2. 1 Belarus: Window of Opportunity to Enhance Competitiveness and Sustain Economic Growth A Country Economic Memorandum for the Republic of Belarus

3. 2 Major questions Whether Growth? If Yes, Whether Growth? If Yes, What are the drivers? How they have being changing over time? What are the drivers? How they have being changing over time? Is it sustainable? What are the major risks? Is it sustainable? What are the major risks? What could be done about them under the existing political constrains? What could be done about them under the existing political constrains?

4. 3 Outline 1. Main Message 2. Analysis of Growth Patterns 3. Main Policy Weaknesses and Risks 4. Policy Recommendations

5. 4 Main Message Recent performance was strong and based on a certain set of competitive advantages Recent performance was strong and based on a certain set of competitive advantages The effect of these advantages has been eroded The effect of these advantages has been eroded Earlier growth drivers weakened, while no replacement has emerged Earlier growth drivers weakened, while no replacement has emerged We expect a slowdown in growth if there is no policy reform We expect a slowdown in growth if there is no policy reform Moreover, the economy is highly vulnerable to external shocks Moreover, the economy is highly vulnerable to external shocks

6. 5 GDP Growth and Poverty Outcomes are impressive

7. 6 Two growth phases Phase I: 1996-2000 The expansionist monetary policy that helped to keep the real value of the Belarusian rubel low 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 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 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 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 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

8. 7 Cost advantage against Russia

9. 8 Two growth phases Phase II: 2001 - onwards Improved macro policies: unified exchange rate, stricter monetary policy, considerable fiscal and quasi-fiscal adjustment, and lower inflation 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 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 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 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 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.) Improved external environment (oil prices, Russia, etc.) Much healthier growth: more investments and restructuring

10. 9 Growth Drivers Cost/wage advantage Cost/wage advantage Expanding share of Russian market, gains from re-integration Expanding share of Russian market, gains from re-integration Wage/income growth Wage/income growth High oil prices and strong global growth High oil prices and strong global growth Restructuring due to competitive pressures Restructuring due to competitive pressures Improved capacity utilization Improved capacity utilization Eroding due to the wage/tax policy Eroding due to the wage/tax policy Share of exports to Russia is too high Share of exports to Russia is too high Limits to future growth due to competitiveness concerns Limits to future growth due to competitiveness concerns Cannot remain high forever Cannot remain high forever The extent of restructuring is limited The extent of restructuring is limited Insufficient investments in new capacity Insufficient investments in new capacity

11. 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 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 We do not see a big new thing to push growth up Slow down in growth is quite likely Slow down in growth is quite likely

12. 11 Signs of Strain Trends in industrial productivity and competitiveness: growing costs, low profits, depressed investments in manufacturing 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 Low dynamism of export patterns: concentration, no new products, dependence on Russia Lagging enterprise restructuring: new firms are few and weak Lagging enterprise restructuring: new firms are few and weak Agriculture: heavy subsidization Agriculture: heavy subsidization Energy: slow reforms will hamper investments and upgrade Energy: slow reforms will hamper investments and upgrade

13. 12 Growth in ULC Indicates Erosion in Competitiveness

14. 13 Growth is unbalanced

15. 14 Export Concentration: products 0.27 0.26 0.11 0.05 0.54 0.55 0.26 0.19 0.0 0.1 0.2 0.3 0.4 0.5 0.6 BelarusLithuaniaUkrainePoland HIEDI

16. 15 Export Concentration: exporters

17. 16 Depressed FDI level imposes constrains on future exports growth

18. 17 Business Registration is too Slow (days)

19. 18 Weak Investment Performance Investment structure is biased against manufacturing Investment structure is biased against manufacturing The bulk of industrial firms (97%): < than 4% of GDP in 1999-2003 The bulk of industrial firms (97%): < than 4% of GDP in 1999-2003 Why? Why? - low profitability - mostly state owned economy - excessive government interventions in credit allocation

20. 19 Incidence of State Support, % of GDP

21. 20 Growing Competitive Pressures % of firms calling competition from import not important

22. 21 Slow enterprise restructuring ownership, new entry, new markets, new skills) 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 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 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 Acceleration in restructuring is a must to sustain competitiveness. Reforms will be necessary

23. 22 Energy sector Major success stories: energy efficiency, financial discipline, tariff policy adjustment Major success stories: energy efficiency, financial discipline, tariff policy adjustment Significant medium-term challenges: 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

24. 23 Agriculture Strong growth driven by exchange rate adjustments, a doubling of state support, and improvements in “internal terms of trade.” 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 Scope of state support is unsustainable, 3-4% GDP Food processing is chronically inefficient 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. 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.

25. 24 Major Macroeconomic Risks Low international reserves Low international reserves High dependence on a single and unstable export market (Russia) High dependence on a single and unstable export market (Russia) High concentration of the economy High concentration of the economy Large size of the government Large size of the government Vulnerabilities in the banking sector Vulnerabilities in the banking sector The pension system is unsustainable The pension system is unsustainable Costs of adjustment to future higher prices of Russian energy Costs of adjustment to future higher prices of Russian energy

26. 25 Economic Policies: not conductive to growth in competitiveness High cost economy: taxes, interest rates, price controls, costs of administrative interventions 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 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 Expensive subsidization: undermines competition Trade regime: high incidence of NTBs discourages trade and will be a major barrier for global and regional integration Trade regime: high incidence of NTBs discourages trade and will be a major barrier for global and regional integration

27. 26 Recommendations: Strengthening market discipline for traditional enterprises: 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: 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

28. 27 Urgent steps to improve investment image FDI level: integral measure of reform progress FDI level: integral measure of reform progress Measure of progress towards export diversification, enterprise restructuring Measure of progress towards export diversification, enterprise restructuring New Policy Initiatives: New Policy Initiatives: - Expansion of FEZs (Chinese experience) - 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

29. 28 In the longer-term… The comprehensive reform to sustain growth will be needed sooner or later The comprehensive reform to sustain growth will be needed sooner or later Advance liberalization, privatization and de- politization of the economy Advance liberalization, privatization and de- politization of the economy Political will be required Political will be required Currently, it is a perfect timing to accelerate structural reforms Currently, it is a perfect timing to accelerate structural reforms

30. 29 Window of opportunity Favorable conditions for acceleration of structural reforms: growing economy growing economy positive trends in perceptions of both enterprise and households positive trends in perceptions of both enterprise and households favorable global developments favorable global developments low debt low debt strong administrative capacity of the state strong administrative capacity of the state Belarus is well equipped to mitigate potential costs of reforms