Speech

Belarus: Recent Experience and Challenges Ahead -- Speech by John Odling-Smee, Director, European II Department, IMF

November 6, 2001

I would like to thank the Academy of Management for organizing this event; it is a pleasure to be here and to discuss the experience of Belarus with various representatives of the Belarusian community. I would like to divide this lecture into two parts. First, I will outline the main lessons that have emerged from ten years of what we now call the "transition process". I will then turn to the experience of Belarus and the challenges that lie ahead.

The end of the first decade of transition provides a good opportunity to take stock of efforts to establish market-oriented economies, and to assess the results achieved thus far. In broad terms, the picture is truly impressive:

• all the economies have been growing for at least two years (after initial output declines that averaged 40 percent);
• inflation is at low to moderate levels (generally less than 20 percent, and often in single digits);
• and the share of output generated by the private sector now averages over 50 percent of GDP.

At the same time as market reforms were implemented, many new nations had to be established or reestablished and democratic institutions had to be developed, which greatly complicated the task. Against this background, positive economic results are a testament to the extraordinary progress that has been achieved by transition economies in such a short period of time.

However, the record of economic achievement has been very uneven, with some countries having grown strongly for many years while others have lagged behind. These differences have been analyzed extensively, and the general conclusion is that they are partly explained by geography and history, but also—and importantly—by the quality of the economic policies that have been followed. With regard to policies, four main achievements have been the hallmark of successful transition economies:

• perseverance in pursuing medium-term oriented macroeconomic stabilization policies;
• structural reforms across a wide range of sectors, including the imposition of hard budget constraints;
• establishment of the legal and regulatory frameworks required for a market economy;
• the provision of a well-functioning social safety net to cushion inevitable social dislocations and thereby to ensure sustained support for the transition process.

The importance of sound financial policies as the basis for a strong market economy cannot be overestimated. Why is it so important to achieve macroeconomic stabilization characterized by low inflation in the context of an open trade regime with free prices? The main reason is that high and variable inflation creates uncertainty, which discourages businesses from expanding and investing for the future, and thereby stunts economic growth. Many studies have shown that low inflation was a precondition for the resumption of positive rates of economic growth after the initial output collapse of the early 1990s.

But there is little point in ensuring macroeconomic stability if one does not then allow producers to respond to prices. "Transition" implies a process where, in general, production activities that are no longer profitable should be allowed to fade away, while profitable activities should be allowed to flourish. What is needed is a wide-ranging privatization of enterprises and the establishment of an adequate legal and regulatory framework for private economic activity. In this context, it is worthwhile to highlight the important role of new small- and medium-sized enterprises, which can be a strong driving force for the resumption of economic growth. These processes imply the need to accept—and indeed to foster—rapid and deep structural reform, for there can certainly be no transition without it. Studies of the transition experience—by the Fund, the World Bank, the EBRD, and by many independent scholars—are quite clear in showing that countries that accepted the deepest structural reforms have experienced the fastest rates of growth. Belarus has been singled out as an outlier in these studies, since high growth rates were recorded without deep restructuring. A quasi-monopolistic position on the Russian market for many industrial goods helped Belarus to grow throughout the mid-nineties. As is recognized by many in Belarus, this growth strategy has been virtually exhausted.

Many countries in the region, Belarus among them, attempted to prop up industries, using a variety of mechanisms including cash subsidies from the budget, tax privileges and non-cash tax settlement schemes, barter, provision of virtually free energy resources, directed bank financing, monopoly protection, and import restrictions. These all created what experts call soft budget constraints, meaning the absence of strict financial discipline. But this produced the worst of all economic worlds: output levels from the old industries declined despite the efforts to the contrary, while at the same time output from the new profitable activities did not respond-in part because the new activities faced ever higher tax and regulatory burdens put in place to help the old industries. In Belarus, for example, support for an unreformed and inefficient agricultural sector has proven to be costly not only to the budget—and therefore to the taxpayers—but also to the banking sector, which has often had to provide soft credits without much hope for recovery. State support has not been accompanied by agricultural restructuring, so the sector continues to perform poorly and is a drain on the country's resources.

The need for the state to provide a sound institutional environment that encourages new private sector activities is at the heart of the transition process. The role of government is to put in place and uphold broad rules that ensure freedom of exit and entry of business activities; promote transparency, clarity, and accountability of public decisions and activities; and ensure uniform and evenhanded enforcement of necessary regulations. At the same time, the government should not interfere in the decisions of individual enterprises or otherwise grant privileges or special treatment to private businesses.

Writing legislation that supports these principles has proven to be easier than ensuring that they are actually put into practice. Indeed implementation of reforms of the legal, tax, treasury, and banking institutions and systems has proven to be one of the most difficult tasks in fostering market-based economies in this region. After ten years, the record suggests that some countries are stuck half-way along the transition process. They have achieved macroeconomic stability, they may have liberalized most prices, and they may have privatized some state assets. But they have not yet seen much growth in the private sector. Where this has happened, I believe that a major reason is the rise of a new nomenklatura. Partial and halting reforms have allowed new (and sometimes old!) elites to gain control over productive assets, and they have then successfully used the state as a means to preserve their position by ensuring that they continue to receive privileges. This situation, which occurred to varying degrees in the countries of the region, had the most serious costs when it perpetuated an antiquated industrial structure and prevented the establishment and development of new businesses. There have, however, been gradual reductions in government intervention, subsidization and protection in some countries, including Russia, which have improved the situation.

Key measures have included the greater use of transparent procedures, properly paid civil servants and legal officials, deregulation where possible, and the government tying its own hands through the adoption of international codes and standards of reporting and committing to a stable set of international rules, e.g., by joining the WTO.

Finally, it is the responsibility of policy makers, and those who advise them, to recognize that not everyone gains equally from reform—and that some may even lose from it. It is therefore essential to have in place an effective and affordable social safety net. On this aspect, the record of the past decade has been poor: transition countries in Central Europe and the CIS have shown a dramatic increase in poverty levels, in both absolute and relative terms.

This has been due to slow growth, outmoded labor skills and difficulties in retraining, and a lack of attention and political will to ensure that government expenditures for social needs—on pensions, family assistance, and health—are utilized efficiently. There can be little doubt that transition countries need to make a clear decision on their priorities for the social safety net, and then, whatever they decide, they honor these stated commitments.

The role of the IMF in influencing decisions about economic policy in its member countries is an indirect one. Only the governments, central banks, enterprises and peoples of the countries can directly alter the economic situation. The IMF works indirectly by encouraging and supporting reform efforts that—based on long experience in other parts of the world—we believe have a good chance of success. One of the ways in which we do this is to provide financial assistance in the form of loans to central banks in countries pursuing good economic policies. But we also try to support reforms through macroeconomic policy advice and technical assistance on a number of issues that are critical for achieving and maintaining macroeconomic stability.

Our policy dialogue with Belarus has intensified during the past year, and there has been an increasing convergence between the views of the Belarusian authorities and those of the IMF staff when it comes to the fundamental diagnosis of the economic situation and the main reform measures needed. The relationship between Belarus and the IMF intensifed this year when the staff agreed to monitor Belarus' program of macroeconomic and structural policy measures for the six months ending in September. I believe that the dialogue with Fund staff helped the authorities design and implement the program, which was successfully implemented in many, although not all, respects.

Generally speaking, Belarus' transition to a market economy has been slow. The state continues to play a dominant role in the economy. This role is exercised both directly, through the ownership of assets, enterprises, and banks, and indirectly, through the channeling of resources to priority sectors, and through extensive subsidies and the system of price and administrative controls. Compared to most other countries of the former Soviet Union, the government sector in Belarus is very large—for example, the ratios of tax and expenditure to GDP (more than 40 percent) are much higher than in other countries in the region. Officially-recorded budget deficits are low. However, this is not a reliable indication of overall fiscal discipline because a substantial part of quasi-fiscal activities is carried on outside the budget, including through directed lending by the banking system to priority sectors, notably agriculture.

Belarus' growth strategy from the mid-1990s focused on stimulating growth in priority sectors through soft credits, subsidy schemes, and administrative controls. While this strategy stimulated economic activity in the short run, it very quickly resulted in high rates of inflation and stifled private sector development. It also helped to perpetuate the old industrial structure that will not be competitive under normal market conditions, and thus postponed the realization of Belarus' long-term growth potential. Although positive output growth was recorded—in some years at a high rate—this growth was largely driven by Russia's demand for low-priced Belarusian industrial goods and was not the result of economic restructuring.

More progress needs to be made in advancing structural reforms:

• As a result of the dominant role of the government in the economy, there is relatively little private sector activity compared to other transition economies (20 percent of GDP at the end of 2000, according to EBRD estimates; this is the lowest among transition economies). New private businesses are not growing fast enough. Private sector expansion has been constrained by an unfriendly environment for business, including not only high inflation but also excessive regulations, unpredictable legislation, and uncertainty about the implementation of laws and regulations (e.g. re-registration and licensing requirements). The recent announcement of the government to promote the development of small and medium-size enterprises is a very welcome step in the right direction.

• Little privatization has taken place, and—in contrast to most other transition economies—not even small-scale privatization has been completed. At the same time, enterprise restructuring has been slow in coming, and investment levels are declining. Over one third of all enterprises have recorded losses this year and others make minimal profits. The restructuring of the enterprise sector has been hampered by low levels of privatization, price and wage controls, and the lack of financial accountability by enterprise managers, in other words, soft budget constraints. At the same time, enterprises face a high tax burden, and struggle with an excessive amount of fines and penalties and a system of exemptions and privileges. They are facing increasing competition from neighboring countries, in particular Russia, where more enterprise restructuring is now taking place. In fact, competition seems to be getting tougher, and some of Belarus' traditional products, such as machinery, food products (for instance beer), and TV sets are facing serious competitive challenges abroad and even on the domestic market.

• The banking sector continues to finance the state and loss-making enterprises, often under government directives. Banks have accumulated bad loans in their portfolio and the situation of the sector is fragile. Not surprisingly, they do not find it easy to attract deposits, and have few resources for lending. Credit to the private sector is also limited by the slow pace of privatization and the growth of private businesses.

• The agricultural sector remains largely unreformed, and is a major drain on the financial resources of the country, absorbing about ¼ of total lending by banks as of the middle of this year, or about 3 percent of GDP. Despite the significant amount of subsidies and grants, the majority of farms are making losses and accumulating arrears, especially to energy suppliers. The sector as a whole is not competitive and needs major restructuring, including land reform.

In view of all these structural bottlenecks, it is not surprising that foreign investors have shown little interest in investing in Belarus. FDI levels are very low compared to other transition economies: the prospects for economic recovery will not be bright with FDI at just $6 per capita per year. I welcome the new Investment Code, although it is only one of the improvements to the overall investment climate that is needed.

Recent Economic Developments and Policy Priorities in Belarus

Official statistics point to severe weaknesses in the economy. Since the end of last year inventories have gone up; arrears have accumulated; non-cash transactions have increased; and the financial situation of enterprises has deteriorated, partly as a result of the increased burden of larger wage bills. This suggests the critical need to accelerate economic restructuring to make Belarusian enterprises more competitive and increase the growth potential of the economy, in order to bring about a sustainable increase in living standards of the population. At the same time, it is crucial to foster the development of new businesses and create new jobs.

The unification of the exchange rate system in 2000 was an important step toward creating a market system with meaningful prices. There has been a significant effort to tighten monetary and fiscal policy, bringing inflation down and helping to protect the real incomes of Belarusian households. However, these efforts have been made more difficult by the attempt this year to raise average wages to achieve a dollar wage target.

The reality is that the economy can only pay much higher wages without being macroeconomically destabilizing if it increases productivity to the same extent. While this is a desirable objective, it will not be achieved in a year or two. Moreover, without the productivity increase, wage increases in enterprises have several potential undesirable consequences:

• First, given the fragile situation of enterprises, the higher wage bills eat significantly into their profits, and thus their ability to invest and create growth.

• Second, as the experience of the past couple of months confirms, the additional income received by households puts pressure on the foreign exchange market as households try to convert their additional income into dollars and may lead, as was the case in the last few months, to a loss of international reserves.

• Third, the increase in spending resulting from higher wage income may eventually push prices up, eroding the recent progress in fighting inflation.

In all these ways, a policy of targeting an unachievable level of dollar wages creates merely an illusion of higher living standards and will in time compromise stabilization and growth prospects in Belarus.

This takes us to the challenges ahead. In terms of priorities, efforts should continue to keep monetary and fiscal policies tight and bring inflation down further. At the same time, the process of price liberalization should be completed without delay. In addition, there is clearly a pressing need to accelerate structural reforms and eliminate impediments to private sector development and economic growth. Without decisive moves toward structural reform, there is a serious risk that recent gains in stabilizing prices and the exchange rate may be reversed.

Given the large agenda, priority should be given a few key structural changes: (1) improvement of the business environment; (2) enforcing hard-budget constraints on enterprises; and (3) increasing the transparency of fiscal policy. The common thread between the three is the need to change the role of the government, in particular to establish a clear demarcation of the boundaries between the public and the private sectors.

Regarding the business environment, much is needed to remove barriers to private sector activity, eliminate discretionary regulations, and avoid discriminatory measures. This is crucial to promote private sector development and avoid the growth of underground activities. In simple terms, this boils down to reducing state interference in the economy, while at the same time establishing predictable rules and regulations that promote a competitive market environment. Providing the mechanisms and institutions that guarantee enforcement of contracts, property rights, and the rule of law is crucial in terms of creating new jobs and stimulating investment.

There is a pressing need to promote market discipline and enforce bankruptcy procedures as a first step toward enterprise restructuring. Enterprises should be allowed greater autonomy in setting prices, wages, procurement, and sales practices. This will encourage them to restructure their operations and improve their ability to compete abroad.

Good progress has been made in the development of a modern Treasury and in other areas of fiscal policy, but more remains to be done to improve the transparency of fiscal operations. In particular, all extrabudgetary funds, accounts and operations should be brought into the budget, and the process of budget revisions should be transparent and open to public scrutiny. Finally, a change of policy regarding agriculture financing and other priority sectors is one of the key tests of the credibility of economic policies in Belarus. Any support to agriculture should come transparently from the budget, and not through forced lending by commercial banks. Directed lending severely undermines the main function of the banking system—to distribute credit efficiently to profitable projects with appropriate consideration of risk. Directed credit also means that agricultural enterprises can receive financing without undertaking much needed reforms to improve efficiency and quality. Furthermore, resources directed to the unreformed agriculture sector mean that fewer funds are available to more profitable sectors. Finally, defaults on these credits place a severe burden on the capital of commercial banks or on the state budget if guarantees are called.

The elimination of non-transparent fiscal activities will also involve discontinuing the provision of social benefits by enterprises. The best way to provide those benefits is through the creation of an environment that encourages enterprises to be more efficient and to generate jobs and tax revenues out of which the government should finance an effective social safety net. During the process of transition to market mechanisms, some segments of the population are likely to be more vulnerable to change and need to be protected. But the current protection given by the extensive system of transfers and subsidies provides very little to too many people—as a result there is little effective social protection.

There may be some temporary increase in unemployment when real structural change starts. But countries such as Poland and the Baltics States which went through this stage earlier did not witness social instability. This was because they encouraged the creation of new jobs in small and medium-sized enterprises, and strengthened the social safety net. There is no reason why Belarus cannot do the same.

Other structural reforms are also important. When it comes to privatization, the priority should be to complete small-scale privatization and establish the conditions for future privatization of large enterprises. In particular, there is a need for transparency and openness in this process, to avoid the pitfalls that other transition economies faced.

Banking sector reform is also needed to improve financial intermediation and increase efficiency in resource allocation. The key components of a well functioning banking system are an independent central bank, focused on achieving price stability, and a competitive commercial bank sector. It is important to recognize, however, that banking sector reform can only succeed if implemented in parallel with enterprise reform.

Conclusion

I would like to sum up my remarks about Belarus in the following five points.

First, the state is too dominant in economic life in Belarus. Sustainable growth that will allow permanent increases in incomes and living standards requires that the private sector plays a major role. Belarus needs to follow the route traveled by nearly all other transition countries and shift decisively from the state to the private market economy.

Second, for private enterprises to be established and grow, the business climate needs to be much more friendly. Important steps have been taken over the last two years, especially the unification of exchange rates and liberalization of the exchange system, and the beginning of deregulation and price liberalization. But there is still a very long way to go.

Third, macroeconomic stabilization is a precondition for sustainable growth. There was some progress this year, especially the reduction in inflation. But the big increase in wages worked in the opposite direction. There will continue to be a need to keep monetary and fiscal policies tight as long as inflation is high and the external situation fragile.

Fourth, hard budget constraints must be imposed throughout the economy. In other words, all entities — government agencies, enterprises, farms, banks — must be subject to proper financial discipline. Financial obligations must be honored on time in full, or else the enterprise should go into bankruptcy.

Fifth, the government's financial operations must be fully transparent.

While many other reforms are also important, I have no doubt that rapid progress in these five areas will be rewarded with a strong growth in production and living standards that can be sustained. I certainly hope so, for the benefit of the Belarussian people and Belarus' friends around the world.