Belarus: Window of Opportunity to Enhance Competitiveness and Sustain Economic Growth

1. Belarus: Window of Opportunity to Enhance Competitiveness and Sustain Economic Growth A Country Economic Memorandum for the Republic of Belarus

2. Major questions • Whether Growth? If Yes, • What are the drivers? How they have being changing over time? • Is it sustainable? What are the major risks? • What could be done about them under the existing political constrains?

3. Outline • Main Message • Analysis of Growth Patterns • Main Policy Weaknesses and Risks • Policy Recommendations

4. Main Message • Recent performance was strong and based on a certain set of competitive advantages • The effect of these advantages has been eroded • Earlier growth drivers weakened, while no replacement has emerged • We expect a slowdown in growth if there is no policy reform • Moreover, the economy is highly vulnerable to external shocks

5. GDP Growth and Poverty Outcomes are impressive

6. Two growth phasesPhase I: 1996-2000 • The expansionist monetary policy that helped to keep the real value of the Belarusian rubel low • The policy of multiple exchange rates that was used as an instrument of hidden targeted support for some exporters and as a tool of taxation for others • The strict policy of wage and price controls that helped to keep production costs low and support cost advantages of traditional exports • The encouragement of barter transactions with Russia, which in combination with multiple exchange rates generated a considerable resource transfer to Belarusian exporters • The active political re-integration with Russia, which resulted in improved market access, ensured preservation of preferable gas import prices, as well as tolerance of energy arrears; it also helped to improve capacity utilization in oil refineries and secure a debt write-off in 1996

7. Cost advantage against Russia

8. Two growth phasesPhase II: 2001 - onwards • Improved macro policies: unified exchange rate, stricter monetary policy, considerable fiscal and quasi-fiscal adjustment, and lower inflation • Energy and utility policy that aimed at attaining full cost recovery in tariffs and strict payment discipline • New wage and income policies that stimulated domestic demand • Phasing out barter, which inter alia helped somewhat accelerate export diversification out of the Russian market • Maintaining its political and administrative effort aimed at the preservation of the Belarusian traditional niche at the Russian market • Improved external environment (oil prices, Russia, etc.) Much healthier growth: more investments and restructuring

9. Cost/wage advantage Expanding share of Russian market, gains from re-integration Wage/income growth High oil prices and strong global growth Restructuring due to competitive pressures Improved capacity utilization Eroding due to the wage/tax policy Share of exports to Russia is too high Limits to future growth due to competitiveness concerns Cannot remain high forever The extent of restructuring is limited Insufficient investments in new capacity Growth Drivers

10. Where will new growth be coming from? …Unclear • Earlier growth drivers (cost/wage advantage vs Russia, Russian post 1998 recovery, expansion in domestic demand, oil processing exports to Europe) will not be able to play the same role in the future • We do not see a big new thing to push growth up • Slow down in growth is quite likely

11. Signs of Strain • Trends in industrial productivity and competitiveness: growing costs, low profits, depressed investments in manufacturing • Low dynamism of export patterns: concentration, no new products, dependence on Russia • Lagging enterprise restructuring: new firms are few and weak • Agriculture: heavy subsidization • Energy: slow reforms will hamper investments and upgrade

12. Growth in ULC Indicates Erosion in Competitiveness

13. Growth is unbalanced

14. Belarus 0.6 0.55 0.54 0.8 0.71 0.72 0.71 0.5 0.7 HI EDI 0.6 0.4 0.50 0.46 0.46 0.45 0.5 0.42 0.39 0.27 0.4 0.3 0.26 0.26 0.3 0.19 0.2 0.2 0.14 0.14 0.14 0.11 0.1 0.1 0.05 0.0 2001 2002 2003 0.0 DX_CIS DX_ROW HI_CIS HI_ROW Belarus Lithuania Ukraine Poland Export Concentration: products

15. Export Concentration: exporters

16. Depressed FDI level imposes constrains on future exports growth

17. Business Registration is too Slow (days)

18. Weak Investment Performance • Investment structure is biased against manufacturing • The bulk of industrial firms (97%): < than 4% of GDP in 1999-2003 • Why? - low profitability - mostly state owned economy - excessive government interventions in credit allocation

19. Incidence of State Support, % of GDP

20. Growing Competitive Pressures % of firms calling competition from import not important

21. Slow enterprise restructuring • Growth has a limited foundation in improvements of economic fundamentals (ownership, new entry, new markets, new skills) • Private sector is weak: no difference in performance between SOEs and private firms • Slow and limited restructuring (unbundling, divestiture, foreign ownership, etc.) – less than in Russia 10 years ago • Acceleration in restructuring is a must to sustain competitiveness. Reforms will be necessary

22. Energy sector • Major success stories: energy efficiency, financial discipline, tariff policy adjustment • Significant medium-term challenges: A. Reducing risks associated with the excessive energy dependence on Russia B. Strengthening the creditworthiness of sector companies C. Maximizing benefits associated with energy transit D. Setting a modern regulatory framework E. Securing adequate financing for the sector

23. Agriculture • Strong growth driven by exchange rate adjustments, a doubling of state support, and improvements in “internal terms of trade.” • Scope of state support is unsustainable, 3-4% GDP • Food processing is chronically inefficient • Directions for reforms: (i) price liberalization and the removal of input subsidies; (ii) more effective targeting of support and enforcing a hard budget constraint, (iii) more decisive farm restructuring, and (iv) a more aggressive FDI policy in the processing sector.

24. Major Macroeconomic Risks • Low international reserves • High dependence on a single and unstable export market (Russia) • High concentration of the economy • Large size of the government • Vulnerabilities in the banking sector • The pension system is unsustainable • Costs of adjustment to future higher prices of Russian energy

25. Economic Policies:not conductive to growth in competitiveness • High cost economy: taxes, interest rates, price controls, costs of administrative interventions • Business environment is difficult for new entry: marginal growth from the new private sector, depressed FDI – diminished opportunities for productivity growth and export expansion • Expensive subsidization: undermines competition • Trade regime: high incidence of NTBs discourages trade and will be a major barrier for global and regional integration

26. Recommendations: • Strengthening market discipline for traditional enterprises: - downsize and restructure existing system of state support - advance trade liberalization to expand international competition - accelerate exit of non-viable firms - harden budget constrains (esp. in the agro-food sector) - ensure financial sustainability and efficiency of the energy sector • Encourage growth by reducing operating costs: - reduce tax burden and reform tax structure - liberalize employment and wage policies - advance price liberalization - reduction regulatory costs of doing business - limit discretionary administrative interference - accelerate reform of standards system - consolidate recent progress towards a stable macroeconomic environment

27. Urgent steps to improve investment image • FDI level: integral measure of reform progress • Measure of progress towards export diversification, enterprise restructuring • New Policy Initiatives: - Expansion of FEZs (Chinese experience) - Several visable privatizations (e.g. banks) - a targeted effort to attract FDI into ffod processing - Setting up an investment promotion agency - De-regulation: trade restrictions, golden share, registration procedures

28. In the longer-term… • The comprehensive reform to sustain growth will be needed sooner or later • Advance liberalization, privatization and de-politization of the economy • Political will be required • Currently, it is a perfect timing to accelerate structural reforms

29. Window of opportunity Favorable conditions for acceleration of structural reforms: • growing economy • positive trends in perceptions of both enterprise and households • favorable global developments • low debt • strong administrative capacity of the state Belarus is well equipped to mitigate potential costs of reforms