Growth Framework: macroeconomic environment and investment climate

1. Growth Framework: macroeconomic environment and investment climate CEM for Republic of Belarus

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

3. GDP Growth and Poverty Outcomes are impressive

4. Broad based growth • Growth benefits are broadly shared among different population groups • Income/wage policy: a high share of GDP growth was channeled to finance wage increases • High growth in labor intensive sectors • Low cross-sectoral differentiation in wages • 40% reduction in employment in agriculture

5. Average Annual GDP Growth, %

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

7. Cost advantage against Russia

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

9. 1.6 60 1.4 50 Collections, actual, % costs 1.2 40 Cost recovery in tariffs, % 1 Collection level (rhs) 30 0.8 0.6 20 0.4 10 0.2 0 0 2000 2001 2002 2003 2004 Cost Recovery in Housing

10. Significant Fiscal Adjustment

11. Reduced Inflation Tax

12. External Debt to GDP Ratio, %

13. Inflation remains high

14. Incidence of State Support, % of GDP

15. Weaknesses of the Macro Framework • High level of re-distribution: a heavy tax burden and excessive government interventions; • Government spending is concentrated on social spending and housing , while less funding is available for public investments in infrastructure; • Subsidization remains high, especially in agriculture; • High share of intermediary product: under-developed service sector, as well as a relatively low level of value added in industry; • Profit/wage ratio is low: hampers both savings and investments in the real sector; • The financial sector remains under-developed even relative to the modest saving level.

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

17. Index of Economic Freedom

18. 2001 2002 2003 Individual entrepreneur 45 29 34 Non - state - unitary enterprise 49 60 6 2 State unitary enterprise 79 86 77 Limited liability company 56 66 63 Additional liability company 59 59 66 Closed joint stock company 75 80 68 Open joint stock company 85 76 76 Incidence of Price Control

19. Staffing level Excessive Sufficient Insufficient Do not know Number of employees 1 - 10 4 65 30 2 11 - 50 9 67 22 3 51 - 100 11 70 17 2 101 - 500 21 64 11 3 > 500 27 55 14 5 Restrictive Employment Policies

20. Business Registration is too Slow (days)

21. Trade Restricting Logic of Economic Policymaking • Pressures to meet output targets • Regional support for local enterprises • Restrictions for imports and inter-regional competition • Monopolization of regional markets • Threat of Import Substitution

22. Country Percentile Rank (0-100) BELARUS 27.6 MOLDOVA 21.9 RUSSIA 18.9 UKRAINE 15.3 Perception of Corruption, 2002

23. Market Socialism Re-discovered? • Similarities with market socialism in Yugoslavia and Hungary in the 70s, not real transition as we see it in the CEE • Excessive state ownership and government control • This model proved to have fundamental weaknesses: soft budget constraint, over-borrowing, inflation, weak export performance, and external debt problems

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

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

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

27. In the longer-term… • The comprehensive reform to sustain growth will be needed sooner or later • Advance liberalization, privatization and de-politization of the economy • Political will be required • Currently, it is a great time to initiate such reforms

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