Belarus Country Report 4b

7/30/2019 Belarus Country Report 4b

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SITE Country Report:1

Belarus

Abstract:

During this year a number of key ingredients at the heart of explaining the recent stronggrowth performance of Belarus have changed dramatically. In particular, the increased cost ofnatural gas and reduced oil revenues due to new trade arrangements with Russia will have asubstantial negative impact on the Belarus economy. Also the reliance on the Russian market

for exports looks increasingly problematic. There is no doubt that in the short run the Belarusgovernment will need to raise funds either by borrowing or selling assets if it is to maintain astable currency. Over the medium run, the structure of the Belarus economy needs to bereformed to be less dependent on exogenous developments in Russia and on the oil and gasmarkets. The political leadership in Belarus therefore faces a number of relatively immediatechallenges but the new situation also opens opportunities for engagement (or further isolation)on the part of the international community. Depending on what happens in the near future(and on the political decisions of all involved parties) Belarus can either remain closelydependent on Russia whilst developing closer ties with countries such as Iran and Venezuelaor it can become increasingly integrated in the European community where it geographicallybelongs.

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This report was written for the Swedish Ministry for Foreign Affairs by a SITE team consisting of TorbjrnBecker and Jesper Roine after consultations with several Belarusian and foreign economists and analysts inMinsk, Kiev, Stockholm, and at the IMF and EBRD.


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SITE Country Report Belarus

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Executive Summary

Belarus is facing new challenges in the wake of recent gas price hikes and loss of incomefrom handling Russian oil and gas. This terms-of-trade shock has wide-rangingmacroeconomic and therefore also socio-political implications. The magnitude of the terms-

of-trade shocks is substantial (3-6 percent of GDP in 2007) and prices will continue toincrease to 2011 when Belarus will face European energy prices according to the newagreement with Russia. Since this is a permanent shock the only solution is a major realadjustment, with cuts in government spending and reforms to facilitate the needed adjustmentof the economy. The latter range from reducing the costs of starting new businesses to makingprice signals work to help allocate financial and real resources in the most efficient way.

With a fixed exchange rate the energy shock will initially lead to reduced export earnings andincreased import costs. Consequently the current account will deteriorate. This deficit needsto be financed externally to avoid a devaluation of the currency since the alternative asubstantial real adjustment of imports and exports to balance the current account is difficultin the short run (had the currency been floating it would instead have led to a depreciatingcurrency with different problems described later). However, borrowing is only a way ofmaking the adjustment less painful in the short run, but it does not substitute for real change.Only the timing can be changed, not the need for adjustment. The funding alternatives seemstraightforward, either sell assets or borrow from the rest of the world. The need for outsidefunding has obvious political dimensions. Will Belarus seek funding from Russia and/or otheroil producing and likeminded countries or approach the West for funds, either fromcommercial entities or official bilateral, regional or multilateral institutions? The rhetoricfrom the Belarussian government give a rather mixed picture. New alliances with countriessuch as Iran and Venezuela have been formed at the same time as President Lukashenka has

spoken about the importance of normal relations with the EU and the US. At the same time,all the funding so far has come from Russia, and this may be a case of actions speaking louderthan words.

The prospect of receiving official assistance from the West to finance the current accountseems limited given the political situation in Belarus. However, the West should weigh intoits decision that the alternative is that Belarus becomes even more closely tied to Russia afterselling its asset to and borrowing from its strong neighbour (as seems a more likely scenariothan solving the crises with the help of Venezuela, Iran and the like). The West could remainmore involved in trying to move the reforms in a desired direction by engaging the authoritiesin discussions on what is needed to ensure long-term growth and improved living conditions.

To summarize, Belarus is now likely to enter a phase of building up vulnerabilities that couldeasily lead to a very costly mix of a currency, banking and external debt crisis a few yearsfrom now. This type of external financial meltdown has happened across the world from theAsian crisis to Argentina and some of its neighbours in Latin America. In Thailand forexample, output contracted by 10 percent in the year after the crisis hit and it took 6 years toget back to the pre-crisis income level with cumulative output losses in the order of 50 percentof pre-crisis GDP. In addition, some of the political turmoil the country is dealing with eventoday has its roots in the crisis. Reforms are urgently needed in Belarus to prevent this fromhappening. On the other hand, such a crisis could have the positive side effect of inducing ademocratic turn for the country (Indonesia) but the outcome could just as well be one of

substantial economic and social problems for the population accompanied by an even moreautocratic leadership (Myanmar).


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Basic Data

Source: CIA World factbook


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1 Introduction

Belarus is an important country on the border of the European Union which has chosen adifferent economic and political path from the West with centralized control over theeconomy and weak democratic institutions. Attempts to engage its leadership in a dialoguethat would to move the country in a more open and market oriented direction have not beenvery fruitful. On the other hand, the negotiations with Russia over gas and oil in 2006 and thesubsequent agreements that came into effect 2007 constitute a significant shock to thecountrys external accounts with wide-ranging macroeconomic as well as socio-politicalimplications. Finding large-scale external funding to smooth the shock is an immediatepriority of the government. Since the shock is permanent, substantial reforms are needed tomaintain high growth, a stable exchange rate and controlled inflation. External assistancecould open new avenues for engaging the country in a more productive dialogue.

The aim of this report is to analyze the impact of the shock and identify possible areas of

engagement with Belarus. In order to do this the following sections contain brief descriptionsof the political situation as well as the economic structure and developments prior to theshock. The details of the gas and oil shocks and their impact are then outlined, followed byrecommended reforms to deal with the current situation. Further ahead, the recent and likelyresponses of the government and possible areas for external assistance are discussed. Thereport ends with some concluding remarks.

2 Political Situation

With only a very short history of previous independencebetween March 1918 and January

1919the Republic of Belarus emerged as an independent state as the Soviet Union dissolvedin 1991. After an unstable initial periodAlexander Lukashenka becamepresident in 1994 promising a return tostability. In 1996 the powers of thepresidency were strengthened andLukashenka has since ruled the countryin an increasingly autocratic fashion. Inparticular, through a referendum inOctober 2004 the constitution waschanged so as to allow threepresidential terms, and, unsurprisingly,he was re-elected in 2006.

Even though there has always been a strong element of control of the media and oppression ofany political opposition, it seems that Lukashenka enjoyed relatively large popular support atthe end of the 1990s and even up to the presidential election in 2001. According toindependent polls, Lukashenkas popularity was far below the official figures (according towhich he received close to 76 % of the votes cast) but they nevertheless indicate that he hadthe support of the majority of voters. After the 2001 election, however, his popularity hasgone down considerably although estimates of the level of his real support vary greatly

between different polls. His reaction to this has been to increase control and strike back at theopposition even harder. Even though independent polls in 2002-2003 indicated that a large

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Democratic/Free/Division of power

Autocratic/Non-Free/No division of power

Increasinglydemocratic

Increasinglyautocratic

Democracy indicators, 1991-2006

Constraints on

the Executive

Freedom of

the Press

Polity IV


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majority were against extending the presidents stay in office beyond the constitutional limit

this change was pushed through and Lukashenka officially won the subsequent election in2006 receiving an unlikely 83 percent of the vote. Overall the political development underLukashenka has been characterized by increasing concentration of power vested in thepresidency, increasing control of media, and an increasing repression of political opposition.2

A key factor behind Lukashenkas ability to retain power and popular support has been thestrong economic development since 1996 which has also benefited the population in terms ofincreasing real disposable income, growing average wages, and a declining povertyheadcount. Wage increases have been decided on by the central government and have recentlybeen higher than productivity growth. Worker protection has also been very high and eventhough unemployment is likely to be higher than the official statistics reveal (1.2 percent ofthe economically active population), joblessness is almost certainly less of a concern inBelarus than in other transition countries. The Human Development Index (HDI) puts Belarusin 67th place (out of 177 countries) in between Russia and Brazil. This is better than its rank interms of income (79th) due to high literacy rates and school enrolment, while the relatively

low life expectancy impacts negatively on the HDI. In cross-country studies of self-reportedhappiness Belarus is a negative outlier in an otherwise strong relationship betweenGDP/capita and subjective well-being.

Although the regime is autocratic and controls most of the important economic resources, itdoes share some of the countrys wealth with the rest of the population. Some analysts callthis a social contract where Lukashenka (and the nomenclatura) keeps control of power butalso delivers on promises of increased economic well-being. The desire to hold on to thisarrangement is likely to guide the governments response to the gas and oil shock.

3 The Economic Environment pre-2007

As mentioned in the section on the political situation, strong economic growth has been animportant ingredient of the administrations strategy to keep public protests against political

oppression at bay. Understanding the workings of the economy is therefore central to judgethe importance of the gas and oil shock and its political.

3.1 Oil and Gas

The mechanics of the Belarusianeconomy is intimately linked to the webof special deals in the oil and gas tradewith Russia. While Belarus has almostno oil and natural gas of its own thereare two reasons for why thesecommodities play a central role in theBelarusian economy. First, Belarusinherited much of Soviet refinerycapacity and, second, Belarus is for geographic and infrastructure reasons a key transportchannel for natural gas from Russia to Europe. After 1991 oil and gas have been cornerstones

2 For more on this see Lynch (2005) and Economist Intelligence Unit (2006).

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2001 2002 2003 2004 2005

Value of Oil product Imports and Exports, 2001-2005

Export value (USD mn)

Import cost (USD mn)


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in trade agreements between the countries but it is only recently that the big change in theimportance of these products has occurred. There are many ways in which one could illustratethe increasing importance of these developments. In 2006 fuels and petrochemicalsconstituted about one third of total industrial output, which in turn was about one third of totalGDP. In terms of exports, oil products accounted for about 40 percent of the total, up from

less than 20 percent in 2001.

The increasing difference in the value of oil imports and oil product exports between 2001and 2006 has been an important source of income for Belarus. Even though the difference isnot a pure profit for the economy (since it is typically not just a re-sale of the same productbut a refinement of one oil product into a different one) the striking feature lies in theincreasing difference over time. This does not reflect productivity advances (which would bemore sustainable) but mainly favourable price changes and to some extent changes in exportdestinations.

A similar development can be

seen for natural gas, Belarusby far most important energysource, constituting more than60 percent of total primaryenergy consumption. Thisshould be compared to Russiaand Ukraine, both withconsiderable domesticsupplies, where the shares arearound 50 and 40 percentrespectively while other

countries with little or nonatural gas such as Lithuania and Poland have a share of about 25 and 10 percent. Over thepast years the price of natural gas has increased substantially around the world, increasing thedifferential between Belarus and other countries.3 Belarusian gains from natural gas havecome partly from the transit activities but also from the advantage for all energy intensiveindustries such as refinery activities and metallurgy. To put the figures in perspective, ifBelarus in 2006 would have paid the European market price, the additional cost would havebeen around 10 percent of GDP.

3.2 Economic Structure

Productive sectors. Industrial activity is concentrated in the fuel and petrochemical industry(about 33 percent of output), machine building and metal working (about 24 percent ofoutput) and food production (about 16 percent of output). In agriculture, the main outputs aremeat and dairy products, which before 1991 were produced for the northwest of the SovietUnion and relied heavily on fodder produced in other parts of the union. Since thepreconditions have changed completely the collective and state farms perform poorly and are

3 It should be noted that the price of natural gas differs a lot between countries and between buyers. Many other

transition countries also have favourable agreements giving then lower prices than the average European price,but fact remains that Belarus has had a substantial price advantage compared to other countries that pay two tofive times higher prices.

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Gas Price differentials, 2000-2006

U.K. gas price

(USD per thousand cubic meter)

Belarus import gas price


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kept afloat by government subsidies. Agricultural subsidies have increased over the past yearsand in the 2007 budget they account for about 20 percent of government expenditure.

The majority of output is generated by large state controlled firms where both production andemployment are predetermined by set

government targets. No large firms have beenprivatised. This particular type of governmentinvolvement means that large firms operateunder soft budget constraints. Firms that findthemselves in trouble can be bailed out andsubsidised in various ways, while firms thatgenerate large profits can face higher taxes ina highly arbitrary fashion. There are severalcases of firms where profits go more or lessstraight into the governments budget. Thisstructure also allows the government to mix

economic and political reasons fortransferring funds.

SMEs. Beside the dominant state sector, there is also a private sector where mainly small andmedium sized firms operate. They are predominantly active in retail trade and catering (45percent of all small firms) and serve the domestic market. The economic and financialinteractions between small and large firms are very limited. This is very different from thesituation in, for example, Slovakia and Hungary where many small enterprises act as sub-contractors to larger firms or as independent outlets of their products.

Small firms that are not

state-owned account onlyfor a fraction of totaloutput. Furthermore, thegrowth of small firms isvery low compared to thegrowth rate of theeconomy. One factor in both the low growth rate and limited share of GDP is that theincentives to grow larger are not there. On the contrary, if a small firm is relatively successfuland start to grow, there is a significant risk that the state will try to extract profits in an ad hocway or even transfer ownership of the firm. Due to uncertainty about the conditions for

individual entrepreneurs, their efforts seem to have focused on activities where sunk costs,and thus potential losses, are low.

Health and education. The UNDPs Human Development Index shows a very disparatepicture of the countrys health and education situation. Whereas education is a factor thatgreatly improves on Belarus standing in terms of the HDI, life expectancy is low andsignificantly below its GDP per capita ranking. Universal literacy and free and compulsoryeducation are welcome from a development perspective. However, spending on education isnot isolated from economic turmoil as was evident in the financial crisis at the second half ofthe 1990s. Therefore this may be an area at risk in case a full-blown balance of paymentscrisis develops.


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The health situation in Belarus is not encouraging despite rapid growth and high spending onhealth care. Although spending on health as share of GDP is comparable to Poland, lifeexpectancy has declined by 3 years over the last decade for men and is now around 63 yearswhile for women it is around 75 years. Behavioural issues such as alcoholism in combinationwith environmental issues (in particular the Chernobyl disaster which has affected Belarus

more than any other country) and inefficient allocation of spending are areas that should beaddressed to improve health and the quality of life more generally.

3.3 Macroeconomic picture

Real sector

The steady high growth over the past decade has gone through two faces. Between 1995 and2000 growth was driven mainly by expansionist fiscal and monetary policies paired with re-establishing political and economic ties with Russia. A number of treaties on friendship andco-operation were signed in the period 1995-1998, culminating in the 1999 Belarus-RussiaUnion Treaty, practically abolishing the customs border giving Belarus easy access to theRussian market. Paired with currency depreciations and large subsidies to the main exporters,Belarus was able to gain a significant costadvantage over Russian producers (basedon lower costs rather than higherproductivity) and boosting sales on theRussian market. Since 2001, domesticdemand in the form of privateconsumption and investment has been the

main drivers of growth.

This is not to say that the favourableterms-of-trade situation with regard to gasand oil were not important for growth, it was, but through financing domestic spending on anincreasingly imported goods basket rather than generating external trade surpluses. The roleof the government should also not be ignored in this growth pattern. Households receive alarge share of its income from the government. Social transfers account for 22 percent of totalhousehold income. Consequently the share of wages in total income is relatively low, 58percent. Since 2000, householdsdisposable income has outpaced real GDP

growth substantially, which is a clearindication of the governments policy to

boost household income. However, thistype of policy is clearly not sustainableover the longer run. There are also anumber of government subsidies that go tohouseholds. For example, less than half ofthe investments in housing construction in2006 came from the households ownresources. The rest came from preferentialcredits of (state) banks, state subsidies, housing and investment funds, etc. Price controls on

many important items in the consumption basket also fuel demand for such goods.

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GDP and Disposable income, 1994-2006

Real disposable income

(Index, 1994=100)

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Contribution to growth from expenditure side

Private consumption Public consumption

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Fiscal sector. The size of government spending and revenues is very high for a country at thisincome level (but roughly in line with Sweden). Nevertheless, the government has managed tocontain fiscal deficits and avoided a build up of direct public debt in the past. The strongrevenue performance is intimately linked to increases in oil and gas price differentials detailedearlier and the non-oil balance has shown a relatively large and deteriorating deficit. But since

the overall balance has been well contained and GDP has grown rapidly, Belarus has beenable to keep government debt to GDP below 10 percent.

The governments role in the economy goes far beyond the headline fiscal numbers.

Expenditure has a large social component and has been an important factor in explaining thehigh growth in private consumption as discussed above. In addition, the government is a largeemployer and thus contributes directly to wages and salaries. As the government also ownsmany of the large companies and banks, it also indirectly contributes to employment andaffects many investment decisions.

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Fiscal accounts (general government)

Overall Balance (right hand scale, % of G DP)

Non-oil Balance (rhs)

Revenue (lhs)

Expenditure (left hand scale, % of GDP)

Money and banking. Credit has expanded rapidly over the last couple of years but inflationhas come down due to strong GDP growth, a fall in velocity and price controls. A large shareof credit in the last couple of months has gone to state-owned enterprises (SOEs). Given thestrong element of directed lending involved in this (which is not always based on soundfinancial calculations) and the fact that banks have increased short-term foreign currencyborrowing, this is reason for concern. The fixed exchange rate continues to play the role ofnominal anchor that keeps inflation at bay, but if the government is forced to devalue therubel this will have serious implications for both inflation and the banking system.

The banking system has a large component of state banks that hold a substantial share of rubeldeposits (originating from SOEs), but net domestic assets are only around 20 percent of GDP.Private banks hold more foreign currency deposits which makes them more vulnerable toexchange rate movements; even if they extend foreign currency loans so their portfolios look

balanced, if the currency devalues and the banks borrowers become unable to pay their loans,

the banks still owe foreign currency to its depositors. This is what happened in for exampleThailand in 1997, and could lead to a serious banking crisis if the problem is widespread.

External sector. The external sector is dominated by trade with Russia, not only troughBelarusian import of cheap Russian oil and gas but also from Russia being the main exportdestination for Belarus. More precisely, Russia accounts for about 35 percent of exports whilePoland, the U.K. and Ukraine account for 4 to 5 percent each. In terms of import Russia iseven more dominant with a share of around 60 percent, followed by Germany (9 percent),


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Poland (5 percent) and Ukraine (4 percent). This is despite a trend of less dependence onRussia, mainly based on increased exports of oil products to the EU (but the sharp fall inRussias share of exports in 2005 was also due to a change in the methodology used forcollecting VAT). Sweden has little trade with Belarus.

Exports are dominated by mineral and chemical products, accounting for about half of allexports (mainly oil and petrochemical products), and machinery and equipment, accountingfor another 20 percent of exports. Most of the machinery and equipment is sold to the Russianmarket which, for example, bought 80 percent of all refrigerators, 70 percent of machine toolsand 60 percent of all heavy trucks produced in Belarus in 2006.

Legally the exchange rate is fixed to the Russian rubel but in practice the exchange rate ispegged to the dollar. Recent wage increases have not been accompanied by correspondingproductivity gains which has madeBelarus less competitive and is startingto hurt exports to Russia. Strong

domestic demand has also fuelled asubstantial increase in imports whichled to a significant deterioration in thecurrent account (a surplus of 1.6percent of GDP in 2005 went to adeficit of over 4 percent of GDP in2006). Limited foreign currencyreserves at the central bank and anovervalued currency make itvulnerable to a devaluation.

In the past, short-term borrowing has dominated capital inflows, while FDI flows have beenlimited. Although the ratio of external debt to GDP (at around 19 percent in 2006) is notalarming, the structure of external debt is not very healthy. The risks with short-term foreignborrowing have been highlighted in many external crises, including in Asia 1997.

4 The Energy Shock and its Implications

In January 2007 the price of imported natural gas from Russia more than doubled in a firststep to bring prices to European levels by 2011. While Belarus paid $46.68 per thousand

cubic meters of gas in 2006, the price in 2007 is $100 and the price will then graduallyincrease until 2011 when it will be equal to the European market price (presently $223 perthousand cubic meters). The change is very drastic but still smaller than the initial offer fromGazprom which was to immediately increase the price to $200. To avoid this larger increase,Belarus agreed to sell part of Beltransgaz to Gazprom, giving it increased (and much soughtafter) control of one of the most important transfer routes for natural gas from Russia to theEU.

In a separate agreement, new conditions for trade with oil and oil products were formulated.This aims at aligning export duties on oil products from Belarus with the same exports fromRussia. The mechanics of the oil agreement are more complicated than the price increase on

gas and involves that Belarus will charge an export duty on oil products of between $72-180per tonne depending on the level of refinement (as Russia does). Furthermore, the crude oil


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supplied by Russia will be subject to a share of the regular export duty that Russia levies onexports to other countries. The share is set to go from 29.3% in 2007 to 35.6% in 2009.Finally, the Belarusian government will give Russia a large share of the revenue it gets fromexporting oil to the West; 70% in 2007, 80% in 2008 and 85% in 2009.

The impact of the shock on the trade balance and current account will be substantial.Assuming, somewhat heroically, that imported and exported quantities do not adjust as aresult of the new agreements it is relatively straightforward to compute the direct effects onthe trade balance. In 2007, the combined effect of the oil and gas shock is in the order of $1.7billion, equivalent to over 5 percent of GDP and keeps increasing all the way through 2011when it would be $4.7 billion (this can be compared to estimates of the losses from EUsexclusion of Belarus from the Generalized System of Preferences (GSP) which is likely to bebetween $23 and $36 million). With a fixed exchange rate and gross international reserves at$1.4 billion at the end of 2006 the agenda for 2007 is obvious; find external fundingimmediately.

The estimated impacts on growth are large but also subject to a great deal of uncertainty. Thewider macroeconomic implications of the shocks are complicated to assess since they dependon the governments as well as other actors responses to the shocks. The IMF bases its

analysis on econometrically estimated elasticities of growth from terms-of-trade shocks andarrives at an estimated output loss of 5 percent of GDP in 2007. The losses decline insubsequent years when the relative size of the terms-of-trade diminishes, but the cumulativeloss is reported to be in the 10-15 percent of GDP range. However, these estimates are basedon the experience with this type of shocks in a large sample of countries and Belarus has anumber of factors, such as the fixed exchange rate, rigid economic structure and poorinstitutions, that would tend to increase the effects of terms-of-trade shocks on growth. Thereare also some model-based exercises from IPM that paints a similar picture of the extent of

output losses.


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The outcome could be much worse than the IMF and others forecast and report. First, there isa question of how the estimated output losses are reported. The fact that output growthdeclines by 5, then 4, 3, 2, and 1 percent between 2007 and 2011 does not actually imply thatthe output loss is 15 percent (i.e., the sum of individual years reduced growth rates). If thebenchmark is that the economy grows by 10 percent per year without the shock and the

impact on annual growth rates from the shock is as outlined above, comparing the yearlyoutput level with the hypothesized trend output and summing up all the losses for the yearsuntil 2011 it add up to 67 percent of initial GDP (rather than 15 percent). Even this is not theentire impact of the shock since in 2011 the output level will be 15 percent below thebenchmark trend level and stay behind by this amount in future years as well. In other words,this is a permanent shock that has much larger effects in terms of cumulative output lossesthan is sometimes realized or reported.

The rather mechanical estimates of the output loss do not paint the full dynamic picture of theimpact of the shock and policy actions (or lack thereof) can alter the outlook substantially.The estimates above are based on the assumption that not too much else happen in the wake

of the gas and oil shock. Experience from other countries suggests otherwise. For example,Rodrik (1999) shows that external shocks can be very costly for countries that have poorinstitutions in terms of rule of law and democratic rights, factors that are highly relevant forBelarus.Becker and Mauro (2006) also show that terms-of-trade shocks can be very costly(25-150 percent of GDP for different types of countries). In addition they show that currency,banking and external debt crises can be extremely costly and these are all crises that candevelop from the initial terms-of-trade shock if the government does not take the right policyactions.

The governments likely responses and the needed reforms will be discussed in the following

sections but the important message here is that a terms-of-trade shock of this magnitude can

put economies into free-fall and has certainly done so in the past.

5 Desirable Policy Responses

The governments possible policy responses can be divided into two main categories: first,

reforms that aid the real adjustments needed in response to a permanent shock; and second,short-term fixes (including finding external funding of the current account deficit) that candelay the real adjustment. A third alternative would be for the government to not respond atall, but since this obviously leads to an immediate currency crisis this is not a realistic option.

The sections below describe the progress on reforms and some key institutional factors andthen outlines priority areas for structural reforms and more immediate policy responses.


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5.1 The Need for Reforms and Improved Institutions

In terms of economic reforms Belarus has been characterized by choosing a differenttransition path than other CIS-countries. The Lukashenka administration has graduallyincreased state control and

has relied heavily onrestoring the relationshipswith Russia. Lukashenkahas even stated that a goalof the administration is toreturn to a Soviet-styleeconomic system as seenin the late 1980s.Consequently marketreforms have beenlimited. Belarus scoresvery poorly in terms ofEBRDs transition index,where 1 indicates little orno change from a centrally planned economy and 4+ represents the standards of anindustrialised market economy. The bars depict the range of scores in all transition countriesand the line is Belarus which shows that Belarus is one of the least reformed transitioncountries.

Corruption. Belarus has serious problems with corruption. Contrary to official informationthat the level of corruption has gone down in Belarus, Transparency Internationals

Corruption Perception Index reports that Belarus has fallen sharply since it was included inthe survey in 2002. In terms of corruption Belarus now ranks 151st out of 163 countries,shares its position withUzbekistan, but rankbelow Tajikistan andTurkmenistan, and justabove Haiti, Iraq,Burma, Sudan and theDemocratic Republicof Congo. Thisdevelopment is nothing

short of catastrophic.Compared to other ex-Soviet, ex-communiststates in our part of theworld, Belarus is nowat the very bottom ofthe list from havingbeen a star in thisregard only five years ago.

Cost of doing business. The cost of doing business in Belarus is very high. The World Bank

has since 2003 ranked countries based on a number of criteria related to the ease of doingbusiness such as the ease of starting a business, dealing with licences, employing workers and

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Large-scaleprivatisation

Small-scaleprivatisation

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institutions

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Belarus Transition Indicators 2006

in relation to range of scores for other transition countries

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Corruption Perception Index 2001-2006

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paying taxes. In a sample of 175 countries, Belarus ranks 129 in overall ease of doingbusiness. This is in line with Ukraine (128), but well behind Russia (96) and Poland (75) andworlds behind Lithuania (16) and Estonia (17). Although employing workers and contractenforcement seems to work relativelywell, the arbitrariness of the tax

system and poor investor protectionhurts the overall cost of doingbusiness. The epitome of this is thegolden share rule which gives the

government majority voting rights ineven if it only owns a small number ofshares. In 2004 this was extended toinclude firms in which the governmenthas no ownership claim at all,effectively giving the government theright to intervene in any privatised

firm.

Even in areas where the state is not directly involved, such as the small business dominatedsectors of retail trade and catering, the government effectively controls activity by edicts. It is important to note that this is not just a question of the government deciding on legislation(which clearly is an important role of any government) but it regulates activities in much moredetail and the government sometimes changes the rules of the game ex-post. For example, acompany could suddenly face higher taxation, in some form, as a result of earning a highprofit.

5.2 What Should be Done

Reforms for long-run sustainable growth. The above discussion of the political situation,the economic structure, lack of reforms, poor institutions and cost of doing business makesthe needed reforms rather obvious. The list of needed reforms is long but some key elementsare:

improve institutions ( including rule of law, democracy, tax administration, etc); reduce the role of government in business; allow prices and wages to be set (more) freely to ensure a proper allocation of

resources and create an internationally competitive economy;

remove subsidies that are not consistent with needed transformations of agriculture,industry and the financial sector;

abolish directed lending by banks, i.e., all lending to companies from banks should bedone on commercial ground and terms and not by command of the government;

consider alternatives to the current monetary and exchange rate arrangement; improve energy efficiency and ensure full pass through of increased energy costs to all

sectors of the economy (directly linked to previous energy subsidies provided byRussia that are now being phased out);

continue to build on the populations high level of education and focus on creating anew industry structure and society that derives its competitive edge from a strong

human capital base rather than energy subsidies;


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reform the health system with increased focused on quality, efficiency and efforts toreduce health deteriorating behaviour, especially among men were life expectancy isfar below what could be expected for a country at this income level and amount ofhealth spending.

Short-run smoothing and fine tuning. In addition to the much needed structural reformprogram, there are several actions that can be taken in the short-run to reduce the negativeimpact of the shock. The most immediate steps to consider include:

issue external bonds or loans consistent with a sustainable debt management strategy(only as a way to smooth the impact of the shock and not as a substitute for reforms);

privatize state-owned companies; tighten fiscal and monetary policy; reduce directed lending (part of tighter fiscal and monetary stance but also reduces the

vulnerability of the banking system);

devalue the rubel to reduce import and increase competitiveness for exports, this couldbe very risky since the rubel acts as the nominal anchor and should only be consideredas part of a comprehensive reform program.

6 The Governments Responses to the Shock

The government will fight hard to avoid a sharp contraction of activity, a devaluation of thecurrency and a rapid increase in inflation. Income growth and price stability are central to thesocial contract and at the centre of selling the current economic, social and political set-up asa successful alternative to a market-based, Western oriented, democratic society. Thereforethe much needed overhaul of the entire economic system is very unlikely to occur under the

current leadership. Rather its focus will be on short-term fixes to avoid a full blown balance ofpayments crisis that would have serious consequences for the domestic economy.

The governments initial response to the shockhas been to look for external funding tofinance the current account deficit and avoid devaluing the currency. The external funding in2007 has come from both asset sales and foreign borrowing by the government and thebanking system. So far the government has been able to make inflows of foreign currencygreater than outflows and reserves have increase from $1.4 billion at the end of 2006 to $2.4billion at the end of July 2007. However, this is after receiving $625 million for the sale of thefirst 12.5% of Beltransgaz to Gazprom and increased foreign borrowing by banks but beforesettling debts with Gazprom in the order of $500 million.

In preparation for more foreign borrowing, Belarus solicited ratings from Moodys and

Standard and Poors. In August,both S&P and Moodys issued their first ever ratings forBelarus with foreign currency debt issued by the government obtaining a B1 rating byMoodys. This is the same rating given to, for example, Albania, Philippines, Pakistan, andUkraine and could open the door to foreign bond issues next year.

The need to attract foreign funds will lead to a sharp increase in debt to GDP ratios, albeitfrom low levels. With bonds issued in international markets, Belarus economic policies will

increasingly be scrutinized by foreign investors and make the country subject to swings in

financial market sentiments and thus shocks stemming from the financing rather than currentaccount side of the balance of payments. This calls for a comprehensive debt management


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strategy as well as an oversight of the appropriate monetary and exchange rate arrangement toreduce the risk of a future balance of payments crisis.

Belarus will continue to rely on Russia for support. Despite all the rhetoric surrounding thegas and oil negotiations, Russia is the main supplier of foreign financing and its closest ally in

the international arena. Russian banks have bought two Belarusian banks; Gazprom hasacquired a stake in Beltransgaz; additional funding is planned via loans from the governmentand t-bill issues in the Russian market. Despite the close connections with Russia, there is alsoa strong anti-Russian sentiment among the population which seems to be shared byLukashenka. In short, the new financial deals with Russia replace the dependence on cheapRussian gas and oil with Russian provided foreign exchange. This may well be the start of alarge-scale integration of the Belarusian economy into Russia and an alternative to a union atthe political level. Selling out all the assets of the economy will eventually lead to a veryweak power base for Lukashenka.

Lukashenka is exploring alternatives to a complete Russia sell-out, but it is unclear howsincere his efforts are and how successful they will be. The recent financial deals arestrengthening Russias influence on Belarus and if the country does not develop alternative

sources of funds it risks being even more dependent on Russia in the future. Lukashenka isaware of this and has made more EU friendly statements while negotiating deals with Russia.Connections with Venezuela and Iran can also be seen as ways of diversifying away fromRussian influence but is possibly just a way to scare the West to engage in a dialogue withBelarus and provide financial support. However, discussions surrounding a possible sale to

foreign interest of Belarusian breweries puts in question how open Lukashenka is to FDI fromnon-Russian countries. Indeed, it puts in question his entire privatization and FDI plan as a

Box. Obtaining Foreign Funding

The government has been busy trying to find foreign exchange to fund the current accountdeficit while maintain a stable exchange rate. Efforts to raise money include:

Sale of Beltransgaz to Gazprom. 50 percent of the company will be sold over a fouryear period for a total of $2.5 billion. The sale of the first 12.5 percent has beencompleted in August which generated $625 million in foreign exchange.

Russian banks are allowed to buy two mid-sized Belarusian banks without agolden share rule. Given the low profitability of the banks the sale does notgenerate much foreign exchange.

Short term foreign borrowing by banks has increased sharply. The government is exploring loans from the Russian government and is

contemplating a t-bill issue in the Russian market.

Belarus has received its first ever ratings from S&P and Moodys with the aim ofissuing Eurobonds in 2008.

Delaying debt payments to Gazprom in the order of $456 million. The debt isrelated to the six-month grace period during which Belarus was allowed to deferpaying the new gas price of 100 USD/tm3 (as a result of the delay Russia threatenedto cut off gas supplies in early August).


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way of funding the current account deficit. In summary, Lukashenka questioned why thegovernment should sell profit making companies. Selling loss making companies willcertainly not generate the cash needed to finance the deficit. It may well be that the lionsshare of foreign financing will be debt creating which will increase the risk of crisis.

7 Some Choices for External Assistance

The sections below will first identify some countries that are or have been similar to Belarusin terms of autocratic rule and discuss how these countries have developed. Secondly, adiscussion of possible areas of Swedish engagement with Belarus at the bilateral andmultilateral level follows.

7.1 Lessons from Other Autocratic Regimes

To put the Lukashenka regime in perspective it is useful to identify other countries withsimilarly autocratic rule and see how they have evolved over time. The sample in the tableincludes countries with Polity IV scores at comparable initial levels to Belarus -7 rating. Afew are richer and a few are poorer, some are from the same geographical area while othersshare the dependence on cheap energy. None of the countries matter in terms of imports orexports for Sweden. Thelist is composed to includesome countries that havenot improved their Polityscore and others that have

improved it radically. Theaim here is not to provide afull account of eachindividual country case butto draw some more generalconclusions of howpositive changes havecome about. This generaloverview also helpsidentify what could beinteresting countries for a

more detailed analysis ofhow external forces orassistance have affectedpolitical developments.

Large positive changes in a democratic direction have been connected to specific events thathave triggered fundamental changes in these countries. Glasnost and the fall of communistrule in Eastern European countries; the end of civil war in Tajikistan; the Asian crisis inIndonesia. In the most successful transformations external events were behind the democraticmovements. Although it was probably true that external assistance may have helped lay someof the foundations for democratic change, the actual change could not be attributed to this.


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Taking these experiences at face value one could argue that trying to influence Russia toreignite glasnost or contributing to create a full blown financial/balance of payments crisiswould be the quickest way to democracy for Belarus. Most observers would seriously doubtthat Russia will ever re-launch glasnost, but how about an economic crisis? AlthoughLukashenka would prefer to be in charge of a growing, stable economy to minimize the risk

of more widespread public protests, he has not shied away from using whatever means heseems fit to meet his ends in the past. Therefore an economic crisis will not necessarily lead toa collapse of the regime but may trigger an increased use of all the standard, undemocratic,means of an autocratic regime to secure its power. In other words, although trying to isolateBelarus further may seem as a promising way to destabilize the economy and thus thegovernment, it may backfire and lead to an even less democratic society on the borders of theEU.

Among the non-reformers are Cuba and Libya as well as a number of former Soviet republicsthat share a strong communist/socialist background where a large share of the populationlacks any memories of democracy and a free press. Although many in the West would like to

think that these countries will fundamentally change once their aging leaders fade, the lack ofinstitutions and shared democratic values makes this seems largely as wishful thinking. Inthese cases, there is certainly a role to be played in assisting the countries to developinstitutions and inform about alternative ways of organizing societies so there is some hopethat elections rather than new autocrats take over when the old leaders are gone.

7.2 Some Potential Areas of Engagement

Bilateral engagement. Swedish development assistance covers a broad range of issues which

includes environmental policy but only engages with the government at lower levels. Withinthis framework some additional areas of engagement have become relevant under the currentcircumstances. The first is related to energy efficiency, which is now a top priority for theBelarus government with the increased energy prices. Improving energy efficiency is alsowell in line with more general Swedish priorities. The Belarus governments own focus hasbeen on energy efficiency of large companies while the World Bank is funding a project thataddresses energy efficiency at social institutions (in particular schools and medical facilities).

A neglected segment of the economy that would benefit from improved energy efficiency ishouseholds and SMEs. This may be a relevant area for assistance from Sweden which also fitswith EUs ENPI and more recent initiatives. Such assistance could achieve several goals at

once; improve energy efficiency, gain an entry point to a dialogue with the broad masses andhelp the poor deal with increases in energy prices. At the same this is an area where theBelarus government would likely welcome assistance which would increase the chances ofsuccess.

Improving the information received by the population is crucial to increase the chance ofmoving the country in a democratic direction. Independent surveys suggest that many in theBelarusian population still have a very favourable view of the centrally planned economy andbelieve that their living standards are equal to those in the European Union. Suchmisconceptions will be harder to maintain once a full blown crisis hits the country, but in themean time, efforts to improve the information about the outside world in general and the EU

in particular should be supported.


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Building analytical capacity to enhance the knowledge of how the Belarusian economy isfunctioning is another area where bilateral support could be envisioned. This will not onlyhelp guide the outside worlds advice in the current situation but will be crucial in formulatinga new economic strategy and evaluate policy options over several years to come.

Multilateral engagement. Belarus may well be facing a balance of payments crisis thatrequires large-scale external assistance in the near future. It is easy to defend a position ofisolating non-democratic and/or corrupt regimes and not provide them with internationalsupport. However, the geographic location of Belarus and its importance as a channel forenergy transports from Russia to the EU makes isolating Belarus a potentially costly choice.Currently Belarus is receiving very limited support from multilateral institutions; includingthe EU, the IMF and the World Bank as well as bilaterally (overall ODA is around 0.2 percentof gross national income). The first issue is to what extent the EU and the developed worldmore generally wants to become a serious alternative to primarily Russia but also Iran,Venezuela and other likeminded countries in times of need. For Belarus, the times of needare now and the needs will continue to grow stronger over the next couple of years absent

more fundamental reform efforts. Sweden and other countries that act in the multilateralinstitutions should already start to develop a policy for how to deal with a Belarus that isfacing a full-blown balance of payments crisis of the type that hit Asia and Russia in 1997-98.

If the Belarus government and the banks accumulate foreign debt in response to increasingcurrent account deficits a currency crisis may come together with a debt and banking crisis.This could prove extremely costly and would require even more external assistance. A seriousproblem with extending loans to an autocratic regime is that debt allows the regime to extractresources not only from the current generation but also from future generations of Belarusiantaxpayers. Loans to autocratic regimes should therefore be avoided unless they come withvery strict conditions and an understanding that they will be written off once a democratic

regime takes over. The latter part is not consistent with IMF lending practices and thus it ishard to see in what form and from what source the support should come if the worst casescenario materializes. Can a crisis with external assistance be used to take the country theIndonesian way or will it end up as an isolated international pariah like Myanmar?

8 Concluding Remarks

Belarus is currently facing a massive term-of-trade shock that poses a serious threat to theeconomy. The administration is currently exploring all its alternatives to avoid devaluing the

currency or undertake real reforms. The strategy is heavily focused on attracting foreignexchange to finance the large and growing current account deficit. This is not an unreasonableimmediate response to the shock but absent real reforms this is also the first steps down a paththat leads to the costly mix of an external debt, currency and banking crisis.

The shock is at the macro level and will require external assistant at that level in a not toodistant future. The Wests policy of not providing support to the leadership of the country willbe put to a test. The strategy of only supporting NGOs, environmental efforts and the mostvulnerable segments of the population can be justified on many grounds. However, this typeof support will not suffice in dealing with a full-blown balance of payments crisis. If nosupport is provided to deal directly with the crisis there will be a need for assistance to

individual households that are adversely affected by the economic crisis.


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References

Becker, T. and P. Mauro (2006), Output drops and the shocks that matter, IMF Working

paper 06/172.

Chubrik, A., D. Kruk, and I. Pelilas, (2006), Major Macroeconomic relationships inBelarusian economy: The result of econometric modeling, IPM Research Center.

Chubrik A., Pelipas I. and E. Rakova, Eds. (2007),Business in Belarus: Status, Trends,Prospects, IPM Research Center Policy Report.

EBRD (2006), Strategy for Belarus.

Economist Intelligence Unit (2006), Country Report for Belarus.

Giucci, R. and R. Kirchner, (2007), Energy Shocks and Macroeconomic Management:Policy Options for Belarus GET Policy Paper, IPM Research Center.

Hajduk, K. and V. Silitski (2007), After the GSP withdrawal: the case for the revision of theEU policy towards Belarus, Belarusian Institute for Strategic Studies (BISS).

IMF country reports on Belarus fromwww.imf.org/external/country/BLR/index.htm.

International Finance Corporation (IFC), (2006), Business Environment in Belarus, Survey ofthe Belarusian SME sector.

IPM Research Center, Belarusian Monthly Economic Review, various issues fromhttp://research.by/eng/publications/.

Lynch, D., Ed. (2005), Changing Belarus.

Rodrik, D., (1996), Where did all the growth go,Journal of Economic Growth, Vol 4, No 4,p 385-412.

World Bank (2006), Belarus: addressing challenges facing the energy sector.

World Bank country reports on Belarus fromwww.worldbank.org.

Zeijlon, A. (2006), Sida: Belarus Country Report, Prospects and Recent Developments.
http://www.imf.org/external/country/BLR/index.htmhttp://www.imf.org/external/country/BLR/index.htmhttp://www.imf.org/external/country/BLR/index.htmhttp://research.by/eng/publications/http://research.by/eng/publications/http://www.worldbank.org/http://www.worldbank.org/http://www.worldbank.org/http://www.worldbank.org/http://research.by/eng/publications/http://www.imf.org/external/country/BLR/index.htm

Belarus Country Report 4b

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