Fitch Ratings has said that although Georgia's economy is showing some encouraging signs of resilience, it expects the military conflict to carry significant costs for the economy and risks to the ratings remains on the downside. On 8 August, Fitch downgraded Georgia's Long-term local and foreign currency Issuer Default ratings (IDRs) to 'B+' from 'BB-' (BB minus) and assigned Negative Outlooks to the ratings.

"Despite the ceasefire agreement, some encouraging signs of the Georgian economy's resilience and potential support from international financial institutions, we continue to see downside risks to the economy and creditworthiness due to the conflict," says Edward Parker, Head of Emerging Europe sovereigns at Fitch. "There has been some decline in foreign reserves and outflow of bank deposits since the outbreak of the conflict, though the outflow of deposits slowed towards the end of last week. But it remains too early to judge how severe has been the impact on the real economy and the risk of further military and political conflict remains."

The ceasefire agreement and Russian pledge to withdraw troops are encouraging developments, but skirmishes are possible, important details of the agreement are unclear and a lasting peace agreement remains far from guaranteed. In addition to the loss of life and humanitarian impact of the conflict, it will leave a troublesome legacy in terms of Georgia's relations with Russia and the separatist territories of South Ossetia and Abkhazia.

The impact of the conflict on the economy will be an important driver of future sovereign rating actions. Since 7 August, the lari has been stable against the appreciating US dollar. However, the National Bank of Georgia (NBG) reports that foreign exchange reserves have fallen 6.4% since end-July to USD1,253m (in addition, Georgia's sovereign wealth funds contain USD370m). Banking system are often pressure points at times of uncertainty. Fitch estimates from its contacts with most of the largest banks that between 7 and 14 August they experienced average total customer deposit outflows of around 12% (17% for retail deposits). The agency judges that magnitude as considerable, but manageable as the Georgian banking sector had a reasonably healthy pre-conflict liquidity position, and liquid assets (defined as cash and equivalents, inter-bank placements and government debt) continued to cover more than 25% of total customer and bank funding (for banks where information is available). If required, the agency would expect some banks to be able to draw on support from foreign parents or international financial institutions (IFIs) with which they have partnerships, and the Georgian authorities have also affirmed their willingness to provide support to banks experiencing liquidity problems.

Georgia's substantial current account deficit, which was some 20% of GDP last year, is another potential source of vulnerability for the Georgian economy. Fitch would expect the conflict to adversely affect the country's risk premium and its capacity to attract foreign direct investment (which was equivalent to 19.7% of GDP last year) and other capital inflows on the same scale as before. However, supportive statements by the IMF, other IFIs and the US Treasury suggest that international loans could be made available to meet any external financing gap, though such financing would be less desirable than non-debt FDI.

The displacement of people (estimated by the UNHCR at 160,000), disruption to trade and activity and some damage to infrastructure will affect GDP. Real GDP growth was a robust 9.3% (y-o-y) in Q108 after 12.4% in 2007. Encouragingly, the Ministry of Finance reports that average daily fiscal revenue collection last week remained strong, some 14% above the January-to-July average (and revenue in H108 was up 31% on H107). However, Fitch would expect the conflict to increase budget expenditure with implications for the deficit, which the agency would now expect to exceed the 2% of GDP it had expected prior to the conflict, based on the amended 2008 Budget. Georgia's moderate level of government debt, which was equivalent to 25% of GDP at end-2007, and its long average maturity are rating strengths. Fitch estimates the government faces amortisations equivalent to only around 0.7% of GDP this year.