub-categories, as presented by GeoStat and as subsequently explained in discussions with GeoWel in early 2013.

Reference: GeoStat (2013), Gross Domestic Product at Current Prices by 45 Activities (2012) supplemented through discussion with GeoStat.

It is worth comparing the size of these sectors to other sectors that gain a lot of discussion in Georgian discussions of economic development.

This comparison should give some indication of how large the manufacturing sectors are relative to other important sectors in the economy, which often get discussed far more. Metal and metal products (which is 2.5% of value added) and the construction materials/chemicals sector (worth 2.3%) are similar in size to the entire telecoms sector (3%) or the banking sector (which is 2.8%).

Both of these sector are significantly larger than the entire „restaurant, bar and catering‟ (1.9% of value added). Similarly, at around 0.5% of value added, the railway manufacturing sector is about the same size as the entire hotel sector (0.6% of GDP). Even without manganese, the steel processing sector is 0.37% of GDP, which makes it more than half as large as the entire hotel sector.

In the discussion that follows, we will consider each of the key manufacturing sectors individually, to provide a quick overview of each. This list is not intended to be exhaustive, but should be indicative of the heavy manufacturing sector as a whole.

2.1 FerroalloysIndustry

Ferroalloy manganese is, as its name suggests, an alloy of manganese and iron. As we already highlighted, ferroalloy manganese is largest exports. Mining and processing of ferroalloy, according to discussions with GeoStat, also makes up around 85% of the GEL 500 million in value added in basic metal production.

Reference: GeoStat

Manganese mining and processing largely takes place utilising industrial infrastructure built during the soviet period, though there are some smaller manganese processors in Georgia that have been built more recently.

Manganese is mined. by the LLCs whose holdings includes the manganese mine, Zestafoni ferro-alloy plant, and Vartzikha hydropower. Installed production capacity of Zestafoni ferroalloy plant is 185,000 tons per year.

The company extracts ferroalloy manganese as well as manganese ore-concentrates and manganese oxide, they then process some of the manganese in the Zestafoni plant. Manganese mine includes 4 mines and 3 open quarries.

2.2 FertilizerIndustry

As we have already seen, fertilizer is the second largest export and, like manganese, relies on the utilization of former soviet industrial capital infrastructure that, while probably inefficient by modern standards, would be enormously expensive to build from scratch.

The supplier of the product which is the only major producer of fertilizers in the South Caucasus. The company is situated in Rustavi and it is fully owned subsidiary hires more than 2000 workers.

Ref: GeoStat (reviewed December 2012), Export of Major Commodity Groups

As one can see, production and exports dropped in 2009, as the result of the financial crisis, but have since then have surpassed their previous 2008 high, and are on track to grow further this year.

The technology used for the production of the fertilizer is heavy capital equipment built during the soviet period. This equipment fixes natural gas to produce a range of products, including Ammonia (400 000 Tn. Year), Nitric Acid (372 000 Tn. Year), Ammonium Nitrate (450 000 Tn. Year), Ammonium Sulfate (410 000 Tn. Year), Sodium cyanide (8 000 Tn. Year), Hanun (75 000 Tn. Year), Oxygen (78 300 Thousand m3), Dry ice (3 000 Tn. Year), Carbon dioxide (12 000 Tn. Year).

2.3 Steelprocessingsector

Steel processing is worth about 2.5% of GDP, when classified along with ferroalloy. Taken in itself, it is worth about 0.4% of GDP. As has already been mentioned, this makes it about 2/3 the size of the entire hotel sector. The sector is dominated by Rustavi based steel producers, which mainly consists of the large Rustavi Metallurgical Plant and GeoSteel, and a smelter in Kutaisi, owned by Eurasian Steel Ltd. In addition, there are several dozen small smelters across the country, mostly in the old industrial cities.

It is hard to be sure how many people are employed in the sector at the current time, but local experts estimate somewhere around 3000.

The steel sector in mostly consists in the melting and processing of scrap metal, though some parts of the industry also import particular grades of steel for the production of metal products. This makes the sector heavily exposed to scrap metal exports, as the more scrap is exported, the less is available for local processing.

Historically in Georgia scrap metal has been the bigger business. Until 2005 scrap iron was one of the country‟s principle exports, with much of the iron, ironically, coming from the scrapping of the Rustavi Metallurgical Plant processing infrastructure.

However, as the economy has diversified, and as the steel processing sector has grown, scrap exports have fallen. Scrap iron is now worth 3% of exports, and is slightly lower than processed steel bar (see figure 2). Rustavi Steel will be discussed in more detail below.

2.4 CementIndustry

Another large contributor to GDP, with about GEL 250 million of added value, is non-metal construction materials. This is made up of a range of different materials that are extracted and processed, including lime, chalky soils, gravel and decorative stone.

Interestingly, while added value for non-metal construction materials; remains high in national statistics, and Heidelberg cement has reported strong growth, exports of cement have declined precipitously since 2008.

Source: GeoStat, Exports by Commodity Groups (2000–2011), (Mil. USD)

The most likely account for the drop in exports has been strong growth in demand for cement, reflecting continued post-war government-financed rehabilitation of roads and urban infrastructure.

2.5 Machine-buildingindustry

In addition to the categories listed above, Georgia also produces a number of other steel and industrial products, particularly train parts, steel wire and airplane parts. Each of these businesses, like many of the sectors highlighted above, depend heavily on former soviet infrastructure.

The size of each of these sectors is hard to quantify exactly, particularly in terms of value added. However, they are each dominated by large firms, and one can gain an understanding of each sector by looking at the large firms.

Train carriages are principally produced by Locomotive Maintenance Factory. They currently have 112 million GEL of orders and employ 2000 people in plants based in Tbilisi and Kutaisi. 60% of this business is for the local market, the rest is for export. At USD 17 million, in 2012, locomotives were 0.7% of Georgia‟s exports, and as such was the country‟s 24th biggest export, worth very slightly less than electricity exports.

The existence of train and carriage production is largely a hang-over of industrial organization in the soviet system as the soviets used particular countries to produce and maintain the railway capital materials needed in an entire region. As these businesses provided support for the huge rail system of the region, they were inherently large support-businesses provided this support for both of whom remain large customers. It has also provided large numbers of carriages export.

The largest input for locomotive manufacturing is steel and while some of the steel components come from the large steel sheets, which are used for the carriages, come from outside.

3 The Need for Industrial Policy

Having provided an explanation of the various ways in which manufacturing industry are important for the economy, it is worth considering why this sector may be particularly suitable for governmental support. Therefore, in the section that follows, we will briefly review the economic discussion over the role of the state in economic development planning.

This assessment draws two conclusions. One, that there are strong voices in the economic development community that believe governments need to play a significant role in economic planning. Second, the economics literature seems to suggest that sectoral support should only be provided to those sectors which have the opportunity of facilitating structural change in the economy. These sectors should produce tradeable goods, should have opportunity for increasing value-added and should be employment intensive. As we will show at the end, all of these characteristics apply to the manufacturing sector.