Belarus Macroeconomic Update Achieving Stability and Growth [Type a quote from the document or the summary of an interesting point. You [ [ [ [ [ [ August 13, 2013 The World Bank Group Executive Summary This note assesses recent macroeconomic developments in Belarus and presents a medium-term economic outlook for 2013-2016 in three scenarios. These scenarios are sensitive to underlying assumptions and are provided to illustrate the main macroeconomic policy choices, available to Belarus. The first scenario (baseline scenario) assumes that the authorities continue macroeconomic policies of the past year, with alternating phases of policy loosening and tightening, motivated by attempts to balance growth and stability. Under this scenario, growth will be tepid at 2.5 percent during 2013, on the back of moderate growth in domestic investment and consumption, which would offset a decline in net exports. While macroeconomic policies under this scenario may succeed in avoiding an outright crisis, we expect vulnerabilities to shocks to intensify even under this baseline scenario. Inflationary pressures would persist, the current account deficit would widen (necessitating additional external debt inflows) and exchange rate and foreign reserve pressures would reemerge. The second scenario (expansionary scenario) assumes that the authorities pursue more aggressive expansionary policies (compared to the baseline scenario) to boost growth in the short term. Prioritizing growth at the expense of stability will reignite macroeconomic imbalances. This scenario – while achieving higher growth rates closer to the targets envisaged in the Government’s medium-term development plan – would create large external financing needs, become destabilizing, and lead to a sharper and hence more painful adjustment later on (possibly repeating the 2011 experience). The third scenario (sustainable growth scenario) assumes that the authorities put in place policies that ensure macroeconomic stability and provide a basis for sustainable growth. This includes a policy framework that (i) maintains the flexible exchange rate regime; (ii) sustains tight monetary policy, namely containing credit growth, including under government directed lending programs to contain inflation and real exchange rate appreciation; (iii) balances wage growth so that it does not exceed productivity growth; (iv) maintains tight fiscal policy and a balanced budget over the medium term. In step with a credible macroeconomic adjustment plan, the scenario assumes that the authorities would move forward with a program of structural reforms to strengthen competitiveness, overcome structural balance of payments problems, and kick start growth in a sustainable way. These three scenarios highlight the main macroeconomic trade-offs that Belarus is facing in the current environment. A weak recovery in Belarus’ main trading partners, combined with declining commodity prices (oil and fertilizer) and tightening liquidity constraints in global financial markets (which will raise financing costs for emerging markets, including Belarus) will constrain the policy choices available to Belarus. In our view, a consistent and sustainable macroeconomic policy framework would be the most appropriate policy response, given Belarus’ precarious external position. This framework should aim at curbing inflationary pressures and containing external imbalances. Higher growth is possible, but rather than achieving it through short-term expansionary policies, Belarus’ growth potential could be lifted through deep structural reforms to strengthen the competitiveness of the economy. This note is organized as follows: Section 1 highlights recent macroeconomic trends; Section 2 provides the three macroeconomic scenarios; and Section 3 provides the Bank’s recommendations for macroeconomic and structural policies. Annex 1 outlines the structural modernization agenda that could support sustainable medium term growth. Annex 2 provides detailed assumptions, underlying the three scenarios. Annex 3 presents the results of simple sensitivity analysis of the potential impact of price declines in potash fertilizer. The World Bank Group | Achieving Stability and Growth 2 Contents Recent Macroeconomic Trends ..................................................................................................................... 4 Macroeconomic Outlook – 2013-2016 .......................................................................................................... 7 Policy implications ....................................................................................................................................... 12 Annex 1. A Structural Modernization Agenda for Belarus .......................................................................... 14 Annex 2. Detailed Assumptions of Macroeconomic Scenarios ................................................................... 19 Annex 3. Possible Impact of Potash Prices Declines.................................................................................... 21 Figures Figure 1: Contributions to GDP growth, in percent ........................................................................................... 4 Figure 2: Growth of merchandise exports and imports, in percent y/y ............................................................ 4 Figure 3: Dollarization levels in the Belarusian economy, percent ................................................................... 5 Figure 4: Interest Rates and Inflation ................................................................................................................ 5 Figure 5: GG Revenues and Expenditure Execution, percent of planned annual budget ................................. 6 Figure 6: Growth of real GDP, real wages and productivity in the economy (Q1 2009 = 1) ............................. 6 Figure 7: Emerging Market Bond Yields ............................................................................................................ 8 Figure 8: Medium Term Scenarios................................................................................................................... 12 Figure 9A: Structural Reform Progress in Belarus has been lagging ............................................................... 14 Figure 10A: Slowing Productivity Growth, especially in State-owned Enterprises ......................................... 15 Tables Table 1: Global Growth Outlook ........................................................................................................................ 8 Table 2: Global Commodity Price Outlook ........................................................................................................ 8 Table 3: Base Scenario. Medium-Term Economic Projections for 2013-2016 .................................................. 9 Table 4: Expansionary Scenario. Medium-Term Economic Projections for 2013-2016 .................................. 10 Table 5: Sustainable growth scenario. Medium-Term Economic Projections for 2013-2016 ......................... 11 Table 6: Results of Sensitivity Analysis of Potash Prices , percent of GDP ...................................................... 21 This note was prepared by a team comprising Sebastian Eckardt, Kiryl Haiduk and Maryna Sidarenka with guidance from Lalita Moorty, Yvonne Tsikata and Qimiao Fan. The team is grateful to the Presidential Administration, Ministry of Economy, Ministry of Finance, Belstat and the National Bank, Belarusian research institutions, and Ruslan Piontkivsky for the productive and open discussions during the preparation of the note. The World Bank Group | Achieving Stability and Growth 3 Recent Macroeconomic Trends Real Economy – Domestic Demand Led Growth During H1’13, GDP grew by 1.4 percent, as domestic demand expansion offset sharply declining export performance. A severe decline in industrial production, including of oil refining, contributed negatively to growth (-1.2 percent). Manufacturing declined by -4.2 percent (y/y), accompanied with increased stockpiling of unsold goods (reaching almost 80 percent of monthly output at the end of June). Agricultural output growth remained sluggish at 1.5 percent y/y. These declines were partially offset by increase in retail trade (18.8 percent y/y, with 1.1 percent contribution) which was boosted by rising real wages and incomes (20.6 and 21.5 percent, respectively). Investments in fixed capital also picked up (8.8 percent y/y), mainly driven by statistical base effects (as investment contracted substantially during H1’12) and rising public investment in the construction sector. Figure 1: Contributions to GDP growth, in percent Source: World Bank Staff Estimates based on Belstat data External Sector –The Return of the Current Account Deficit Current account pressures have reemerged as a Figure 2: Growth of merchandise exports and imports, result of a sharp contraction of net exports. in percent y/y After exceptionally strong export growth – especially during the first half of 2012 – foreign trade has reverted back to more typical patterns during the initial months of 2013. Net exports declined sharply during Jan-May’13, due to statistical base effects and weak external demand. From January to May, merchandise exports and imports were both on a declining trend, but exports declined (25 percent y/y) at twice the rate of imports (12.2 percent y/y). Exports of oil products (which account for almost 32 percent in total merchandise exports) dropped by 29 percent y/y in nominal terms. Source: World Bank Staff Estimates based on Belstat data Exports of potash fertilizers (6.4 percent in total exports) decreased by 11 percent on the back of decline of average nominal prices. Exports of major manufacturing goods, such as trucks and tractors declined by 39 and 24 percent respectively, due to weak The World Bank Group | Achieving Stability and Growth 4 external demand. Over the same period, non-energy imports surged by 17 percent, supported by strong domestic demand growth. As a result, the merchandise trade deficit widened to USD 900 mn (1.4 percent of GDP in Jan-May’13), returning the overall trade balance to deficit, and exacerbating pressures on the current account. This alongside interest payments and net payments on custom duties on refined oil products within the customs union – widened the current account deficit to around 11 percent of GDP in H1’13. External financing needs were met by external borrowing, including USD 880 mn disbursement of the fourth and fifths tranches from the EurAsEc ACF (bringing the total disbursement to USD 2.56 bn out of the USD 3 bn commitment), which helped to stabilize foreign exchange reserves at USD 6.4 bn (end of June’13). However, low reserve coverage – at less than two months of imports and only 40 percent of external debt-service payments due in the next year – remains a major cause for concern. Monetary and Exchange Rate Policies – Slowing Inflation, but Continued Real Exchange Rate Appreciation In an effort to balance monetary stability and Figure 3: Dollarization levels in the Belarusian economic growth, the National Bank has pursued economy, percent stop-and-go monetary policy. In response to worse 80 than expected economic performance during the 60 initial months of 2013, the refinancing rate was cut to 23.5 percent (down from 30 percent at the 40 beginning of the year). Domestic credit growth 20 continues to expand rapidly at 15.3 percent real 0 credit growth (y/y end of June). Inflation – while Jun-13 Dec-09 May-09 Apr-12 Oct-08 Sep-11 Jan-07 Aug-07 Mar-08 Jul-10 Feb-11 Nov-12 continuing to ease - remains in double digits at 18 percent y/y in June’13. Moreover, high foreign exchange deposits (at about 59 percent of total % of deposits in FX FCD to M3 deposits as of July 1’13) signal persistently high inflation and devaluation expectations. Demand for Source: World Bank Staff Calculations based on NBRB Data foreign cash increased by 23 percent while supply decreased by 12.4 percent (July’13 to June’12). Since the beginning of the year, the Belarusian ruble depreciated against the USD in nominal terms by 3.62 percent. Yet, with domestic inflation exceeding that of trading partners, the trend for real exchange rate appreciation remains, although the pace slowed by mid-2013. While in March’13, RER appreciated by almost 14 percent as against March’13, in June’13 – by 5.3 percent. Over the year, RER appreciation might reach 7 percent, eroding the competitiveness gained in the 2011 devaluation. Figure 4: Interest Rates and Inflation Source: World Bank Staff Estimates based on NBRB data The World Bank Group | Achieving Stability and Growth 5 Fiscal Policy – Revenues Shortfalls and Expenditure Containment Figure 5: GG Revenues and Expenditure Slowdown in economic activity and decline in Execution, percent of planned annual budget exports resulted in revenue shortfalls (compared to 80 H1'2013 the planned budget), but measures to contain 70 expenditures achieved a small budget surplus during 60 H1'2012 the first half of 2013. The economic slowdown 50 40 resulted in a real contraction of profit tax and taxes 30 on international trade which declined by 3.2 and 14.2 20 percent y/y, respectively. These declines were 10 partially offset by strong growth in excises (by 30 0 percent y/y), fuelled by rate increases and Excises VAT Wages and salaries PIT expenditures Total revenues Taxes on foreign Total expenditures consumption growth as well as in personal income Capital trade taxes (by 23 percent y/y), which benefited from strong wage growth. Overall revenues increased by 9 percent y/y in real terms, but remained below targets envisaged in the budget. On the expenditure side, the higher than expected refinancing rate resulted in Source: World Bank Staff Calculations based on Ministry of higher spending on interest rate subsidies (compared Finance data to the original budget), but the MOF took steps to balance the budget by containing growth of capital expenditures. Tariff increases in the economy in January and April raised the wage bill, which was partially offset by employment cuts in the civil service. Overall, expenditure grew by 9.7 percent (remaining below the budget plans), resulting in a surplus of 0.9 percent of GDP H1’13 (down from 1.1 percent during the same period of the last year). Income Policies – Eroding Competitiveness Figure 6: Growth of real GDP, real wages and Real wages continue to grow much faster than labor productivity in the economy (Q1 2009 = 1) productivity. In the first half of 2013, the government increased the first grade tariff rate (which is the base rate for setting wages in the budgetary sector) twice in nominal terms, by 7 percent from January 1’13 and by 4 percent from April 1’13. As a result, in January-May real wages in budgetary sector increased by 6.3 percent y/y. Wages in the rest of the economy grew at a staggering 21.5 percent during H1’13,. This rapid real wage growth (far above the productivity growth rate of 3.5 percent during H1’13), is adding significant cost pressures, fueling inflation, and undermining competitiveness of the Belarusian economy. Source: World Bank Staff Estimates based on Belstat data The World Bank Group | Achieving Stability and Growth 6 Macroeconomic Outlook – 2013-2016 In this section, we present three macroeconomic scenarios, covering the period 2013 to 2016. The base scenario assumes continuation of current macroeconomic policies, characterized by gradual policy loosening to support higher growth, with inconsistent attempts to reduce external imbalances and to pursue price stability. The second scenario illustrates the harmful consequences of a more aggressive expansionary policy mix, where increasing short-term growth becomes the overriding objective of macroeconomic policy. The third scenario highlights the likely impact of stability oriented policies, aimed at rebuilding resilience and mitigating macroeconomic risks in a challenging global economic environment. All three scenarios are based on the same assumptions regarding developments in the external environment, which are summarized in Box 1. In line with recent projections by the IMF and World Bank, we expect that global output will continue to expand tepidly over the coming years. Most recent growth forecasts for both Russia and the EU – the main export market for Belarus – were revised downwards. In addition, the expected monetary tightening in the US is expected to be associated with tightened global liquidity and reversals of capital flows to emerging markets. This will complicate issuance of external debt, including Eurobonds. In addition to the weak global outlook, Belarus’ exports are expected to come under intensified competition in the Russian market, due to Russia’s WTO accession. The World Bank Group | Achieving Stability and Growth 7 Box1: External Environment: Global growth prospects- More stable, but lower growth External demand has been slowing and is expected to remain weak. The global economy appears to be entering a period of less volatile, but slower growth. Global GDP is projected at 2.2 percent for 2013, slightly below the 2012 level, and expected to accelerate thereafter. Growth will be particularly sluggish in high-income countries, where growth is expected at modest 1.2 percent this year, with a continued recession in the Euro area partially offsetting the stronger than expected recovery of the US economy. The projected modest growth acceleration in high-income countries in 2014 and 2015 together with more stable external conditions is expected to propel developing-country growth to 5.6 and 5.7 percent in 2014 and 2015. Table 1: Global Growth Outlook 2012 2013 2014 2015 World Economy 2.3 2.2 3.0 3.3 Russia 3.4 2.3 3.5 3.9 EURO Area -0.6 -0.6 0.9 1.5 Source: World Bank Global Economic Prospects Global Financial Markets – Tightening Liquidity and Reversal of Capital Flows Figure 7: Emerging Market Bond Yields With the end of quantitative easing in the US, global financial markets are expected to enter a period of tight liquidity. The expected monetary tightening in advanced economies, most importantly the US, have weakened capital flows to emerging markets and pushed up yields on the bonds of low- and middle- income countries. Yields on high-spread emerging market sovereign debt have risen by about 100 bps and rates on Belarus Euro bonds are up 200 bps since May. Going forward, global liquidity is expected to tighten further as a result of the end of quantitative easing in the US, forcing emerging markets, especially those with persistent inflationary pressures and high external financing needs to raise interest rates, even at the expense of growth. Global Commodity Markets – Easing Oil and Fertilizer Prices Weak global economic growth is expected to depress commodity prices during the remainder of the year and over the medium term. Oil prices remained within a tight band around $105/bbl over the past 18 months. Price increases in early 2013 reflected problems in the Middle East and improving global outlook prospects. However, as supply conditions improved and growth prospects weakened, prices began falling. Crude prices are now 5 percent lower than at the beginning of 2013. Oil prices are expected to average $101/bbl in 2013, down from $105/bbl in 2012. Fertilizer prices have also been falling as result of weak demand. In addition, the recent decision by URALKali to exit from the BPC cartel is expected to result in potash prices to fall sharply. Simple sensitivity analysis shows that the price declines of 25 percent would reduce Belarus’ exports by 1.0-1.3 percent of GDP annually, depending on the scenario and year (see Annex 3 for results). Table 2: Global Commodity Price Outlook 2012 2013 2014 2015 Crude oil, avg, spot, $/bbl 105.0 102.4 101.7 101.0 Potash Fertilizer, $/ton 467 445 445 - Source: World Bank Global Economic Prospects The World Bank Group | Achieving Stability and Growth 8 Continuation of Current Macroeconomic Policies may Prop up Growth in the Short Run, but would Build up Significant Macroeconomic Vulnerabilities (Base Case scenario) Under the base case scenario, growth is expected to be around 2.5 percent during 2013, mainly driven by domestic demand expansion to offset weak export performance. This assumes further easing of credit conditions to fuel investment and continued wage increases to support consumption, particularly ahead of the elections in 2015. Weak external demand, particularly in Russia, along with real exchange rate appreciation, would further contribute to deterioration of Belarus’ external position to 7.8 percent of GDP in 2013. We expect inflationary pressures to intensify during the second half of 2013, as the rate of nominal Ruble depreciation is likely to pick up. Over the projection period, we expect inflation to remain above 15 percent. Even in the baseline case, a widening current account deficit would require foreign direct investment at the level of at least USD 2.5 bn along with additional borrowing, including outstanding disbursements of EurAsEc ACF and issuance of Eurobonds or similar obligations. Macro-economic vulnerabilities would intensify, mirrored in persistent inflationary pressures, widening of the current account (necessitating additional external debt inflows) and reemerging exchange rate and foreign reserve pressures. The policy framework, even in the base case would not be resilient to internal or external shocks (for example, in case tightening of external liquidity and risk averseness of international investors would constrain access to external liquidity). External imbalances and exchange rate pressures would worsen over time, eventually requiring an adjustment in macroeconomic policies. Table 3: Base Scenario. Medium-Term Economic Projections for 2013-2016 2013 2014 2015 2016 Nominal GDP, BRB billion 637872 755560 903649 1092964 Real GDP, % growth 2.5 3.0 4.0 2.5 Consumption, % growth 12.8 2.6 4.7 0.0 Investment, % growth 7.0 1.5 4.0 -2.4 Export of Goods and Services, % growth -4.3 2.9 2.7 3.9 Import of Goods and Services, % growth 3.2 2.0 3.3 -0.5 CPI, % eop growth 16.7 15.3 16.2 17.6 Current Account Balance, % GDP -7.8 -8.2 -9.3 -8.2 Terms of Trade, % change -0.2 -0.5 0.0 0.1 General Government Revenues, % GDP 39.6 39.8 39.6 39.6 General Government Expenditures, % GDP 39.9 40.4 40.4 40.7 General Government Balance, % GDP -0.3 -0.6 -0.8 -1.1 Foreign Reserves (excl. gold), months of imports 1.5 1.3 1.0 1.4 External debt, % GDP 54.2 56.4 56.3 65.4 PPG debt, % GDP 31.5 29.1 27.9 28.4 IMF SBA (net credit), % GDP -2.4 -1.9 -0.1 0.0 Source: World Bank Staff Estimates The World Bank Group | Achieving Stability and Growth 9 More Aggressive, Expansionary Policies may succeed in Boosting Short-Term Growth, but will be Unsustainable (Expansionary scenario) The expansionary scenario assumes that achieving higher growth will become the overarching objective of macroeconomic policies, even if it results in macroeconomic instability. Prioritizing growth at the expense of stability would reignite macroeconomic imbalances and will be self-defeating. Given the weak external outlook, higher growth targets could only be reached through domestic consumption and investment growth, which would require further loosening of monetary and fiscal policies, compared to the baseline. GDP growth would accelerate reaching 6.5 in 2015, supported by higher investment and consumption growth than in the base case scenario. Growth would be higher than in the baseline, but so would be external imbalances and financing needs, implying either heavier reliance on external debt instruments or the use of available forex reserves. External debt to GDP will increase to 74.2 percent by 2016 (compared to 65.4 percent in the base scenario). However, we assume that external liquidity constraints will not allow sufficient financing of external financing needs, even if substantial FDI inflows and additional external debt were to materialize. This would trigger mounting pressures that would intensify in 2015/16 and eventually induce a sharper and therefore more harmful adjustment. Table 4: Expansionary Scenario. Medium-Term Economic Projections for 2013-2016 2013 2014 2015 2016 Nominal GDP, BRB billion 640984 797015 1018585 1281992 Real GDP, % growth 3.0 4.5 6.5 1.5 Consumption, % growth 12.5 6.7 11.4 0.0 Investment, % growth 10.0 3.5 5.0 -11.1 Export of Goods and Services, % growth -4.3 2.7 1.9 4.7 Import of Goods and Services, % growth 3.6 4.2 5.7 -2.5 CPI, % eop growth 19.3 19.7 21.2 27.3 Current Account Balance, % GDP -8.0 -9.6 -12.0 -11.3 Terms of Trade, % change -0.2 -0.6 0.0 0.2 General Government Revenues, % GDP 39.7 39.8 39.6 39.6 General Government Expenditures, % GDP 39.9 41.2 41.8 42.5 General Government Balance, % GDP -0.3 -1.4 -2.1 -3.0 Foreign Exchange Reserves (excl. gold), Months of Imports 1.2 0.8 0.6 1.0 External debt, % GDP 52.4 51.7 52.3 74.2 PPG debt, % GDP 31.5 28.5 26.4 28.9 IMF SBA (net credit), % GDP -2.4 -1.8 -0.1 0.0 Source: World Bank Staff Estimates The World Bank Group | Achieving Stability and Growth 10 Sound Macroeconomic Management may Imply Lower growth in the Short Term, but Mitigates Macroeconomic Risks and Underpins Sustainable Medium-Term Growth (Sustainable Growth scenario) The sustainable growth scenario assumes policies to secure macroeconomic stability combined with structural reforms to boost competiveness. This scenario assumes that monetary and fiscal policies will remain tight over the projection period, even if this means somewhat lower growth in the short run. Credit and wage growth would be contained and domestic demand would therefore only expand gradually. Inflationary pressures would subside, which combined with flexible exchange rate will avoid real exchange rate appreciation. This would contain external imbalances and reduce external financing needs. Debt levels would stabilize and external reserves would be rebuilt. Meanwhile, accelerated structural reforms would kick start growth by strengthening competitiveness, especially of non-commodity exports. Growth will be higher and more sustainable in the outer years, allowing Belarus to take advantage of the projected recovery in global demand. Table 5: Sustainable growth scenario. Medium-Term Economic Projections for 2013-2016 2013 2014 2015 2016 Nominal GDP, BRB billion 618623 715122 810233 914565 Real GDP, % growth 2.0 2.3 3.0 3.6 Consumption, % growth 9.3 0.8 1.7 1.9 Investment, % growth 6.3 0.6 0.7 2.4 Export of Goods and Services, % growth -3.5 3.6 3.8 3.8 Import of Goods and Services, % growth 1.6 1.6 1.7 2.0 CPI, % eop growth 14.4 11.7 9.2 8.8 Current Account Balance, % GDP -6.4 -6.2 -5.8 -5.7 Terms of Trade, % change -0.2 -0.5 0.0 0.1 General Government Revenues, % GDP 39.7 39.8 39.6 39.6 General Government Expenditures, % GDP 39.4 39.7 39.6 39.5 General Government Balance, % GDP 0.3 0.1 0.1 0.1 Foreign Reserves (excl. gold), months of imports 1.5 1.6 1.8 2.0 External debt, % GDP 56.1 57.7 58.2 57.8 PPG debt, % GDP 31.5 29.8 28.1 26.8 IMF SBA (net credit), % GDP -2.5 -2.0 -0.1 0.0 Source: World Bank Staff Estimates The World Bank Group | Achieving Stability and Growth 11 Policy implications The scenarios presented in this note illustrate the main trade-off between economic growth and macroeconomic stability. With global growth and therefore external demand expected to remain weak, Belarus’ economic outlook in the short run will depend mostly on domestic demand. A weak recovery in Belarus’ main trading partners, combined with easing commodity prices and tightening liquidity constraints (which will raise financing costs for emerging markets, including Belarus), will constrain the policy choices available to Belarus. Achieving higher growth in the short run is unlikely without boosting domestic demand, but looser macroeconomic policies would heighten the risk of a renewed bout of policy induced instability. Figure 8: Medium Term Scenarios GDP Growth CPI Inflation (y/y, percent change) (eop) 30.0 7.0 Adjustment 6.0 25.0 Expansionary 5.0 Base 20.0 4.0 15.0 3.0 10.0 Adjustment 2.0 Expansionary 1.0 5.0 Base 0.0 0.0 2013 2014 2015 2016 2013 2014 2015 2016 Current Account Balance (percent of GDP) External Debt 0.0 80.0 (percent of GDP) Adjustment -2.0 Expansionary 75.0 Adjustment Base 70.0 Expansionary -4.0 Base 65.0 -6.0 60.0 -8.0 55.0 -10.0 50.0 -12.0 45.0 -14.0 40.0 2013 2014 2015 2016 2013 2014 2015 2016 Source: World Bank Staff Estimates In our view, a consistent, macroeconomic policy framework, aimed at curbing inflationary pressures and containing external imbalances would be the most appropriate policy response, given Belarus’ precarious external position. Given the weak external environment, pursuing a high growth rate through domestic demand stimulation is not only unrealistic, but also harmful for living standards and medium-term prosperity of the country. In contrast, a consistent, medium term macroeconomic plan would help strengthen credibility and attract financing, especially in the context of significant external debt refinancing needs over the coming years. The key parameters of this policy framework would be (i) maintaining the The World Bank Group | Achieving Stability and Growth 12 flexible exchange rate regime; (ii) sustained tight monetary policy, namely containment of credit growth, including under government directed lending programs; (iii) balanced wage growth not exceeding productivity growth; (iv) maintaining fiscal policy and a balanced budget over the medium term. A credible, realistic and consistent macroeconomic framework would reassure markets and citizens, while anchoring expectations and thereby reinforcing stability. Communication of the Government’s plans and macroeconomic policies will be a key to aligning expectations of citizens (and markets) to the new economic reality, which will most likely be characterized by lower growth. Especially, the practice of stating ambitious wage growth targets in US Dollar terms is not only fueling devaluation expectations but also feeds perceptions of inconsistent macroeconomic policies, and therefore contributes to uncertainty. While a sustainable macroeconomic framework is needed, overcoming the structural balance of payment problems in Belarus will require a structural transformation of the economy and strengthening of competitiveness, in particular of the tradables sector. Increasing Belarus’s competitiveness requires productivity-led growth, which in turn implies a reallocation of labor and capital to high productivity segments, restructuring of the SOE sector, and implementation of reforms to support the private sector development. Therefore, the current situation offers an opportunity to undertake comprehensive, sequenced structural reforms that will lay the foundation for sustained, long-term growth and also allow Belarus to reap the full benefits of the intended membership in WTO. The main elements of such a structural modernization program would comprise: (i) further liberalization of product and factor markets; (ii) transformation and modernization of state owned sector; (iii) creating the environment for vibrant private sector growth. A more detailed set of structural policy recommendations is provided in Annex 1. The World Bank Group | Achieving Stability and Growth 13 Annex 1. A Structural Modernization Agenda for Belarus While macro-economic imbalances have been excerbated by the global economic slow down, they have deep structural roots in Belarus’ state driven growth model. Belarus has pursued a gradual economic transition with limited structural reforms. While these policies have avoided some of the social costs of restructuring, they have created serious vulnerabilities. Overall structural reforms have been slow and piecemeal compared to many other transition economies (Figure 9A). Figure 9A: Structural Reform Progress in Belarus has been lagging 4.0 Privatization 3.0 Competition Policy 3.5 2.5 3.0 2.0 2.5 2.0 1.5 1.5 1.0 1.0 Transition Economies Average Transition Economies Average 0.5 0.5 Belarus Belarus 0.0 0.0 1991 1993 1995 1989 1997 1999 2001 2003 2005 2007 2009 2011 2009 1989 1991 1993 1995 1997 1999 2001 2003 2005 2007 2011 3.0 Enterprise Restructuring 5.0 Price Liberalization 2.5 4.0 2.0 3.0 1.5 2.0 1.0 Transition Economies Average 1.0 Transition Economies Average 0.5 Belarus Belarus 0.0 0.0 1993 2003 1989 1991 1995 1997 1999 2001 2005 2007 2009 2011 1991 1997 2003 2009 1989 1993 1995 1999 2001 2005 2007 2011 Source: EBRD Transition Indicators Note: Transition Economies Average includes values of 28 transition economies, tracked in the EBRD transition indicators. Reported privatization indicator reflects the average of the indicators on large and small scale privatization. Dependence on energy and resource intensive exports and underpriced energy imports from Russia: Imports of mineral products, including crude oil and natural gas account for 38.3 percent of the country’s total imports, while mineral exports, mainly of refined oil products account for about 36 percent of total exports (2012). Belarus continues to import natural gas and crude oil from Russia at below world market prices. While these underpriced energy imports have spurred economic growth, they expose the country to increased commodity price volatility and risks associated with the negotiation of energy trade agreements with Russia. Slowing productivity growth: At the same time, productivity growth in non-energy sectors has been stagnating, especially in the state-owned sector. Aggregate productivity growth has been on a declining trend since 2004 (Figure 10A). While productivity growth contributed over one-half of GDP growth in 2000– The World Bank Group | Achieving Stability and Growth 14 04, it represented only 24 percent of overall growth in 2010. Moreover, SOEs not only tend to have lower levels of total factor productivity, but their productivity also increases at a slower pace than comparable private sector enterprises, reflecting less efficient use of factors of production in the state owned sector. Figure 10A: Slowing Productivity Growth, especially in State-owned Enterprises Total Factor Productivity Total Factor Productivity 5% 7 0.25 TFP Levels 6 TFP Growth Rates 0.20 0.2 4% 5 4 0.15 3% 3 5.8 0.1 4.7 2% 2 0.05 1 0.04 1% 0 0 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010 State-owned firms Non-state-owned firms Source: World Bank Staff Estimates, based on Belstat and NBRB data Loss in competitiveness: Rapid growth in real wages has outpaced labor productivity growth, periodically creating cost pressures and undermining competitiveness. Real wages more than tripled during 2000–2011. These internal cost pressures were compounded by the fixed exchange rate regime, which de facto prevailed until 2011, and which was associated with a steady real exchange rate appreciation. At the same time, the wage gap between Belarus and Russia is widening. With the free movement of labor within the Single Economic Space, persistent wage differentials will likely induce brain drain and migration, especially of skilled workers. Skill shortages are noted by private businesses, including dynamically evolving IT sector. Out-migration is also amplifying aging related challenges in the pension system of Belarus. Coupled with stability-oriented macroeconomic management, deep and accelerated structural reforms are required to correct economic imbalances and lift Belarus’ growth potential. Increasing Belarus’s competitiveness requires productivity-led growth, which in turn implies a reallocation of labor and capital to high productivity segments, restructuring of the SOE sector, and implementation of reforms to support the private sector. In addition to accelerating liberalization and privatization to bring strategic investment, both financially and in terms of production technologies, this will entail changes in the incentive structure of SOEs to ensure efficient employment of both capital and labor. Incentives of SOE managers have to be changed from merely ‘absorbing’ investment to more efficient, performance-based utilization of resources, and to adapt to changes in demand and supply. Belarus’s intention to join the WTO offers an important opportunity to accelerate structural reforms to strengthen the competitiveness of the economy. To reap the full benefits of WTO membership, Belarus will not only need to commit to liberalize trade in goods and services, but also more generally to promote competition and to implement further WTO-conforming economic reforms. This will have implications across a range of structural policies, including state aid and subsidies, regulation of foreign direct investment, liberalization of service sectors, and competition policy. The table below summarizes the main structural policy options. The World Bank Group | Achieving Stability and Growth 15 Table 1A. Structural Modernization Policy Options Policy Area Policy Recommendations Expected Impact Timeframe Liberalizing product and factor markets Removing  Reduce the number of socially-important goods and services with Reduced distortions in product markets. Short-term Price Controls regulated prices. Financial viability of utilities, fiscal savings, in Product  Gradually increase utility tariffs for households to increase cost incentives to reduce energy consumption. Short- Markets recovery levels. Medium-term  Liberalize labor markets by removing wage targets and administrative Increased productivity through reallocation Short-term controls on wages and employment level for all economic agents of labor from less to more productive including SOEs in which the government has a controlling stake and in sectors and firms. enterprises that receive state support.  Strengthen unemployment benefits and safety nets to mitigate risks Short-term associated with more dynamic labor markets. Simplify the Facilitating a requirements for unemployment registration and eliminate the Transition in obligation to participate in paid public works to receive Labor Market unemployment benefits. The unemployment benefit should be extended to workers without employment for no longer than the first six months. The cap for the unemployment benefit should be redefined to provide a minimum level of income for the unemployed.  Establish a proper unemployment insurance mechanism. Medium-term  Reform active labor market policies to support skill development and Short-term job creation in the private sector.  Phase out Government directed lending through state-owned Better allocation and increased returns to Short-term commercial banks and give these banks full autonomy to decide on capital. their lending portfolios.  Foster competition, and enhance corporate governance in the Short-term Reducing banking system, including clear lines of accountability, a greater focus Distortions in on performance throughout management, and independent Capital management boards. Allocation  Reduce government ownership and encourage foreign investment in Medium-term the Banking sector.  Expand channels of non-bank funding of the economy through the Medium-term development of capital markets and non-depository financial The World Bank Group | Achieving Stability and Growth 16 institutions (such as microfinance and housing finance). Transforming SOE Sector Enhance  Eliminate the system of quantitative targets to ensure decision- More efficient and commercially oriented Short-term incentives for making autonomy of SOE managers regarding the mix of inputs, level SOE sector. Incentives for SOEs to SOE managers of prices outputs, and markets. modernize, maximize profitability, and Short-term through  Introduce a time-bound plan to phase out soft budget constraints enhance productivity. Fiscal savings from Improved through reforms of state support programs in compliance with WTO reduced industrial subsidies. Corporate requirements. Governance  Restructure vertically integrated SOEs by bringing strategic investors Medium-term to the top-of the-chain companies and privatize the feeder companies.  Introduce genuine performance-based contracts for SOEs managers, Short-term delinked from the quantitative targets system. Creating Environment for Development of a Vibrant Private Sector  Reduce the cost of exit by enacting a modern Bankruptcy Law. More rapid development of private sector, Short-term  Strengthen property and investor rights legal frameworks (land and especially SME. Short-term Improve the real state, IPR) and their enforcement in the courts (recent Business investment law). Environment  Reduce the burden of taxes, state controls and inspections on Short-term businesses.  Strengthen the framework for competition (Competition Law and Short-term Institutionalization of Competition Council).  Privatization should be aimed at investors that bring advanced Modernization of enterprise sector, Medium-term technology and modern management practices. increased inflow of FDI through Establish a  Non-core sectors such as agriculture, food processing, privatization. process for pharmaceuticals, and light manufacturing are suitable sectors to implementing launch competitive and transparent privatizations. competitive  Core machine building enterprises (“top of the chain”) could also be and sold to strategic investors in tandem with the sale or the restructuring transparent of their “feeder companies”. privatization  NIPA should be the main vehicle for privatization and ensure a transparent process.  Relieve new owners/investors from maintaining recommended levels of employment or carrying on any social responsibilities in privatized The World Bank Group | Achieving Stability and Growth 17 SOEs.  Simplify regulations to entry and growth of services sector. Increased share of services sector in Medium-term Support  Divest non-core assets and non-core functions from SOEs, such as employment and incomes. development accounting. of the services  Assure equal access to resources, including bank loans, land, sector, infrastructure for service enterprises. including  Encourage the creation of an efficient infrastructure for services business development, ICT, transport and logistics. services  Expand private participation in utilities, banking, telecommunications, transport and logistics. Improve  Pursue further trade liberalization to expose local producers to More competitive and diversified tradable Short- Export international competition, especially for trade in services. goods and services. Medium-term Competitiven  Advance WTO accession process. ess and  Adopt EU harmonized standards across the board, including sanitary Enhance and phyto-sanitary standards. Integration in  Improve the incentives for collaboration between state R&D Global institutions and the private sector. Markets The World Bank Group | Achieving Stability and Growth 18 Annex 2. Detailed Assumptions of Macroeconomic Scenarios Baseline Scenario 2013 2014 2015 2016 External demand (% Change) Global GDP 2.20 3.00 3.30 3.70 Russia GDP 2.30 3.50 3.90 4.50 EU GDP -0.60 0.90 1.50 2.00 Export Prices (USD) Oil Price, barrel 102.4 101.7 101.0 101.0 Natural Gas Price, thousand cub.meters 165.0 165.0 165.0 165.0 Potash Price, ton 467.0 445.0 445.0 445.0 Exchange Rates Nominal Exchange Rate (Devaluation Rate p.a.) 8.50% 15.00% 10.00% 25.00% Real Exchange (% Change) -6.0% 0.9% -0.9% 3.4% Financing Net FDI (Million, US$) 2500.0 2500.0 2500.0 2500.0 Net Long Term Debt Disbursement (Excluding IMF) 4988.8 3674.4 3044.1 4800.3 Net Short Term Debt Disbursement 350.0 400.0 500.0 750.0 Net IMF Credit -1658.1 -1360.0 -84.0 0.0 Change in Reserves 882.1 -534.4 -1107.1 1222.9 Expansionary Scenario 2013 2014 2015 2016 External Demand (% Change) Global GDP 2.20 3.00 3.30 3.70 Russia GDP 2.30 3.50 3.90 4.50 EU GDP -0.60 0.90 1.50 2.00 Prices (USD) Oil Price, barrel 102.4 101.7 101.0 101.0 Natural Gas Price, thousand cub.meters 165.0 165.0 165.0 165.0 Potash Price, ton 467.0 445.0 445.0 445.0 Exchange Rate Nominal Exchange Rate (Devaluation Rate p.a.) 14.04% 13.95% 10.31% 46.24% Real Exchange (% Change) -2.49% -4.19% -8.77% 19.00% Financing FDI (Million, US$) 2500.0 2500.0 2500.0 2500.0 Net Long Term Debt Disbursement (Excluding IMF) 3780.0 3328.9 4401.7 5279.6 Net Short Term Debt Disbursement 250.0 500.0 750.0 500.0 IMF Credit -1658.1 -1360.0 -84.0 0.0 Change in Reserves 967.8 -629.2 -1784.8 998.7 The World Bank Group | Achieving Stability and Growth 19 Sustainable growth scenario 2013 2013 2014 2016 External Demand (% Change) Global GDP 2.2 3.0 3.3 3.7 Russia GDP 2.3 3.5 3.9 4.5 EU GDP -0.6 0.9 1.5 2.0 Prices (USD) Oil Price, barrel 102.4 101.7 101.0 101.0 Natural Gas Price, thousand cub.meters 165.0 165.0 165.0 165.0 Potash Price, ton 467.0 445.0 445.0 445.0 Exchange Rate Nominal Exchange Rate (Devaluation Rate p.a.) 12.5% 14.0% 9.0% 8.0% Real Exchange (% Change) 0.0 0.0 0.0 0.0 Financing FDI (Million, US$) 2500.0 2500.0 3000.0 4000.0 Net Long Term Debt Disbursement (Excluding IMF) 3689.2 3364.2 2162.8 1875.5 Net Short Term Debt Disbursement 0.0 100.0 150.0 150.0 IMF Credit -1658.1 -1360.0 -84.0 0.0 Change in Reserves 547.9 640.5 1202.3 1853.9 The World Bank Group | Achieving Stability and Growth 20 Annex 3. Possible Impact of Potash Prices Declines The impact of the recent decision of URALkali to exit from the BPC price cartel on potash prices and production volumes is still unfolding. Initial market reactions resulted in share prices of main Potash producers to lose between 20-30 percent during July 29-31 2013 after the URALKali announcement. It is likely that prices will drop more significantly than envisaged in price assumptions underlying our projections. In order to assess the likely impact of sharper price declines we conducted a simple sensitivity analysis, assuming -25% and -37.5% price declines. Depending on the magnitude of price decline and the scenario realized, this would result in export contraction, equal to 1-2.4 percent of GDP, adding to the current account deficit. The table below shows the detailed results. Table 6: Results of Sensitivity Analysis of Potash Prices , percent of GDP 2013 2014 2015 2016 25% 37.5% 25% 37.5% 25% 37.5% 25% 37.5% Base -1.0 -1.8 -1.0 -1.9 -1.1 -2.0 -1.1 -2.1 Expansionary -1.0 -1.8 -1.0 -1.8 -0.9 -1.7 -1.2 -2.2 Adjustment -1.0 -1.9 -1.1 -2.0 -1.2 -2.1 -1.3 -2.4 Source: World Bank Staff Estimates The World Bank Group | Achieving Stability and Growth 21