SITE Country Report:1

Belarus

Abstract: During this year a number of key ingredients at the heart of explaining the recent strong growth performance of Belarus have changed dramatically. In particular, the increased cost of natural gas and reduced oil revenues due to new trade arrangements with Russia will have a substantial 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 Belarus government will need to raise funds either by borrowing or selling assets if it is to maintain a stable currency. Over the medium run, the structure of the Belarus economy needs to be reformed to be less dependent on exogenous developments in Russia and on the oil and gas markets. The political leadership in Belarus therefore faces a number of relatively immediate challenges 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 closely dependent on Russia whilst developing closer ties with countries such as Iran and Venezuela or it can become increasingly integrated in the European community where it geographically belongs.

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

SITE Country Report

Belarus

Executive Summary
Belarus is facing new challenges in the wake of recent gas price hikes and loss of income from handling Russian oil and gas. This terms-of-trade shock has wide-ranging macroeconomic and therefore also socio-political implications. The magnitude of the termsof-trade shocks is substantial (3-6 percent of GDP in 2007) and prices will continue to increase to 2011 when Belarus will face European energy prices according to the new agreement with Russia. Since this is a permanent shock the only solution is a major real adjustment, with cuts in government spending and reforms to facilitate the needed adjustment of the economy. The latter range from reducing the costs of starting new businesses to making price 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 and increased import costs. Consequently the current account will deteriorate. This deficit needs to be financed externally to avoid a devaluation of the currency since the alternative a substantial real adjustment of imports and exports to balance the current account is difficult in the short run (had the currency been floating it would instead have led to a depreciating currency with different problems described later). However, borrowing is only a way of making 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 seem straightforward, either sell assets or borrow from the rest of the world. The need for outside funding has obvious political dimensions. Will Belarus seek funding from Russia and/or other oil producing and likeminded countries or approach the West for funds, either from commercial entities or official bilateral, regional or multilateral institutions? The rhetoric from the Belarussian government give a rather mixed picture. New alliances with countries such 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 louder than words. The prospect of receiving official assistance from the West to finance the current account seems limited given the political situation in Belarus. However, the West should weigh into its decision that the alternative is that Belarus becomes even more closely tied to Russia after selling its asset to and borrowing from its strong neighbour (as seems a more likely scenario than solving the crises with the help of Venezuela, Iran and the like). The West could remain more involved in trying to move the reforms in a desired direction by engaging the authorities in 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 could easily lead to a very costly mix of a currency, banking and external debt crisis a few years from now. This type of external financial meltdown has happened across the world from the Asian crisis to Argentina and some of its neighbours in Latin America. In Thailand for example, output contracted by 10 percent in the year after the crisis hit and it took 6 years to get back to the pre-crisis income level with cumulative output losses in the order of 50 percent of pre-crisis GDP. In addition, some of the political turmoil the country is dealing with even today has its roots in the crisis. Reforms are urgently needed in Belarus to prevent this from happening. On the other hand, such a crisis could have the positive side effect of inducing a democratic 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 more autocratic leadership (Myanmar).
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Basic Data

Source: CIA World factbook

SITE Country Report

Belarus

1 Introduction
Belarus is an important country on the border of the European Union which has chosen a different economic and political path from the West with centralized control over the economy and weak democratic institutions. Attempts to engage its leadership in a dialogue that would to move the country in a more open and market oriented direction have not been very fruitful. On the other hand, the negotiations with Russia over gas and oil in 2006 and the subsequent agreements that came into effect 2007 constitute a significant shock to the countrys external accounts with wide-ranging macroeconomic as well as socio-political implications. Finding large-scale external funding to smooth the shock is an immediate priority of the government. Since the shock is permanent, substantial reforms are needed to maintain high growth, a stable exchange rate and controlled inflation. External assistance could 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 descriptions of the political situation as well as the economic structure and developments prior to the shock. The details of the gas and oil shocks and their impact are then outlined, followed by recommended reforms to deal with the current situation. Further ahead, the recent and likely responses of the government and possible areas for external assistance are discussed. The report ends with some concluding remarks.

2 Political Situation
With only a very short history of previous independence between March 1918 and January 1919 the Republic of Belarus emerged as an independent state as the Soviet Union dissolved in 1991. After an unstable initial period Democracy indicators, 1991-2006 Constraints on Alexander Lukashenka became the Executive 1 president in 1994 promising a return to 0,9 stability. In 1996 the powers of the 0,8 Polity IV presidency were strengthened and 0,7 0,6 Lukashenka has since ruled the country 0,5 in an increasingly autocratic fashion. In 0,4 Freedom of particular, through a referendum in the Press 0,3 October 2004 the constitution was 0,2 0,1 changed so as to allow three 0 presidential terms, and, unsurprisingly, he was re-elected in 2006.
Democratic/Free/ Division of power
Increasingly democratic Increasingly autocratic
Autocratic/Non-Free/ No division of power

Even though there has always been a strong element of control of the media and oppression of any political opposition, it seems that Lukashenka enjoyed relatively large popular support at the end of the 1990s and even up to the presidential election in 2001. According to independent polls, Lukashenkas popularity was far below the official figures (according to which he received close to 76 % of the votes cast) but they nevertheless indicate that he had the support of the majority of voters. After the 2001 election, however, his popularity has gone 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 the opposition even harder. Even though independent polls in 2002-2003 indicated that a large
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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 in 2006 receiving an unlikely 83 percent of the vote. Overall the political development under Lukashenka has been characterized by increasing concentration of power vested in the presidency, 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 the strong economic development since 1996 which has also benefited the population in terms of increasing real disposable income, growing average wages, and a declining poverty headcount. Wage increases have been decided on by the central government and have recently been higher than productivity growth. Worker protection has also been very high and even though unemployment is likely to be higher than the official statistics reveal (1.2 percent of the economically active population), joblessness is almost certainly less of a concern in Belarus than in other transition countries. The Human Development Index (HDI) puts Belarus in 67th place (out of 177 countries) in between Russia and Brazil. This is better than its rank in terms 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-reported happiness Belarus is a negative outlier in an otherwise strong relationship between GDP/capita and subjective well-being. Although the regime is autocratic and controls most of the important economic resources, it does share some of the countrys wealth with the rest of the population. Some analysts call this a social contract where Lukashenka (and the nomenclatura) keeps control of power but also delivers on promises of increased economic well-being. The desire to hold on to this arrangement 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 an important ingredient of the administrations strategy to keep public protests against political oppression at bay. Understanding the workings of the economy is therefore central to judge the importance of the gas and oil shock and its political.

3.1 Oil and Gas

Value of Oil product Imports and Exports, 2001-2005

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The mechanics of the Belarusian economy is intimately linked to the web of special deals in the oil and gas trade with Russia. While Belarus has almost Export value (USD mn) no oil and natural gas of its own there are two reasons for why these commodities play a central role in the Import cost (USD mn) Belarusian economy. First, Belarus inherited much of Soviet refinery capacity and, second, Belarus is for geographic and infrastructure reasons a key transport channel for natural gas from Russia to Europe. After 1991 oil and gas have been cornerstones
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For more on this see Lynch (2005) and Economist Intelligence Unit (2006).
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in trade agreements between the countries but it is only recently that the big change in the importance of these products has occurred. There are many ways in which one could illustrate the increasing importance of these developments. In 2006 fuels and petrochemicals constituted about one third of total industrial output, which in turn was about one third of total GDP. 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 2001 and 2006 has been an important source of income for Belarus. Even though the difference is not a pure profit for the economy (since it is typically not just a re-sale of the same product but a refinement of one oil product into a different one) the striking feature lies in the increasing difference over time. This does not reflect productivity advances (which would be more sustainable) but mainly favourable price changes and to some extent changes in export destinations. A similar development can be Gas Price differentials, 2000-2006 seen for natural gas, Belarus by far most important energy source, constituting more than 60 percent of total primary energy consumption. This should be compared to Russia U.K. gas price (USD per thousand cubic meter) and Ukraine, both with considerable domestic supplies, where the shares are Belarus import gas price around 50 and 40 percent respectively while other countries with little or no natural gas such as Lithuania and Poland have a share of about 25 and 10 percent. Over the past years the price of natural gas has increased substantially around the world, increasing the differential between Belarus and other countries.3 Belarusian gains from natural gas have come partly from the transit activities but also from the advantage for all energy intensive industries such as refinery activities and metallurgy. To put the figures in perspective, if Belarus in 2006 would have paid the European market price, the additional cost would have been around 10 percent of GDP.
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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 of output) and food production (about 16 percent of output). In agriculture, the main outputs are meat and dairy products, which before 1991 were produced for the northwest of the Soviet Union and relied heavily on fodder produced in other parts of the union. Since the preconditions have changed completely the collective and state farms perform poorly and are

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 to five times higher prices.
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kept afloat by government subsidies. Agricultural subsidies have increased over the past years and 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 and employment are predetermined by set government targets. No large firms have been privatised. This particular type of government involvement means that large firms operate under soft budget constraints. Firms that find themselves in trouble can be bailed out and subsidised in various ways, while firms that generate large profits can face higher taxes in a highly arbitrary fashion. There are several cases of firms where profits go more or less straight into the governments budget. This structure also allows the government to mix economic and political reasons for transferring funds. SMEs. Beside the dominant state sector, there is also a private sector where mainly small and medium sized firms operate. They are predominantly active in retail trade and catering (45 percent of all small firms) and serve the domestic market. The economic and financial interactions between small and large firms are very limited. This is very different from the situation in, for example, Slovakia and Hungary where many small enterprises act as subcontractors to larger firms or as independent outlets of their products. Small firms that are not state-owned account only for a fraction of total output. Furthermore, the growth of small firms is very low compared to the growth rate of the economy. One factor in both the low growth rate and limited share of GDP is that the incentives to grow larger are not there. On the contrary, if a small firm is relatively successful and start to grow, there is a significant risk that the state will try to extract profits in an ad hoc way 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 disparate picture of the countrys health and education situation. Whereas education is a factor that greatly improves on Belarus standing in terms of the HDI, life expectancy is low and significantly below its GDP per capita ranking. Universal literacy and free and compulsory education are welcome from a development perspective. However, spending on education is not isolated from economic turmoil as was evident in the financial crisis at the second half of the 1990s. Therefore this may be an area at risk in case a full-blown balance of payments crisis develops.

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The health situation in Belarus is not encouraging despite rapid growth and high spending on health care. Although spending on health as share of GDP is comparable to Poland, life expectancy has declined by 3 years over the last decade for men and is now around 63 years while for women it is around 75 years. Behavioural issues such as alcoholism in combination with 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 be addressed 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 and 2000 growth was driven mainly by expansionist fiscal and monetary policies paired with reestablishing political and economic ties with Russia. A number of treaties on friendship and co-operation were signed in the period 1995-1998, culminating in the 1999 Belarus-Russia Union Treaty, practically abolishing the customs border giving Belarus easy access to the Russian market. Paired with currency depreciations and large subsidies to the main exporters, Belarus was able to gain a significant cost Contribution to growth from expenditure side advantage over Russian producers (based 20 on lower costs rather than higher 15 productivity) and boosting sales on the 10 5 Russian market. Since 2001, domestic 0 demand in the form of private -5 consumption and investment has been the -10 main drivers of growth. 2001 2002 2003 2004 2005 2006
Private consumption Public consumption This is not to say that the favourable Investment Trade and discrep. terms-of-trade situation with regard to gas and oil were not important for growth, it was, but through financing domestic spending on an increasingly imported goods basket rather than generating external trade surpluses. The role of the government should also not be ignored in this growth pattern. Households receive a large share of its income from the government. Social transfers account for 22 percent of total household income. Consequently the share of wages in total income is relatively low, 58 percent. Since 2000, households GDP and Disposable income, 1994-2006 disposable income has outpaced real GDP growth substantially, which is a clear Real disposable income indication of the governments policy to (Index, 1994=100) boost household income. However, this type of policy is clearly not sustainable over the longer run. There are also a number of government subsidies that go to Real GDP (Index, 1994=100) households. For example, less than half of the investments in housing construction in 2006 came from the households own resources. The rest came from preferential credits 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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Fiscal sector. The size of government spending and revenues is very high for a country at this income level (but roughly in line with Sweden). Nevertheless, the government has managed to contain fiscal deficits and avoided a build up of direct public debt in the past. The strong revenue performance is intimately linked to increases in oil and gas price differentials detailed earlier 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 been able 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 the high growth in private consumption as discussed above. In addition, the government is a large employer and thus contributes directly to wages and salaries. As the government also owns many of the large companies and banks, it also indirectly contributes to employment and affects many investment decisions.
Fiscal accounts (general government)
48 46

Expenditure (left hand scale, % of GDP)

8
6 4

Revenue (lhs)
44

2
0

42
40

Overall Balance (right hand scale, % of GDP) Non-oil Balance (rhs)

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-2 -4 -6

38

-8

Money and banking. Credit has expanded rapidly over the last couple of years but inflation has come down due to strong GDP growth, a fall in velocity and price controls. A large share of credit in the last couple of months has gone to state-owned enterprises (SOEs). Given the strong element of directed lending involved in this (which is not always based on sound financial calculations) and the fact that banks have increased short-term foreign currency borrowing, this is reason for concern. The fixed exchange rate continues to play the role of nominal anchor that keeps inflation at bay, but if the government is forced to devalue the rubel 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 rubel deposits (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 to exchange 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 example Thailand 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 trough Belarusian import of cheap Russian oil and gas but also from Russia being the main export destination for Belarus. More precisely, Russia accounts for about 35 percent of exports while Poland, the U.K. and Ukraine account for 4 to 5 percent each. In terms of import Russia is even 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 on Russia, mainly based on increased exports of oil products to the EU (but the sharp fall in Russias share of exports in 2005 was also due to a change in the methodology used for collecting VAT). Sweden has little trade with Belarus. Exports are dominated by mineral and chemical products, accounting for about half of all exports (mainly oil and petrochemical products), and machinery and equipment, accounting for another 20 percent of exports. Most of the machinery and equipment is sold to the Russian market which, for example, bought 80 percent of all refrigerators, 70 percent of machine tools and 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 is pegged to the dollar. Recent wage increases have not been accompanied by corresponding productivity gains which has made Belarus less competitive and is starting to hurt exports to Russia. Strong domestic demand has also fuelled a substantial increase in imports which led to a significant deterioration in the current account (a surplus of 1.6 percent of GDP in 2005 went to a deficit of over 4 percent of GDP in 2006). Limited foreign currency reserves at the central bank and an overvalued currency make it vulnerable to a devaluation. In the past, short-term borrowing has dominated capital inflows, while FDI flows have been limited. Although the ratio of external debt to GDP (at around 19 percent in 2006) is not alarming, the structure of external debt is not very healthy. The risks with short-term foreign borrowing 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 first step 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 gradually increase until 2011 when it will be equal to the European market price (presently $223 per thousand cubic meters). The change is very drastic but still smaller than the initial offer from Gazprom 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 sought after) control of one of the most important transfer routes for natural gas from Russia to the EU. 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 from Russia. 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 $72-180 per 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 on exports 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 from exporting 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 a result of the new agreements it is relatively straightforward to compute the direct effects on the trade balance. In 2007, the combined effect of the oil and gas shock is in the order of $1.7 billion, equivalent to over 5 percent of GDP and keeps increasing all the way through 2011 when it would be $4.7 billion (this can be compared to estimates of the losses from EUs exclusion of Belarus from the Generalized System of Preferences (GSP) which is likely to be between $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 funding immediately. The estimated impacts on growth are large but also subject to a great deal of uncertainty. The wider macroeconomic implications of the shocks are complicated to assess since they depend on 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 and arrives at an estimated output loss of 5 percent of GDP in 2007. The losses decline in subsequent years when the relative size of the terms-of-trade diminishes, but the cumulative loss is reported to be in the 10-15 percent of GDP range. However, these estimates are based on the experience with this type of shocks in a large sample of countries and Belarus has a number of factors, such as the fixed exchange rate, rigid economic structure and poor institutions, that would tend to increase the effects of terms-of-trade shocks on growth. There are 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 is a question of how the estimated output losses are reported. The fact that output growth declines by 5, then 4, 3, 2, and 1 percent between 2007 and 2011 does not actually imply that the output loss is 15 percent (i.e., the sum of individual years reduced growth rates). If the benchmark 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 yearly output level with the hypothesized trend output and summing up all the losses for the years until 2011 it add up to 67 percent of initial GDP (rather than 15 percent). Even this is not the entire impact of the shock since in 2011 the output level will be 15 percent below the benchmark 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 losses than is sometimes realized or reported. The rather mechanical estimates of the output loss do not paint the full dynamic picture of the impact 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 poor institutions in terms of rule of law and democratic rights, factors that are highly relevant for Belarus. 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 can develop from the initial terms-of-trade shock if the government does not take the right policy actions. 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 can delay the real adjustment. A third alternative would be for the government to not respond at all, 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 and then 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 different transition path than other CIS-countries. The Lukashenka administration has gradually increased state control and Belarus Transition Indicators 2006 in relation to range of scores for other transition countries has relied heavily on restoring the relationships 4,5 with Russia. Lukashenka 4 has even stated that a goal 3,5 of the administration is to 3 return to a Soviet-style economic system as seen 2,5 in the late 1980s. 2 Consequently market 1,5 reforms have been limited. Belarus scores 1 Large-scale Small-scale Enterprise Price Trade and Competition Banking Non-bank Infrastructure very poorly in terms of privatisation privatisation restructuring liberalisation forex system policy reform financial reform institutions EBRDs transition index, where 1 indicates little or no change from a centrally planned economy and 4+ represents the standards of an industrialised market economy. The bars depict the range of scores in all transition countries and the line is Belarus which shows that Belarus is one of the least reformed transition countries. Corruption. Belarus has serious problems with corruption. Contrary to official information that the level of corruption has gone down in Belarus, Transparency Internationals Corruption Perception Index reports that Belarus has fallen sharply since it was included in the survey in 2002. In terms of corruption Belarus now ranks 151st out of 163 countries, shares its position with Corruption Perception Index 2001-2006 Uzbekistan, but rank below Tajikistan and 5 Lithuania Turkmenistan, and just above Haiti, Iraq, 4,5 Belarus Burma, Sudan and the Poland Democratic Republic 4 of Congo. This development is nothing 3,5 short of catastrophic. Latvia Compared to other ex3 Soviet, ex-communist states in our part of the 2,5 Russia world, Belarus is now Ukraine at the very bottom of 2 2001 2002 2003 2004 2005 2006 the list from having been a star in this regard 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 doing business such as the ease of starting a business, dealing with licences, employing workers and
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paying taxes. In a sample of 175 countries, Belarus ranks 129 in overall ease of doing business. This is in line with Ukraine (128), but well behind Russia (96) and Poland (75) and worlds behind Lithuania (16) and Estonia (17). Although employing workers and contract enforcement seems to work relatively well, the arbitrariness of the tax system and poor investor protection hurts the overall cost of doing business. The epitome of this is the golden share rule which gives the government majority voting rights in even if it only owns a small number of shares. In 2004 this was extended to include firms in which the government has no ownership claim at all, effectively giving the government the right to intervene in any privatised firm. Even in areas where the state is not directly involved, such as the small business dominated sectors 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 more detail and the government sometimes changes the rules of the game ex-post. For example, a company could suddenly face higher taxation, in some form, as a result of earning a high profit.

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 makes the needed reforms rather obvious. The list of needed reforms is long but some key elements are: 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 be done 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 by Russia that are now being phased out); continue to build on the populations high level of education and focus on creating a new 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 to reduce health deteriorating behaviour, especially among men were life expectancy is far below what could be expected for a country at this income level and amount of health spending.

Short-run smoothing and fine tuning. In addition to the much needed structural reform program, there are several actions that can be taken in the short-run to reduce the negative impact 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 could be very risky since the rubel acts as the nominal anchor and should only be considered as 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 the currency and a rapid increase in inflation. Income growth and price stability are central to the social contract and at the centre of selling the current economic, social and political set-up as a successful alternative to a market-based, Western oriented, democratic society. Therefore the 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 of payments crisis that would have serious consequences for the domestic economy. The governments initial response to the shock has been to look for external funding to finance the current account deficit and avoid devaluing the currency. The external funding in 2007 has come from both asset sales and foreign borrowing by the government and the banking system. So far the government has been able to make inflows of foreign currency greater than outflows and reserves have increase from $1.4 billion at the end of 2006 to $2.4 billion at the end of July 2007. However, this is after receiving $625 million for the sale of the first 12.5% of Beltransgaz to Gazprom and increased foreign borrowing by banks but before settling 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 for Belarus with foreign currency debt issued by the government obtaining a B1 rating by Moodys. This is the same rating given to, for example, Albania, Philippines, Pakistan, and Ukraine 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, albeit from 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 current account 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 to reduce the risk of a future balance of payments crisis. Belarus will continue to rely on Russia for support. Despite all the rhetoric surrounding the gas 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 has acquired a stake in Beltransgaz; additional funding is planned via loans from the government and t-bill issues in the Russian market. Despite the close connections with Russia, there is also a strong anti-Russian sentiment among the population which seems to be shared by Lukashenka. In short, the new financial deals with Russia replace the dependence on cheap Russian gas and oil with Russian provided foreign exchange. This may well be the start of a large-scale integration of the Belarusian economy into Russia and an alternative to a union at the political level. Selling out all the assets of the economy will eventually lead to a very weak power base for Lukashenka.

Box. Obtaining Foreign Funding The government has been busy trying to find foreign exchange to fund the current account deficit 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 four year period for a total of $2.5 billion. The sale of the first 12.5 percent has been completed in August which generated $625 million in foreign exchange. Russian banks are allowed to buy two mid-sized Belarusian banks without a golden share rule. Given the low profitability of the banks the sale does not generate 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 of issuing Eurobonds in 2008. Delaying debt payments to Gazprom in the order of $456 million. The debt is related to the six-month grace period during which Belarus was allowed to defer paying the new gas price of 100 USD/tm3 (as a result of the delay Russia threatened to cut off gas supplies in early August).

Lukashenka is exploring alternatives to a complete Russia sell-out, but it is unclear how sincere his efforts are and how successful they will be. The recent financial deals are strengthening 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 is aware 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 from Russian influence but is possibly just a way to scare the West to engage in a dialogue with Belarus 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 from non-Russian countries. Indeed, it puts in question his entire privatization and FDI plan as a
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way of funding the current account deficit. In summary, Lukashenka questioned why the government should sell profit making companies. Selling loss making companies will certainly not generate the cash needed to finance the deficit. It may well be that the lions share 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 Belarus in terms of autocratic rule and discuss how these countries have developed. Secondly, a discussion of possible areas of Swedish engagement with Belarus at the bilateral and multilateral level follows.

7.1 Lessons from Other Autocratic Regimes

To put the Lukashenka regime in perspective it is useful to identify other countries with similarly autocratic rule and see how they have evolved over time. The sample in the table includes countries with Polity IV scores at comparable initial levels to Belarus -7 rating. A few are richer and a few are poorer, some are from the same geographical area while others share the dependence on cheap energy. None of the countries matter in terms of imports or exports for Sweden. The list is composed to include some countries that have not improved their Polity score and others that have improved it radically. The aim here is not to provide a full account of each individual country case but to draw some more general conclusions of how positive changes have come about. This general overview also helps identify what could be interesting countries for a more detailed analysis of how external forces or assistance have affected political developments. Large positive changes in a democratic direction have been connected to specific events that have triggered fundamental changes in these countries. Glasnost and the fall of communist rule in Eastern European countries; the end of civil war in Tajikistan; the Asian crisis in Indonesia. In the most successful transformations external events were behind the democratic movements. Although it was probably true that external assistance may have helped lay some of 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 to reignite glasnost or contributing to create a full blown financial/balance of payments crisis would be the quickest way to democracy for Belarus. Most observers would seriously doubt that Russia will ever re-launch glasnost, but how about an economic crisis? Although Lukashenka 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 he seems fit to meet his ends in the past. Therefore an economic crisis will not necessarily lead to a 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 isolate Belarus further may seem as a promising way to destabilize the economy and thus the government, it may backfire and lead to an even less democratic society on the borders of the EU. Among the non-reformers are Cuba and Libya as well as a number of former Soviet republics that share a strong communist/socialist background where a large share of the population lacks 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 of institutions and shared democratic values makes this seems largely as wishful thinking. In these cases, there is certainly a role to be played in assisting the countries to develop institutions and inform about alternative ways of organizing societies so there is some hope that 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. Within this framework some additional areas of engagement have become relevant under the current circumstances. The first is related to energy efficiency, which is now a top priority for the Belarus government with the increased energy prices. Improving energy efficiency is also well in line with more general Swedish priorities. The Belarus governments own focus has been on energy efficiency of large companies while the World Bank is funding a project that addresses energy efficiency at social institutions (in particular schools and medical facilities). A neglected segment of the economy that would benefit from improved energy efficiency is households and SMEs. This may be a relevant area for assistance from Sweden which also fits with 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 and help the poor deal with increases in energy prices. At the same this is an area where the Belarus government would likely welcome assistance which would increase the chances of success. Improving the information received by the population is crucial to increase the chance of moving the country in a democratic direction. Independent surveys suggest that many in the Belarusian population still have a very favourable view of the centrally planned economy and believe that their living standards are equal to those in the European Union. Such misconceptions will be harder to maintain once a full blown crisis hits the country, but in the mean 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 is functioning is another area where bilateral support could be envisioned. This will not only help guide the outside worlds advice in the current situation but will be crucial in formulating a new economic strategy and evaluate policy options over several years to come. Multilateral engagement. Belarus may well be facing a balance of payments crisis that requires large-scale external assistance in the near future. It is easy to defend a position of isolating non-democratic and/or corrupt regimes and not provide them with international support. However, the geographic location of Belarus and its importance as a channel for energy transports from Russia to the EU makes isolating Belarus a potentially costly choice. Currently Belarus is receiving very limited support from multilateral institutions; including the EU, the IMF and the World Bank as well as bilaterally (overall ODA is around 0.2 percent of gross national income). The first issue is to what extent the EU and the developed world more 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 need are 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 multilateral institutions should already start to develop a policy for how to deal with a Belarus that is facing 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 increasing current 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 serious problem with extending loans to an autocratic regime is that debt allows the regime to extract resources not only from the current generation but also from future generations of Belarusian taxpayers. Loans to autocratic regimes should therefore be avoided unless they come with very 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 is hard to see in what form and from what source the support should come if the worst case scenario materializes. Can a crisis with external assistance be used to take the country the Indonesian 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 the economy. The administration is currently exploring all its alternatives to avoid devaluing the currency or undertake real reforms. The strategy is heavily focused on attracting foreign exchange to finance the large and growing current account deficit. This is not an unreasonable immediate response to the shock but absent real reforms this is also the first steps down a path that 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 too distant future. The Wests policy of not providing support to the leadership of the country will be put to a test. The strategy of only supporting NGOs, environmental efforts and the most vulnerable segments of the population can be justified on many grounds. However, this type of support will not suffice in dealing with a full-blown balance of payments crisis. If no support 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 in Belarusian 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 the EU policy towards Belarus, Belarusian Institute for Strategic Studies (BISS). IMF country reports on Belarus from www.imf.org/external/country/BLR/index.htm. International Finance Corporation (IFC), (2006), Business Environment in Belarus, Survey of the Belarusian SME sector. IPM Research Center, Belarusian Monthly Economic Review, various issues from http://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 from www.worldbank.org. Zeijlon, A. (2006), Sida: Belarus Country Report, Prospects and Recent Developments.

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