Report No. 32346-BY Belarus Window of Opportunity to Enhance Competitiveness and Sustain Economic Growth A Country Economic Memorandum for the Republic of Belarus (In Two Volumes) Volume I: Main Report November 8, 2005 Poverty Reduction and Economic Management Unit Europe and Central Asia Region Document of the World Bank GSP Generalized System o f Preferences HH Households H S HarmonizedSystem (for tariffs) IFS InternationalFinancial Statistics IIT Intra-industryTrade IMF InternationalMonetary Fund IPM Institute o f Privatizationand Management I S 0 InternationalOrganization for Standartization ITT Internal Terms o f Trade JSC Joint Stock Company Jv Joint Venture KAM Knowledge Assessment Methodology MCM Million Cubic Meters MFA MinistryofForeignAffairs MFN Most FavoredNation MMTOE Million Metric Tons o f Oil Equivalent MOF MinistryofFinance M S A Ministryof Statistics andAnalysis NBB National Bank o f Belarus NBK National Bank o f Kazakhstan NBL National Bank o f Lithuania NBP National Bank o f Poland NBU National Bank o f Ukraine NPL Non-performing Loan NTBs Non-Tariff Barriers OECD Organization for Economic Cooperation andDevelopment PCA Partnership and Cooperation Agreement PER Public Expenditure Review PPI Producer Price Index PPP Purchasing Power Parity PS Profit to Sales ratio PR Property Restructuring PSE Producer Subsidy Equivalent R&D Research and Development RCA Revealed Comparative Advantage RIME Research Institute of the BelarusianMinistryo f Economy ROSC Report on the Observance o f Standards and Codes ROW Rest o f the World SDDS Special Data Dissemination Standard SBC Soft Budget Constraints SE Small Enterprises SL Sales per Worker SME Small and Medium Enterprises SNA System o fNational Accounts SPF Social ProtectionFund SOE State-Owned Enterprise SR Strategic Restructuring T&D Transmission and Distribution TFP Total Factor Productivity TOE Tons o f Oil Equivalent TOT Terms o f Trade TFUl'S Trade-Related Aspects o f IntellectualProperty Rights ULC UnitLabor Costs UNCTAD UnitedNations Conference on Trade and Development USSR Uniono f Soviet Socialist Republics VAT Value Added Tax WART Weighted Average Retail Tariff WBI WorldBank Indicators WDI WorldDevelopment Indicators WITS/COMTRADE World Integrated Trade SolutiodUnited Nations Statistical Division WTO WorldTrade Organization Country Director: Paul G.Bermingham Sector Director: Cheryl W. Gray Sector Manager: Asad Alam TABLE OF CONTENTS CHAPTER1MACROECONOMIC FRAMEWORK GROWTH: FOR RECENT TRENDS AND RISKS 1 . A 1 B ROLEOFECONOMIC .. MACROECONOMIC OVERVIEW OF GROWTH PERFORMANCE .......................................... GROWTH MODELS ........................................................................................................... POLICIESINGROWTH PERFORMANCE: TWO PHASESAND TWO 10 c 16 D ROLEOFSTATESUPPORT .. STRUCTUREAND SOURCESOF GROWTH (SNAVIEW) .................................................... ................................................................................................ 24 E CONCLUSIONS:MAJOR . STRATEGY ........................................................................................................................ MACROECONOMIC THECURRENTGROWTH R I S K S OF 28 CHAPTER2 INDUSTRIAL PERFORMANCE: PRODUCTIVITY, COMPETITIVENESS,AND MEDIUM-TERMRISKS .......................................................................................... 33 A 34 B INDUSTRIAL 39 C ........................................................................ 40 D GROWTH ....PECULIARITIES OF INDUSTRIAL STRUCTURE .................................................................. PERFORMANCE ............................................................................................ ALTERNATIVEINDICATORSOFGROWTH DRIVERS ........................................................................................................... 43 E EMPLOYMENT .................................................................... 48 F TRENDS 52 G INVESTMENT ... AND PRODUCTIVITYTRENDS INUNITLABOR COSTS ....................................................................................... AND FINANCIAL PERFORMANCE ................................................................. 55 H COMPARATIVEADVANTAGESOFBELARUSIAN . COMPETITIVENESS SURVEY ............................................................................................. INDUSTRY: THE RESULTSOFTHE 62 I MAINRISKSOFTHEPREVAILINGGROWTH . TRATEGY ................................................... 65 CHAPTER3 ENTERPRISE BELARUS ............................................................................................................... RESTRUCTURING IN INDUSTRY:IN DoTHEYDOIT DIFFERENTLY 68 A HYPOTHESES AND MEASUREMENT OF PERFORMANCE ................................................... 70 B 72 c ENTERPRISE ... ENTERPRISE PERFORMANCEAND RESTRUCTURINGINBELARUS .................................. PERFORMANCE,RESTRUCTURINGAND OWNERSHIP: TESTS HYPOTHESES .................................................................................................................... OF 78 D CONCLUSIONS . ................................................................................................................... 82 ANNEX 3.1: LESSONS FROMTHE ENTERPRISERESTRUCTURINGANALYSIS INTRANSITION 87 ANNEX 3.2: SPECIFICATION OF HYPOTHESES ...................................................................... 90 ANNEX 3.3: KEYRESULTSOFTHEENTERPRISERESTRUCTURINGSURVEY ......................... 91 CHAPTER4 TRADEAND GROWTH ......................................................................................... 100 A. OVERVIEW OF TRADE PERFORMANCE ........................................................................... 100 B EXPORT . CONCENTRATION AND SPECIALIZATION. TRADE COMPLEMENTARITYAND INTRA-INDUSTRY TRADE ................................................................................................ 111 c TRADEWITHRUSSIA:TRENDS, . ........................ 117 F CONCLUSIONSAND RECOMMENDATIONS . ROLE OF POLITICAL FACTORS, RISKS ...................................................................... 135 ANNEX 4.1. TRADESTATISTICS .................................................................................... 138 ANNEX 4.2. CLASSIFICATIONOFBELARUS CLASSES 154 CHAPTER5 BUSINESS ............................................................................................................................... EXPORTS IMPORTSINTOTHEBASICSNA AND ENVIRONMENT FORTHE ENTERPRISE SECTOR DEVELOPMENT 155 A 156 B BEHAVIORAL 158 c... STRUCTURAL DETERMINANTS THE BUSINESS OF ENVIRONMENT ................................ DETERMINANTSTHEBUSINESS OF ENVIRONMENT ................................ REGULATORY COMPLIANCE COSTS .............................................................................. 163 D QUALITATIVE 173 E CONCLUSIONS .. ANALYSISOFTHEBUSINESS ENVIRONMENT ......................................... ................................................................................................................. 175 CHAPTER6 PERFORMANCEAND PROSPECTSOFTHEAGRO-FOOD SECTOR ....................... 177 A .................................................... 177 B STRUCTURAL CHANGE AND POLICY DEVELOPMENTS 180 c EXPLAININGOUTPUT 186 D THEAGRO-FOOD ....OVERVIEW OF TRENDS INTHE AGRO-FOOD SECTOR ................................................... AND PRODUCTIVITY GROWTH INAGRICULTURE ........................ COMPLEX IS COMPETITIVE, BUT THE SOURCES OF ITSAPPARENT COMPETITIVENESS ARE NOT SUSTAINABLE ................................................................... 189 E THESUSTAINABILITY OFTHE SECTOR'S PERFORMANCE .............................................. 200 F CONCLUSIONSAND RECOMMENDATIONS .. ...................................................................... 202 CHAPTER7 DEVELOPMENTS INTHEENERGY SECTOR ........................................................ 205 A DYNAMICOFTHE ENERGY SECTOR INDICATORS IN2001.04 ....................................... 206 B ENERGYEFFICIENCYINBELARUS ................................................................................. 209 c. .. BELARUS' D THEDELIVERYOFACCEPTABLE . ..............................................................................................................................................215 DEPENDENCERUSSIA THE PRIMARYSOURCEOFENERGY ON AS SUPPLIES 212 UTILITYSERVICESTO DOMESTIC CUSTOMERS E MAXIMIZING BENEFITASSOCIATEDWITHBELARUS' . THE TRANSITCOUNTRY ........................................................................................................ ROLEASAN ENERGY 220 F PROTECTINGTHE INTERESTS OFTHE STAKEHOLDERSINTHE SECTOR 223 G CONCLUSIONSAND RECOMMENDATIONS .. ...................... ...................................................................... 224 CHAPTER8 PRIORITYDIRECTIONSFORREFORMS ............................................................... 226 REFERENCES .......................................................................................................................... 231 Listof Tables Table 1.1: Belarus: Basic Macroeconomic Indicators.................................................................... 1 Table 1.2: Selected Trade andDebt Ratios UsingOfficial andAlternative Exchange Rate, % of Table 1.3: Price Regulation inBelarus ........................................................................................... GDP" ....................................................................................................................................... 3 6 Table 1.4: Belarus: Actuarial, Conventional, andHiddenDeficits .............................................. Table 1.5: GDP Growth, Average Annual GrowthRates, % ....................................................... 14 17 Table 1.6: Contributionto GDP GrowthbyPeriod: Expenditure-Side View .............................. 17 Table 1.7: Consumer Goods Imports inHousehold Consumption inBelarus, 2000-03 19 Table 1.8: GDP by Sector, In% to Nominal GDP at Factor Costs .............................................. .............. Table 1.9: Wages and Employment .............................................................................................. 21 23 Table 1.10: Incidence of State Support, Current BYRbillion andpercent of GDP ..................... 26 Table 1.11:Tax Concentration inBelarus: Shares of 10, 50 and 100Taxpayers inTotal Proceeds 31 Table 2.1: IndustrialStructure, Shares of Selected Sub-sectorsin............................................... of Consolidated Budget, %................................................................................................... 33 Table 2.2: Distribution of Industrial Enterprisesby Size ............................................................. 34 Table 2.3: Share of Exports to Russia inTotal National Output (4)............................................. Table 2.4: Ownership Structure inIndustryin2004, %............................................................... 35 Table 2.5: Tax Burdenby Industrial Sub-Sector, %a' ................................................................... 36 38 Table 2.6: Summary Indicators of Industrial Development, 1996-2003 ..................................... 39 Table 2.8: Capacity Utilization inIndustry, 1995-2003, %.......................................................... Table 2.7: Indices of Total Output by IndustrialSectors, InPercent to the Previous Year..........43 47 Table 2.9: Decomposition of GrowthinIndustrial Output: Contributions ofEmploymentand ProductivityFactors to SectoralGrowth, 1997-2003, YO...................................................... 51 Table 2.10: Developments inUnit Labor Costsby Industry, 1997=1 .......................................... 53 Table 2.11:Investment/Output Ratio inIndustry, 1999-2003, YO 58 Table 2.12: Profitability and Gross Profit Margin, 1999-2004,Percent....................................... ................................................ Table 2.13: Competitive Advantages inIndustry by Markets ...................................................... 60 63 Table 2.15: Factors that Hinder Growth inCompetitiveness ....................................................... Table 2.14: Dynamics of competitive advantage inindustry ....................................................... 64 Table 3.1: Characteristics ofEnterprise Sample........................................................................... 65 72 Table 3.2: Difference inAttitudes among Enterprise Groups, 2000 and2004............................. 74 Table 3.3: Percentage o f EnterprisesReporting Recent GrowthinMainPerformance Indicators ............................................................................................................................................... 75 Table 3.4: The Most Important Sources of Investment Financing for Enterprises 75 Table 3.5: Use ofFinancia1 Resourcesby FirmType, 2004 (% total) ......................................... ....................... 76 Table 3.6: Social Assets Owned by Enterprises ........................................................................... 77 Table 4.2: Indicators o f Trade Performance: Belarus and SelectedEuropeanCountries...........101 Table 4.1: Belarus: Merchandise Trade Dynamics, 1996-2004 ................................................. 102 Table 4.3: Geographical Structure of Merchandise Exports, % ................................................. 104 Table 4.4: Geographical Structure o fMerchandise Imports, % ................................................. 104 Table 4.5: Commodity Structure of Merchandise Exports in 1998 - 2004, % ........................... 108 Table 4.6: Commodity Structure of Merchandise Imports in 1998-2004, % ............................. 108 Table 4.7: Indices o f Export Concentration for Belarus, 2001-03.............................................. 112 Table 4.8: Export Concentration Indicators: Belarus, Lithuania, Ukraine andPoland .............. 113 Table 4.9: Export Specializationby Export Market: Number o f Product Groups with a Strong 114 Table 4.10: Grubel-Lloyd Indices for Belarus, Ukraine andPoland, 1998-2004....................... R C A (>2)* .......................................................................................................................... 115 Table 4.11: Shares o f Belarus Exports to Russia inRussianVisual Consumption andProduction, 118 Table 4.12: Resource Transfer from Russia, by Selected Channel, US$ million....................... Percent................................................................................................................................. 119 Table 4.13. Import-Weighted Average Tariff Rates inBelarus (inpercent) .............................. Table 4.14: Basic Characteristics o f Tariff Schedules inBelarus and Selected Countries ......... 125 126 Table 4.15: Import-Weighted Average Tariff Rates Appliedto Agricultural Imports from All Table 4.16: Taxation o f Trade inBelarus ................................................................................... MFNPartnersin2003, byHS Chapter, Percent................................................................. 127 132 Table 5.1: Private Sector Share inGDP (%)............................................................................... Table 4.17: Legislative Issues on WTO Accession .................................................................... 134 156 Table 5.2: DifferentRegulatory Regimes for New and Traditional Enterprises ........................ 160 Table 5.3: Index o f Economic Freedom ..................................................................................... 160 Table 5-4:InwardFDIPerformance Index (ratio o fFDIglobal share to GDP global share) and Table 5.5: Changes inProcedures and Conditions Attached to Import Transactions ................ 166 InwardFDIPotential (ranking among 140 countries), 1997-2002..................................... 168 Table 5.6: Changes inProcedures and Conditions Attached to Export Transactions ................ 168 Table 5.7: Assessment o f Taxation Problems bythe Polled Economic Entities........................ 169 Table 5.8: How does the State Control Prices for Goods and Services? (% o fpositive answers) ............................................................................................................................................. 170 Table 5.9: D o State Agencies Exert Any Influence on Pricing? (%) ......................................... 170 Table 5.10: How Managers Assess the Current Employment Level o f Their Firms, by size o f the 171 Table 5.11: Reasons Precluding Reduction o f Staff (% o fpositive answers) ............................ firm (%)............................................................................................................................... 171 Table 5.12: Hiringand FiringIndicators, 2004.......................................................................... Table 5.13: Dynamics o f Bankruptcy Cases, 1998-2002 ............................................................ 172 Table 5.14: Efficiency o f the Bankruptcy Procedures inTransition, 2003-04 ........................... 173 173 Table 6.1: Average Annual Growth (Decline) inGross Agricultural Output inBelarus, Russia andUkraine, percent ........................................................................................................... 178 Table 6.2: ProductionVolume Index for the Selected Agricultural Commodities inBelarus Table 6.3: Growth inOutput Volume, Landand Labor Productivities (2000-2004) ................. 179 (1999=100) .......................................................................................................................... 178 Table 6.4: Development inthe Belarusian Food-Processing Sector........................................... 180 180 Table 6.6: Legal and Organizational Types o f Larger Agricultural Enterprises ........................ Table 6.5: Belarus FoodTrade (US$ million) ............................................................................ Table 6.7: Number and Average Size of Agricultural Organizations and Private Farms........... 184 183 Table 6.8: Structure of Agricultural Output and Land Holdings by DifferentFarmCategories (%) Table 6.9: ProductionandUtilization of Agricultural Machinery and Fertilizers inBelarus ....184 ............................................................................................................................................. 185 Table 6.10: Use of Selected Inputs inAgricultural Productionby Agricultural Enterprises in Belarus, 2000-03 ................................................................................................................. 186 Table 6.11: Profitability of Sales for Selected Agricultural Commodities by Agricultural Enterprises inBelarus, 2000-03, percent ............................................................................ 188 Table 6.12: Estimate of the Implicit Tax on Agricultural Producers 2000.03. percent of output ............................................................................................................................................. 190 Table 6.13 : Levels of Agricultural ProducerPrices inBelarus andRussia for Selected Table 6.14: SelectedAgricultural InputPrice Levels inBelarus and Russia, BYRper unit...... 191 Commodities, BYRper ton, 2000-03 ................................................................................. 192 Table 6.15: Comparative Trends inPartial Productivity Indicators for Selected Commodities, Belarus and Russia.............................................................................................................. 193 Table 6.16: Retail Prices for SelectedFoodstuffs, Belarus andRussia, BYR ............................ 194 Table 6.17: Processor Prices for Selected Foodstuffs, Belarus andRussia, BYR...................... Table 6.18: Agricultural Output, LandUse and StateBudgetary Support, 2000-05 .................. 195197 Table 6.19: Sources o f Budgetary Expenditure to the Agro-Food Sector, 2001-05 (Billion Table 6.20: Credit Subsidies, 2001-05........................................................................................ Rubles)................................................................................................................................ 197 199 Table 6.21: Interest Rates andthe Level of Lending to the Productive Sectors inBelarus, 2003- Table 6.22: Volumes o f Budgetary Support to Agriculture inSelected Countries in2003 .......200 04......................................................................................................................................... Table 7.1: Belarus Actual Gas Tariffs with VAT, US$/MCM................................................... 201 Table 7.2: Belarus, Poland andUkraine Electricityand Gas Sector Data, 2001-04 208 Table 7.3: Belarus Primary Energy Supply andConsumption................................................... ..................207 Table 7.4: Cost of Energy Imports.............................................................................................. 213 214 216 Table 7.6: Gas Sector Implicit Subsidies.................................................................................... Table 7.5: Electricity Sector Implicit Subsidies ......................................................................... 216 Table 7.8: Prices of Energy Purchasesfrom Russia................................................................... Table 7.7: Electricity and Gas Tariffs in2004............................................................................ 216 Table 7.9: Price of Gas at the Border of CIS Countries Suppliedby Russia ($/MCM) .............218 219 Table 7.10: EstimatedEconomic Gain ofBelarus from Depressed Import Gas Prices (US$) ...219 Table 7.11:Gas Transit Fee Arrangements ................................................................................ 222 Listof Figures Figure 1.1. Belarus: Macroeconomic PerformanceinComparative Perspective........................... 4 Figure 1.2: Belarus Transition Indicators. 2004 ............................................................................. 6 Figure 1.3: Cross-Subsidization and Cost Recovery inthe Utility Sector (For Services Provided to Households) ........................................................................................................................ 6 Figure 1.4:Domestic Credit andReal Lending Rates inBelarus andNeighboringCountries Figure 1.5: Seignorage and Inflation Tax inBelarus. %. GDP..................................................... .... 12 15 Figure 1.7: Monetization(M2/GDP), %....................................................................................... Figure 1.6: Dollarization: Foreign Currency Deposits/M3, % ..................................................... 15 16 18 Figure 1.9: Labor Productivity and Wage Growth ....................................................................... Figure 1.8: Contribution to GDP Growth, Expenditure Side View.............................................. Figure 1-10:Domestic Savings, Investment andthe Gap, % GDP............................................... 19 21 Figure 1.11: Contribution to GDP Growth, Production Side View, in% .................................... 22 Figure 1.12: Tax BurdeninBelarus and inRussianFederation, % GDP, 2003 Figure 2.2: Profit/Wage Ratio inIndustry,%............................................................................... Figure 2.1:Privatization and Corporatization of Enterprises HeldinRepublican Ownership,....30 ........................... 36 37 Figure 2.3: SectoralContributions to Industrial Growth, 1999-2003, % ..................................... 39 Figure 2.4: Wage and Productivity inIndustry, 1995-2004, 1995=100 ....................................... 40 Figure 2.5: Trends inIndustrialOutput According to Official and SurveyData......................... 41 Figure 2.6: Changes inOutput. Demandand Inventories According to the Survey Data (Balance Figure 2.7: Industrial Growth inBelarus, Russia, andUkraine (Balance of Answers) ................42 of Answers) ........................................................................................................................... Figure 2.8: Dynamics o f Relative ProducerPrices inBelarus, Ukraine, andRussia ...................44 45 Figure 2.9: Relative ConsumerPrices and Wages inBelarus andRussia.................................... 45 Figure 2.10: Labor Market Trends inBelarus, 1990-2004........................................................... 48 Figure 2.12: Employment andProductivity Growthby Industrial Sub-sector, ........................... Figure 2.11:Employment GrowthinSelectedTransition Economies, ........................................ 49 51 Figure 2.13: ProductivityTrends inVarious Industrial Sub-sectors, ........................................... Figure 2.14: Developments inUnit Labor Costs inIndustry,Belarus andRussia, 1995-2003 ....52 54 Figure 2.15: Labor Productivity inSelected Industrial Sub-sectorsinBelarus and Russia, ........ 55 Figure 2.16: FixedCapital InvestmentsinSelected Transition Economies, ................................ 56 Figure 2.17: Changes inOutput and InvestmentsinIndustryinBelarus andRussia (Balance o f Answers) ............................................................................................................................... 56 Figure 2.18: Investment GrowthinIndustry, 2000-03, % to the Previous Year .......................... Figure 2.19: Managers' Answers about Recent Changes inPerformance o ftheir Enterprises....57 59 Figure 2.20: Share of Loss-making Enterprises, % ...................................................................... 61 61 Figure 2.22: Changesin Sales at DifferentMarkets..................................................................... Figure 2.21: Profitability and Labor Costs inIndustry, 1997-2003.............................................. 62 Figure 3.1: Percent of firms calling competition from import not important or only slightly Figure 4.1: Merchandise Exports, Imports andTrade Balance, 1996-2004(US$ million)........ 101 important in 1999and2002.................................................................................................. 85 101 Figure 4.3: Trade Reorientation: Belarus and the Neighboring Countries ................................. Figure 4.2: Belarus: Trade inServices, 1996-2004 (US$ million) ............................................. 103 Figure 4.4a: Trade Balance by Export Markets (US$ million) andBilateralReal ExchangeRates 105 Figure4.5: Terms of Trade Index, 1997-2004............................................................................ Indices (1996=100) ............................................................................................................. Figure 4.6: Price- andNon-price Factors of GrowthinExports and Imports, 1997-2004, % .... 106 107 Figure 4.7: Merchandise Exports andImports by End-useCategories, percent......................... 110 Figure 4.8: Merchandise Exports andImports by End-useCategories:Belarus andNeighboring Countries, * percent............................................................................................................. 110 Figure 4.9: Factor Intensity o f Exports: Dynamics and Comparison with Neighboring Countries, Percent................................................................................................................................. 111 Figure 4.10: Factor Intensity o f Imports: Dynamics and Comparison with Neighboring 111 Figure 4.11: Trade Complementarity Indices for Belarus, 1998-2003....................................... Countries, Percent............................................................................................................... 114 116 Figure 4.13: RussianExport Prices of Oil to SelectedDestinations, US$ per ton..................... Figure4.12: Export-FDIinterlink: a global view, 1995-2002.................................................... 120 Figure 5.1: Numbero f Small Enterprises and Their Share inOutput andEmployment............ 157 Figure 5.3: Global View: Economic Incentives Regime ............................................................ Figure 5.2: Business Telephone Connection Charge as Share of GDP per capita, 2002, %......158 Figure 5.4: Share of surveys firms that are involved inbribing government officials, 2002 .....161 Figure 5.5: Perception of the Business Environment Evolution................................................. 162 Figure 5.6: Average Duration for Business Registration, days .................................................. 163 164 Figure 5.7: From Which of the Followingdoes Your Company Face the Greatest Competitive Threat? ................................................................................................................................ 165 Figure 5.8: Evaluation of the Severity o f Problems (10-point scale: 10 i s severe problem and 1i s no problem) andtheir Dynamics by the Regulatory Area (1O-point scale: -/+5 i s the largest negative/positive change during the last year) .................................................................... 167 Figure 5.9: Average Number of Days it Took in2001 to Clear Imported Goods through Customs ............................................................................................................................................. 168 Figure6.1:Volume Index of Agricultural Outputby Farm Category (1990-2004) ................... 186 Figure6.2: Real Producer Prices and the "Internal Terms o fTrade" inBelarus Agriculture, ... 187 Figure 6.3: Real producer Prices for Selected Commodities. 2000-03 ....................................... 188 Figure 6.4: Schematic Depiction o f the System o f State Support for the Agro-Food Sector in Belarus ................................................................................................................................ 196 Figure6.5: Sources o fState Fundingo f Support to the Agro-Food Sector in2004 (top) and 2001 .......................................................................... Figure 7.1: Comparisons o f Household and Industrial Tariffs for Gas, 2001-04 ....................... (bottom) (Inconstant 2001 US$ millions) 198 209 Figure 7.3: GDP (inPPP) Energy Intensity inSelected Countries in2002................................ Figure7.2: Total Primary Energy Supply per GDP (PPP), kgo.e.AJS$l,OOO ........................... 210 211 Figure7.4: Financingo fEnergyEfficiency Projects inBelarusin2000-05 .............................. 212 Figure 7.5: Belarus Domestic and Foreign EnergyDebts as o f January 1, 2004" ..................... 217 Figure7.6: Belarus Paymentto Russiafor Imported Electricity................................................ 218 Figure7.7: Belarus Payment to RussianGas Suppliers .............................................................. 218 Figure 7.8: Russian Gas Transit through Belarus' Territory ...................................................... 222 List of Boxes Box 1.1: Quality of Belarusian Statistics........................................................................................ 2 Box 1.2: "Golden Share" Rule inBelarus ...................................................................................... 8 Box 1.3: Belarus Recovery and GrowthExperience: Important Earlier Lessons from Transition 9 Box 1.4: Improvements inthe Area o f Fiscal Management ......................................................... 13 Box 1.5: Some Weaknesses o f the Existing Macroeconomic Framework ................................... 28 Box 1.6. Balance of Payments Vulnerability ................................................................................ Box 2.1: MinskTractor Plant: A Typical Story of Transitional Survival .................................... 29 Box 3.1:Methodology ofthe Survey............................................................................................. 46 Box 3.2:. Comparing the Results o f 2000 and2004 Enterprise Restructuring Surveys ............... 68 73 Box 4.1: Comparative Dynamics o f Exports to Russia from Ukraine and Belarus.................... Box 4.2: Russia-Belarus Sugar Dispute...................................................................................... 123 124 Box 4.3: Anti-DumpingMeasures Belarus Faces Recently ....................................................... 130 Box 4.4. Selected Directions for Export Promotion for 2005..................................................... 131 Box 5.1: Business Environment and Growth .............................................................................. Box 5.2: The Main Weaknesses of the Market Socialism o fthe 1970s and 1980s.................... 155 159 Box 5.3: Business Climate Survey Methodology ....................................................................... Box 7.1: International Borrowings byNaftogaz of Ukraine....................................................... 165 221 Box 8.1. Major Government ReformandDevelopment Programs ............................................ 226 ACKNOWLEDGMENTS The study was prepared by the World Bank team lead by Lev Freinkman in close cooperation with the Ministry of Economy of Belarus and in partnership with several Belarusian think tanks. The primary authors o f the study are Marina Bakanova and Lev Freinkman (Chapter l), Lev Freinkman (Chapter 2), Saul Estrin (Chapter 3), Marina Bakanova and Evgeny Polyakov (Chapter 4), Gregory Jedrzejczak and Svitlana Lewis (Chapter 5), Gerry Boyle and Bekzod Shamsiev (Chapter 6), Yuri Mirochnichenko (Chapter 7), and Lev Freinkman (Chapter 8). Maryna Sidarenka provided the researchassistance. The team gratefully thanks the Government Interagency Working Group led by the Deputy Minister o f Economy Ms. Tatiana Starchenko for guidance, cooperation, and support at all stages o f the CEM preparation. The intensive efforts o f the Ministry o f Economy and other agencies in helping to prepare this report are gratefully acknowledged. The team is particularly grateful to the Deputy Minister o f Statistics and Analysis, Ms. h a Medvedeva, and other staff o f the Ministry o f Statistics and Analysis, for the highquality and timely statistical support. Inaddition, the team benefited greatly fkom discussions withthe representativeso fthe donor community, local think tanks, and independent experts. The background papers for the study were prepared by Alexander Gotovsky, Igor Zeltkov, Dmitry Khamchukov and Irina Kovalevskaya (Research Institute o f the Ministry o f Economy); Victor Tomashevich and Vladimir Elsukov (Research Institute o f the Ministry o f Statistics and Analysis); Elena Klochan (World Bank); Vera Volchok, Igor Pelipas and Sergei Pukovich (Institute o f Privatization and Management); and Victor Vorobiev (Belarusian State Economic University). Important contributions were also provided by Olga Antimonova, Veronica Bacalu, Valery Dashkevich, Brenda Gonzalez- Hermosillo, Balazs Horvath, Nikolai Lisai, John Litwack, Elena Rakova, Mikhail Prydilnikov, Konstantin Senyut, Dmitry Kaletchitz and Irina Torskaya. The team i s also grateful for the valuable comments and suggestions received from Benoit Blarel, Mark Davis, Timo Hammaren, Ruslan Piontkivsky, Peter Thomson, Lucio-Mauro Vinhas D e Souza, Vadim Voronin, and Rostyslav Zhuk. Usha Rani Khanna and Emily Evershed assisted with editing the report, while Ludmila Mazai, Irina Partola and Helena Makarenko provided excellent support during the entire preparation process for the study. Daniela Gressani (ECCU7) and Thomas Richardson (IMF) were the peer reviewers for the study. Asad Alam was the Sector Manager supervising the preparation o f the study. Cheryl Gray was the Department Director, and Paul G. Bermingham was the Country Director for Belarus. The preparation o f the study also benefitedfrom generous co-funding provided by the government o f Ireland. CHAPTER 1 MACROECONOMIC FRAMEWORKGROWTH:FOR RECENT TRENDS AND R I S K S 1.1 This chapter presents an overview of macroeconomic developments in Belarus since 1996, including the sources and structure of the country's economic growth. It also analyzes the role of the government's macroeconomic policies in supporting growth, including the provision of state support to the real sector, as well as employment and wage benefits from the recent economic expansion. Special attentioni s paidto the risks for future growth associatedwith Belarus' macroeconomic performance. A. MACROECONOMIC OFGROWTH OVERVIEW PERFORMANCE 1.2 The Belarusian economy has experienced steady and sizable growth since 1996. Following an estimated decline of close to 40 percent during the period 1992-95, GDP growth resumed in 1996.' During1996-2004, GDP grewby 77.4 percent, at 6.6 percent on averageper annum. Annual growthrates fluctuated between 2.6 and 11.4 percent (Table 1.1). Rates of GDP growth in 1999-2002, inthe aftermath of the Russia crisis, were relatively moderate, but growth accelerated in2003 to 7 percent and further to 11percent in2004. Table 1.1:Belarus: BasicMacroeconomicIndicators, 1996-2004 1996 1997 1998 1999 2000 2001 2002 2003 2004 GDP (nominal, US$ m)* 14,328 13,845 14,522 11,158 13,055 12,313 14,557 17,755 22,880 GDP per capita (current US$)* 1,413 1,372 1,445 1,114 1,307 1,237 1,471 1,803 2,335 GDP per capita PPP (current international US$) 3,360 3,831 4,215 4,430 4,802 5,163 5,542 6,065 6,906 % changes over theprevious year: GDP 2.8 11.4 8.4 3.4 5.8 4.7 5.0 7.0 11.0 Industrial output 3.5 18.8 12.4 10.3 7.8 5.9 4.5 7.1 15.6 Agricultural output 2.4 -4.9 -0.7 -8.3 9.3 1.8 0.7 6.6 12.9 Consumer prices 52.7 63.8 73.0 293.7 168.6 61.1 42.6 28.4 18.1 Real wages 5.1 14.3 18.0 7.3 12.0 29.6 7.9 3.2 16.8 Unemploymentrate, %** 4 2.8 2.3 2.1 2.1 2.3 3.O 3.1 1.9 Poverty incidence (national definition) 38.6 32.1 33.0 46.7 41.9 28.9 30.5 27.1 17.8 Gini (income concentration) 25.4 25.8 28.3 26.9 27.0 27.8 27.2 25.4 25.4 General government balance, %GDP -1.6 -0.7 -1.o -2.0 -0.1 -1.9 -1.8 -1.4 0.0 Merchandise trade balance, % GDP -8.0 -10.2 -10.3 -5.1 -6.8 -6.6 -6.3 -7.1 -9.0 Current account balance, %GDP -3.6 -6.2 -7.0 -1.7 -2.6 -3.2 -2.1 -2.4 -4.6 FDI, net (BOP, current US$ m) 104.5 349.5 200.9 443.2 118.6 95.5 453.3 170.3 168.1 FDI per capita, net (BOP, current US$) 10.3 34.6 20.0 44.2 11.9 9.6 45.8 17.3 17.2 Gross official reserves (inmonths of imports o f goods and services) 0.7 0.5 0.5 0.5 0.5 0.5 0.6 0.5 0.6 Population, m 10.14 10.09 10.05 10.0 9.99 9.95 9.90 9.85 9.80 ** At * Officially average official exchange rate. registered. Sources; MSA, NBB, MOF, IMF, WDI. 'For a detailed description of Belarus' initial conditions and initial recovery and growth, see Bakanova et al., 2004. 1 Box 1.1: Quality of Belarusian Statistics Belarusian official statistics are often met with significant skepticismbased onthe assumption that the close monitoring o f targets for output and growth creates incentives to inflate the data at all levels. This seems to be too simplistic view. Given Belarus' specifics as a highly concentrated and regulated economy, the statistics i s rather rich and the reporting requirements are high, fairly abundant and strictly monitored. Administrative punishment i s equally severe for unmet targeted indicators and data distortions. At the same time, the quality o f personnel in government agencies responsible for statistics i s high and the government has a good track record in implementing the recommendations o f technical assistance missions on statistics. Belarus subscribed to the SDDS on December 22, 2004. I In 2004, the IMF assessed the quality o f the six major macroeconomic datasets (National Accounts, CPI, PPI, Financial, Monetary and Balance o f Payments statistics) using the Data Quality Assessment Framework (DQAF) and prepared the Report o n the Observance o f Standards and Codes (ROSC) data module. The Report concluded that the quality o f Belarus' macroeconomic statistics has improved significantly inmany areas during the last few years, but that further progress i s to be made. Inparticular, the following points are worth mentioning: 1 Prerequisites of quality. The legal framework for statistical activity has been established. Staff resources at all three major agencies (Ministry o f Statistics and Analysis, Ministry o f Finance, and the National Bank o f Belarus) are mostly adequate. 1 Assurances of integrity. All three agencies demonstrate professionalism, and all provide guidelines on ethical conduct for their staff. 1 Methodological soundness. All datasets are in the stages o f meeting internationally accepted methodological guidelines but could come closer in certain areas. Some work is under way, especially that related to the implementation o f international classifications. 1 Accuracy and reliability. In general, datasets receive high marks for their accuracy and reliability. Belarus' statistical system has generally comprehensive and timely sources o f data. The measures taken in assessing and validating source data, intermediate data, and statistical outputs appear appropriate. However, there is a concern about the accuracy and reliability of the actual data produced, particularly for GDP and for industrial and agricultural production. T o erase this concern, it was recommended to all the data agencies to enhance their data assessment and validation procedures, finding ways to increase users' confidence in the accuracy andreliability o f official statistics. InJanuary 2005, the more recent IMFmissionon National Accounts Statisticsconcludedthe following: . 1 The Ministryo f Statistics and Analysis (MSA) has implemented or i s inthe process o f implementing most o f the recommendations o f the 2004 ROSC mission. The M S A does its best to improve the production o f data o n a continuous basis and adheres to the international and best recommended standards. 1 Ingeneral, sound techniques and procedures are applied for the compilation o f the national accounts and only a few additional refinements would further improve the estimates. The latter refers to the improvemenl inthe calculations o fthe volume indices o fintermediate consumption andthe volume index o fretailtrade. 1 The estimates o f the economic activities o f the informal sector could be improved. 1 Regarding the GDP growth rates, the methods and procedures applied by the M S A are in accordance witk international standards and the GDP data are consistent with the source data. 1 The switch to the new industrial production index starting from 2006 and its incorporation in GDF calculations is strongly encouraged. Sources: IMF f2005a and 2005bl 2 1.3 Although the official data on Belarusian growth are often met with considerable skepticism,2 our comparison o f the official growth data with alternative growth estimates, based on business surveys, has revealed a fairly high correlation in the identified growth trends. This supports the argument that economic growth inBelarus has been real and not merely a statistical phen~menon.~(See also Box 1.1on other statistical issues.) 1.4 Economic growth in Belarus has been rather broad-based. It has been driven primarily by improvements in labor productivity and increases in both energy efficiency and capacity utilization (see Chapters 2 and 7 for details). Fiscal and external adjustments were significant and helped to improve the macroeconomic conditions for growth. Incontrast to some other CIS countries, where growth and exports remain concentrated inthe extracting sectors with limited employment opportunities, the growth structure in Belarus has been much more beneficial for labor. As is shown later in this report, growth in labor- intensive sectors, backed by government wage and income policies, helped to ensure that the benefits from the recent growth were fairly broadly shared by the p~pulation.~Poverty rates declined substantially, while inequality remained stable and moderate. The poverty headcount ratio (national definition) fell from 38.6 percent o f the population in 1996 and 46.7 percent in 1999 to 17.8 percent in 2004, while inequality, which was moderate by regional standards duringthe entire period o f economic growth, decreased further after 2001, This decline inpoverty is, however, inline with a broader trend inpoverty reduction that took place recently inthe transition economies. A recent World Bank study (2005b) concluded that more than 40 million people moved out o f poverty during 1998-2003 in the E C A region. This remarkable achievement i s the result o f a unique constellation of factors - rapid "catch-up" growth in the CIS accompanied by reductions in inequality in some countries. Table 1.2: SelectedTrade and Debt RatiosUsingOfficial and Alternative ExchangeRates, - CurrentAccount Externaldebt** balance/GDP,YO and servicedGDP, % Balance/GDP,YO outstanding/GDP,YO Off. Alt.rate Rate Alt.rate Off. Rate Akrate - I I 1996 -8.0 -9.3 -4.0 -4.7 -3.6 -4.2 6.7 7.8 1997 -10.2 -12.3 -6.2 -7.5 -6.2 -7.5 7.0 8.5 1998 -10.3 -23.2 -7.0 -15.8 -7.0 -15.7 7.0 15.6 1999 -5.1 -9.1 -2.3 -4.1 -1.7 -3.1 7.9 14.2 2000 -6.8 -9.0 -3.4 -4.6 -2.6 -3.5 6.2 8.3 2001 -6.6 -6.5 -4.1 -4.1 -3.2 -3.2 6.2 6.1 2002 -6.3 -6.2 -3.3 -3.3 -2.1 -2.1 5.6 5.5 -2.4 -2.4 4.2 4.2 -2003 -7.1 -7.1 -3.8 -3.8 2004 -9.0 -9.0 -5.9 -5.9 -4.6 -4.6 3.2 3.2 * The alternative rate is calculated as 0.3*official NBBrate+0.7parallel market rate (inall cases, period averages were **used). Medium-andlong-termdebtonly. Source; World Bank staff calculations. See IMF (2005~)for the summary o f statistical measurement issues and sources o f potential upward bias in reported national accounts. However, the conclusion is that "the overall size o f statistical measurement biases remains to be quantified, but appears not to fundamentally alter the picture conveyed by official national accounts statistics pointingto strong output growth inrecent years" (p.4). See Chapter 2 for details. This is confirmed by findings from the recent Poverty Assessment by the World Bank (2004a), which concluded that poverty reduction in Belarus was significant and that this has been almost entirely due to economic growth, sharedbroadly across sectors, regions, and population groups. 3 Figure 1.1:Belarus: Macroeconomic Performance in Comparative Perspective Figure 1.1B: Annual Inflation Figure1.1A: GDP Growth, YO (ChangeinPeriod-Average CPI, YO) 10 . ................ ., ,I OCEEBS ...................................................... ...... ELithuanir EaPoland OCIS ERussia IWI-IIX4 I DUkraine OUkraine -2 ................ PBelarus ~ sBelarus 19962000 20014004 Figure 1.1C: FiscalBalance, %GDP Figure 1.1D: ExternalDebt to GDP Ratio, YO ... ........................ ....._.--- ... ..I 70 0CEEBS CEEBS 4 3Llthuaoia ELithuanii 50 0Polaod 0Poland 40 CIS ....... ' 30 0 Russia Russia 20 OUkraloe 0Ukralne ................. .........................................., IO I EBelarus Belarus -10 I 0 199bIWO 2001-2004 Figure 1.1E: CurrentAccount Balance, YOGDP Figure 1.1F:Net FDIper Capita, Cumulative per Periol (US$ m) t 16 OCEEBS 800 ........ .......................................... UICEEBS 10 .-- BLlthuanla BLlthumla 5 DPolnnd ElPoland 0 mCIS CIS 5 0Russla Ruiris .10 ..... .................................................... 1 OUkraine OUkrPine EBelarus 199b2WO 2WI-2001 UBslarvr -15 ......... ..... ........... .... Source: WorldBank ECA regional database. 4 1.5 We distinguish between the two periods of growth, 1996-2000 and from 2001 onwards.' Both external and internal environments differ substantially among these two periods, influencing Belarus' growth patterns (as shown below inthis chapter). Belarus' performance vis-a-vis other transition economies has also been somewhat different during the two periods (Figure 1.1A-F).For a number o f indicators (GDP growth, debt and deficit), Belarus ranks favorably in relation to its comparators. However, its relative strength became less prominent during the second period and even disappeared in some instances. Thus, before 2001 in terms o f economic growth Belarus outperformed both the Central Eastern European and Baltic countries (CEEBS) and the CIS, but during the second period (2001-04), the CIS as a group had a stronger performance than Belarus and the difference in growth rates between Belarus and the CEEBS decreased. Inaddition, Belarus' relatively strong debt and trade indicators in the late 1990s should be treated with caution: the use o f the official exchange rate at the time o f the multiple exchange rate system distorted the data. The application o f the alternative exchange rate6 revealed that duringthe first period o f growth Belarus had much more serious problems with its balance of payments than i s usually recognized (Table 1.2). In 1998 the current account deficit amounted to almost 16 percent of GDP, while the official numbers show only 7 percent. However, both measures show a strong post- 1999 recovery in all main indicators o f external vulnerability, indicating a strong external adjustment (Figure l.lD).7 1.6 The macroeconomic performance during the years of economic growth has been rather mixed (Table 1.1). Belarus has managed to maintainmoderate budget deficits and debt levels. However, such indicators as inflation, FDIinflow, and the current account balance were weak. Inflation in Belarus, which i s being reduced substantially lately, remained significantly higher during both periods than in other transition economies, including neighboring countries. The current account position i s still precarious, given the low level o f reserves, the inability to attract a sizable amount o f FDI, and the limited access to international financing. 1.7 Progress in structuralreforms has been slow and inconsistent.Ingeneral, Belarus is lagging behind most o f the transition economies in various aspects o f the transition (Figure 1.2). Across nine broad reform areas, most o f the progress attained relates to price and trade liberalization. However, it i s indicative that among all transition economies Belarus with its rating o f 2.5 remains the least advanced country inthis areaa8After the initial liberalization, which took place in the early years o f independence, little progress was made during 1996-2000. During the second period (2001-03), some further progress was achieved: the number o f goods and services subject to price regulation was reduced, cost-recovery in utility tariffs by population increased, while the level o f cross-subsidization was lowered substantially. However, even in this area there i s still considerable room for further liberalization. Moreover, some worrisome signs o f policy reversal appeared in 2004 -- the number o f goods subject to price regulation increased, cost-recovery inutilities declined, and arrears for utilities began to accumulate again (Table 1.3 and Figure 1.3). The first year of economic growth, 1996 is somewhat transitional. Strictly speaking, 2000-01 should also be considered as a transitional sub-period to another pattern o f growth. For simplicity o f analysis, we include 2000 in the first growth period and 2001in the second one. The alternative rate is estimated based on the official andparallelmarket average exchange rates, with the weights o f 30 percent and 70 percent, respectively. 'It i s worth noting that there was another significant deterioration inboth the current account and the trade balance in 2004. Both still remain stronger than in 1997-98. Out o f 27 transition economies, only Belarus, Turkmenistan and Uzbekistan had such a low rating inthis area. 5 Figure 1.2: BelarusTransitionIndicators, 2004 2.5 2.0 1.5 1.0 0.5 0 0 1 -Belarus -CMm -Max I Source: EBRD Transition Report 2004, Table 1.3: PriceRegulationinBelarus, 2000-04 2000 2001 2002 2003 2004 Number o f positions (goods and services) for whichprices are regulated (either fixed or ceiling prices are used) 66 66 62 59 61 Share of goods/services with regulatedprices inCPIbasket, % 27 25 24 21 24 Number o f positions (goods and services) for which margins are regulated (either profitability or trade margin is restricted) 8 7 7 8 8 Number o f enterprises which are on the list of monopolists/ and which require government clearance for their price increases 312 300 265 205 197 Number o f export commodities for which minimumexport prices are used 12 12 12 10 11 Source: Ministry o f Economy. Figure 1.3: Cross-Subsidizationand Cost Recovery inthe Utility Sector (for services provided to households), 2000-04 Figure1.3A: FinancingStructureinthe Utilitv Sector. YOof total .-I Cross-subsidizatio .! 0Subsidies from localbudgets .-I OTotal ~ Losses o f utilities companies 2000 2001 2002 2003 2004 6 Figure1.3B:ActualandEstimatedCostRecovery,YO 60 1 6 50 1 4 1 2= Collections, actua 40 % costs I O 30 0 8 Cost recovery in tariffs. % 0 6 20 0 4-I-Collectionlevel 10 (rhs) 0 2 0 0 0 2000 2001 2002 2003 2004 Source: Ministry o f Economy. 1.8 Small-scale privatization has yet to be completed, while large-scale privatization has been minimal and has practically stalled recently. Even those corporations that have been either partially or completely privatized are usually subject to a high degree o f administrative control. The "golden share" provisions are excessive and they are exercised inrelation to a number o f privatized enterprises (Box 1.2). As documented in recent global studiesg and in Chapter 5 of this report, small private businesses and individual entrepreneurs in Belarus face one o f the most hostile business environments among the European transition economies. Not surprisingly, the share of the private sector in GDP i s about 25 percent - the lowest among all transition economies" -- and the FDIinflow i s much lower than needed and predicted given Belarus' strategic geographical location, privileged access to the Russian market, educated and skilled labor force, and relatively good infkastructure. 1.9 Overall, the Belarusian economy hasa number of features that make it quite differentfrom its neighborsinboththe CIS and CEEBS. These features include: (i) the dominance o f traditional firms (state-owned or partially privatized) in production and exports; (ii) high degree o f government the interventions in enterprise operations, including the preservation o f some elements of central government planning o f output, wages, and employment; (iii) the high level o f the tax burden and the major budget redistribution of funds aimed at supporting traditional firms and employment; and (iv) the high dependence on trade with Russia and along with the slow pace o f geographic diversification o f exports. 1.10 This combination o f factors has supported continual predictions by economic analysts o f immediate economic decline and macroeconomic instability in Belarus. Yet Belarus has to date managed to defy these expectations. Moreover, the recent history of economic growth and relative stability has provided a degree o f credibility regarding the chosen economic strategy within the country and has provided support for the government's rejection o f the rapid market reform strategy o f neighboring countries, which was labeled as being socially disruptive. World Bank (2004c and 2005b). lo EBRD (2004). Only for Turkmenistan is the value o f the indicator the same. According to the national classification o f ownership, the M S A figure for 2003 was 52.1 percent. Uponthe IMF's request, the M S A computed the share o f private ownership in GDP in 2003 (where genuinely private and JSC companies with less than 50 percent of state capital were taken into consideration) and arrived at 40.7 percent. However, none o f these estimates allows for cross-country comparisons and even for inter-temporal comparisons for Belarus only. 7 Box 1.2: "Golden Share" RuleinBelarus Presidential Decree No. 125 o f March 1, 2004, "On the Special Right ("Golden Share") o f the State to Participate in the Management of Business Entities", has replaced the previous Decree of 1997. According to the new Decree, the "golden share" may be introduced inthe following situations: wage arrears inexcess o f three months; serious weakness inthe financial performance o f a business entity over a six month period; a need to address the defense and security concerns o f the state; and the need to protect the economic interests o f the state. This is fairly broad justification: in international practice the introduction o f the golden share i s normally justified only by national security concerns. Inthe case of Belarus the "golden share" mechanism is perceivedby the international community as one o f the major impediments to private investments. Meanwhile, two important issues are often missing in the discussion on the golden share mechanism inBelarus: The golden share can be introduced only inbusiness entities that were created on the basis o f state property. In other words, it cannot be introduced inde novo firms. Thus, by law, greenfield FDI i s fully protected from this mechanism. The golden share mechanism has to date largely played a signaling role, representing a potential rather than an operational threat. It has not been widely used. As o f April 1, 2005, it was in effect at 5 JSC with Republican property (a refrigerator company, two shoe manufacturing companies, a confectionary company, and a textile company) and five JSC with municipal property (two retail trade companies, a textile company, a dairy company, and a machinery company). Moreover, even when introduced, the rule may not be exercised, as, for example, has been the case with the confectionary factory. However, the recent case o f Mozyr N P Z plus Ltd. - a private company that i s not a former SOE, where the golden share was introduced through the decision o f the regional government inearly 2005 - casts serious doubts o n the strict adherence to the Decree. Moreover, it highlights a broader problem, which is a degree o f exposure o f any business inBelarus to local government harassment. The golden share should be abolished or, at minimum,the existing legislation should be modified inline with the international experience. The golden share provision in Belarus i s perceived by the rest o f the world as an embodiment o f the state's interventionist policy toward the real sector. While it i s seldom used, its existence sends an excessively strong negative signal to potential investors, who tend to view Belarus' investment climate as too unpredictable and risky. Overall, the rule's costs are too high in terms o f damaging the country's investment image. At the same time, the Belarusian government actually does not need this mechanism. It can and does exercise its powers without resorting to the golden share. It i s indicative that it was not introduced at any o f the largest f i i that may be considered o f strategic importance. Most Belarusian enterprises, while not being affected by the golden share, are still restricted in their decision making by various administrative controls and are pressed to meet output and wage targets. Thus, the major development challenge for the country i s not just to eliminateirestrict the golden share mechanism, but to improve the business environment for all companies, domestic and foreign, public and private. Source: World Bank Staff analysis based on information from the Ministryo f Economy and the IMF. 1,ll The Belarusian experience is somewhat at odds with the standard transition paradigm, and the relative stability o f the Belarusian economy has even been called a "puzzle."" Belarus has now experienced nine years of an unbroken growth record, and an impressive decline in poverty rates, supported by rapid growth in real wages and pensions and low unemployment rates. At the same time, growth has not been backed by sound and consistent macroeconomic policies, advanced structural and institutional reforms, and a thrivingprivate sector. Despite some liberalization undertaken inthe course of reforms, the economy remains highly regulated and under predominant state control. A comprehensive assessment o f this puzzle represents both an intellectual challenge and a highrelevance for Bank policy 11Fischer and Sahay (2000); Havrylyshyn and W o l f (1999). 8 dialogue with the government. Box 1.3 presents several conclusions regarding Belarus' "unusual" track record inthe 1990s, suggested by the earlier regional study by the World Bank. Box 1.3: Belarus' Recoveryand GrowthExperience:ImportantEarlierLessonsfrom Transition In the light o f the partial and poorly implemented reforms seen in many CIS countries, the slow pace o f restructuring inBelarus canbe seen as enabling it to avoid some key mistakes o f the early transition. First, while continued state ownership did little to promote more efficient operational or strategic decision- making at the enterprise level, it did deter the large-scale asset stripping, tunneling, and tax evasion that have damaged growth in the 1990s in other CIS countries. Nevertheless, the rapid decentralization and even fragmentation o f power inother CIS countries at the start o f transition might have precluded such a policy option. Second, the capacity o f the Belarusian state to maintain high levels o f tax collection highlights the importance o f these taxes in smoothmg the initial output decline. The strength o f fiscal revenues has maintained the ability to support declining sectors and socially oriented expenditures. Belarus will need to maintain its ability to collect taxes if it chooses to accelerate economic reforms. Though it may be tempting to explain this fiscal performance as a result o f the authoritarian state, similar political regimes have not guaranteed similar outcomes inTurkmenistan or Uzbekistan. Third, the preservation o f traditional economic linkages could smooth transitional shocks. Other CIS countries saw their exports to Russia collapse while their energy imports became far more expensive, leading to a massive terms-of-trade shock. While Central European transition economies were redirecting their exports to the EU, backed by FDIinflows, CIS countries had nowhere to go but Russia. Belarus continued to earn export and service revenues by maintaining close economic ties with Russia, thus softening the initial trade shocks. In summay, as i s also emphasized later in this report, although its growth strategy has been subject to considerable risks that raise serious concerns about its longer term sustainability Belarus has-perhaps inadvertently-avoided someproblems, associated with rapid economic liberalization. The ability o f the state to prevent the collapse o f its institutional capacity early in transition appears to have prevented the Belarusian economy from experiencing the rapid decline observed elsewhere in the CIS. Yet such an outcome was not guaranteed by the slow pace o f economic reform, but rather by dependence on Russia, whose willingness to subsidize, directly and indirectly, Belarus' inaction was a finction o f the geostrategic importance o f the country. Such an option was not necessarily available to other CIS countries. Source: World Bank, Transition: TheFirst Ten Years (2002b), p 47. 1.12 The peculiarities of the pre-reformindustrialstructure and the short-term effects of both state ownership and administrative controls contributed to the Belarusian recovery and growth (including its recent acceleration) for the following reasons: 0 Belarus inherited several unique USSR economic assets in the manufacturing sector (e.g., in the automobile and tractor industries), which proved to be more competitive inthe Russian market than the rest o f the USSR industry. At the time o f strong Russian growth, these f m s have been facing a strong export demand. Moreover, Belarus inherited significant manufacturing capacity inthe chemical andoilprocessing industries, whichprovedto be highlycompetitive inthe Europeanmarkets. 0 Incontrast to many large manufacturing enterprises inother FSUrepublics, many enterprises in Belarus lost a smaller share o f their original productive capacity during the early transition period. This was due to a lower incidence o f asset stripping and capital flight inBelarus (because o f slow privatization and much stronger administrative controls). Also, special political relations with Russia helpedmany firms to acquire some Russian orders and to keep operating even inthe most difficult periods o f low demand inthe early 1990s. 9 0 Many leading Belarusian exporters are traditional SOEs that enjoy soft budget constraints. Profit maximization i s not an overwhelming priority for these enterprises. Some o f them, as claimed, continue exporting even when their export turns out to be unprofitable. 0 The government of Belarus encourages import-substitution activities by imposing non-tariff import restrictions, which act as an additional channel o f state support for local industries. These non-tariff restrictions are most significant for consumer goods. Such restrictions tend to reduce the impact o f government demand stimulus ontotal import demand inthe economy. 0 It is known that administrative interventions could be efficient for a limited period for solving specific well-defined production problems and some o f Belarus' recent successes are clearly due to their broad usage. For instance, a strong administrative control over the energy sector's performance led to smaller quasi-fiscal deficits and a smaller accumulation o f energy debts, which contributed considerably to keeping the overall public debt at quite a low level, as well as to maintaining overall macroeconomic stabilization. 1.13 Access to a considerable amount of economic rents has been another source o f relative economic stability in Belarus. These rents are quite efficiently taxed by the state1*and broadly distributed inthe economy to subsidize non-viable enterprises, pushup domestic demand, andprovide some degree o f employment guarantees to households. The primary sources o f such rents relate to the following: 0 The activities o f several large enterprises in the sector o f primary resources and basic commodities (oil processing, fertilizers). These enterprises benefited recently from strong prices on global commodity markets. Belarus on average benefits from higher global oil prices because o f its major oil processing capacity. 0 Privileged access to the Russian market, especially in the machinery sector, which i s labor intensive and has major backward linkages to the rest o f the local economy. In the past, successful exporters were subject to additional taxation through the multiple exchange rate regime (see Chapter 4). 0 Privileged access to the underpriced Russian energy supply. A significant portion o f the benefits related to cheap energy were not passed on to energy consumers but were centralized by the government (see Chapter 7). 1.14 The integration process with Russia has been important for economic recovery in Belarus in two fundamental ways. First, it provided direct demand support. In the second half o f the 1990s preferential access to the Russian market helped Belarus to keep some o f the key production capacities of its manufacturing operation^.'^ A more recent economic recovery in Russia led to a considerable expansion in traditional Belarusian exports, including labor-intensive items in the machinery and equipment sector (trucks, tractors, television sets, etc.). Second, the integration process was a primary driver for recent policy adjustments, including several major reform steps such as the unification o f the exchange rate and the phasingout of direct NBB financing o f the budget deficit. B. ROLEOFECONOMIC POLICIES INGROWTH PERFORMANCE: TWO PHASESAND TWO GROWTH MODELS 1.15 Belarus relied on two quite different growth models during its ongoing growth episode. Duringthe first phase in1996-2000, the growthmodelwas primarily influencedby the following: l2Our estimates inChapter 2 suggest that the oil processing sector has beenfacing an effective tax rate that exceeds 80 percent o fthe value added it generates. l3 See Chapter 4 for more details. 10 e The expansionist monetary policy which helped to keep the real value o f the Belarusian rube1 (BYR)low e The policy o f multiple exchange rates which was used as an instrument o f hidden targeted support for some exporters and as a tool o f taxation for others e The strict policy of wage and price controls which helped to keep production costs l o w and to support the cost advantages of traditional exports e The encouragement o f barter transactions with Russia, which in combination with multiple exchange rates generated a considerable resource transfer to Belarusian exporters e The active political re-integrationwith Russia, which resultedinimproved market access, ensured the preservation o f preferential gas import prices as well as the tolerance o f energy arrears, and which also helped to improve capacity utilization inoil refineries and to secure a debt write-off in 1996. 1.16 This growth model had serious limitations and could not be sustained. First, it required the preservationo f low (relative to Russia and other neighbors) wages, which gradually became an acute political problem. After the unification o f the exchange rate in2000, the government fundamentally modified its wage policy andintroduced targets for growth indollar wages as one o f its top policy priorities, undermining one o f the pillars of the previous growth model. Second, high inflation and excessive government interventions in price and exchange rate mechanisms made it difficult for enterprises inthe real sector to initiate any longer- term restructuring. The level o f industrial investments was depressed. Third, in an environment inwhich the main comparative advantage in the major market was based on low production costs - which were seen by enterprises largely as a result o f government policies but not as the effect o f their own efforts -the incentives for enterprises for modernization and restructuring were further weakened. Fourth, macroeconomic stabilization in Russia after 1998 led to a rapid evaporation o f barter and thus removed another source o f earlier Belarusian growth. Finally, more recent economic expansion inRussia, with its impressive growth in real householdincomes, raised the quality requirements for imports, which created much stronger competitive pressuresonBelarusian producersthanever before. 1.17 Macroeconomic policies in Belarus during the first phase were anti-stabilizing in their nature. Loose monetary policy with subsidized credits to some sectors o f the economy (agriculture, housing, and manufacturing) stimulated aggregate demand and domestic consumption, but resulted in high inflation, negative interest rates and a reduction in savings, thus depleting domestic sources for investments. The exchange rate policy was characterized by a multiple exchange rate system with an overvalued official exchange rate, foreign exchange rationing and surrender requirements as a tax on exporters. At its maximum in 1998, the gap between market and official exchange rates reached 200 percent, This policy stimulated import substitution, ensured a certain level o f "strategic imports" (energy, food, medicines), and provided hidden support for selected exporters. At the same time, it worsened conditions for exports in general, thus holding back economy-wide productivity growth. This also led to the development o f parallel currency markets, significant real depreciation, depleting hard currency reserves, and growth in barter and rent-seeking activities. The fiscal policy was based on the very high government centralization o f resources and their re-distribution through fiscal and quasi-fiscal channels. Explicit general government expenditures accounted for about half o f GDP, while their true level was considerably higher.I4 1.18 At the same time, these economic policies resulted in a substantial decline in key relative prices in Belarus vis-his Russia, creating a significant temporary price advantage for local exporters, which appears to be fundamental in explaining Belarusian growth at that time (see Chapter 2). Another l4World Bank(2003b). 11 important positive outcome o f the above growth model was the preservation o f considerable operational capacity in industry, which could be better utilized as soon as external conditions improved." 1.19 The changein external and domestic conditionsresultedina gradual(in 2000-01) transition to a new growthmodelinBelarus,which, despite all its remainingproblems discussed elsewhere inthis report has been fundamentally much healthier, as it i s based on less market-distortive policies. Its main features are the following: 0 Improved macro policies: a unified exchange rate, a stricter monetary policy, considerable fiscal and quasi-fiscal adjustment, and lower inflation 0 An energy and utilitypolicy that aimed at attaining full cost recovery intariffs and strict payment discipline 0 New wage and income policies that stimulated domestic demand 0 The phasing out o f barter, which inter alia helped somewhat to accelerate export diversification out o f the Russian market 0 The maintenance o f its political and administrative effort to preserve the Belarusian traditional niche at the Russian market. 1.20 The secondperiodis characterizedby several positive developments, first of all in the area of macroeconomicmanagement. The exchange rate was unified in September 2000. The NBB regained formal independence inJune 2000.16 The monetary policy was tightened and the NBB started to pursue a policy o f positive interest rates. The costs o f credit in Belarus have been increasing gradually and real lendinginterest rates have exceeded those inall neighboring countries except Ukraine. Domestic credit to the economy has been growing from 14.8 percent o f GDP in 2001 to 17.8 percent in 2003, which i s still below the levels o f the neighboring countries (Figure 1.4). Figure1.4: Domestic Credit andRealLendingRatesinBelarusandNeighboringCountries Figure 1.4A: DomesticCredit/GDP,% 1 35 ..... __ - . .................. ..................................................................... ~ ..................... ........................ ... : w--w 101.................. ..... : ../.< .............................. ! 1 I 5 .................................................................. I $ f g g g g $ $ g Source: World Bank staffcalculations based on IFS data. l5Large declines inmanufacturing capacity were quite common for the CIS countries duringthe transitional recession, with enterprises being closed down and equipment sold as scrap. l6By Presidential Decree, the former decision which subordinated the NBBto the government was canceled. 12 Figure 1.4 B: Real LendingRates,% ......... mLlthunnls ......... Poland ......... 0Runslaa Federation 0Ukraine 19998 1000 lW1 1001 1w3 Bdarun ~......... -100 _- - - - - - - - - J - __ - -- -J I Sources: World Bank Staff calculations based on IFS data. 1.21 The Government initiated significant improvements in the area of fiscal management. The World Bank (2003b) andthe IMF(2004) acknowledgedthe progress made inBelarus insome important areas o f fiscal management, includingthe steps taken toward budget consolidation, the increase inbudget coverage, improvements inthe methodology o f budgeting and reporting, etc. (Box 1.4). At the same time, a number o f fiscal weaknesses still remain. The overall size o f the government budget remains very large compared to those o f other countries inthe region, with negative implications for the health o f the corporate sector and for competitiveness. Although considerably reducedinsome sectors (e.g., energy), quasi-fiscal activities continue to be common (e.g., state support via directed credits from the banking sector and tax exemptions). Government interventions in credit allocation remain extremely high. The trends in the pension system are unsustainable andpresent a major contingent liability. Box 1.4: Improvements in the Area of FiscalManagement Belarus has made noticeable progress in reforming fiscal management in the direction o f greater . sustainability andtransparency. A comprehensive legal and administrative framework for fiscal management has been introduced. The . Budget Systems Law provides for an explicit commitment to an open and transparent budget process and the government is currently working onthe Budget Code and a Special Part of the Tax Code. The government undertook important steps toward further budget consolidation by incorporating into the . budget major remaining off-budget funds (Social Protection Fund from 2004, and sectoral innovation hnds from 2005). Treasury coverage has been significantly expanded - regionalbudget accounts were incorporated into the . treasury system during 2000-02 and local budget accounts have been gradually incorporated as well. SPF accounts were transferred to the Treasury in2004, and innovation funds were transferred in2005. Budget deficit financing by the NBBceased as o f 2004. Budget classification has beenimproved substantially. I Sources:World Bank (2003b), IMF (2004), MOF. 1.22 Fiscal stabilization progressed, and after 2000 fiscal adjustment was fairly impressive, although it remained almost unnoticed. The official levels o f the budget deficit (both cash and accrual) have always been fairly low in Belarus. However, the data are not particularly informative since quasi- fiscal (hidden) deficits are not taken into account. The indicator o f actuarial deficit provides more 13 accurate estimates for the broad trend in the accumulation of the public sector's liabilities." The size of the actuarial deficit inBelarus declined from 11percent o f GDP in2000 to 1percent in2004.'' This was driven by the reduction in external debt flows, the phasing out of quasi-fiscal activities in the energy sector and a decline inthe quasi-fiscal activities of the National Bank (Table 1.4). Table 1.4: Belarus: Actuarial, Conventional, and HiddenDeficits (Annual Flows and as a Percent o f GDP) 2000 2001 2002 2003 2001 External Debt, BYRbln 474.1 297.4 395.1 77.8 75.6 as % of GDP 5.2 1.7 1.5 0.2 0.2 DomesticDebt, BYRbln 241.2 656.0 352.9 751.4 672.0 as % of GDP 2.6 3.8 1.4 2.1 1.4 ReserveMoney, BYRbln 221.1 439.8 270.6 570.6 707.1 as % of GDP 2.4 2.6 1.o 1.6 1.4 Energy Sector External Arrears, BYRbln 197.1 198.5 (162.8) 49.5 (364.6 as % of GDP 2.2 1.2 (0.6) 0.1 (0.7 Budget Arrears, BYRbln 62.0 182.9 (17.4) (73.9) 53.7 as % of GDP 0.7 1.1 (0.1) (0.2) 0.1 4. TotalIncreaseinLiabilities,BYRbln 1,195.5 1,774.6 838.4 1,375.4 1,143.8 as % of GDP 13.1 10.3 3.2 3.8 2.3 Privatization Proceeds, BYRbln 7.3 12.5 427.0 36.0 39.7 as % of GDP 0.1 0.1 1.6 0.1 0.1 Loss in Gross Reserveso f NBB, BYRbln (185.8) (163.9) (351.3) (187.1) (630.6 as % of GDP (2.0) (1.0) (1.3) (0.5) (1.3 B. Total Loss of Assets, BYR bln (178.0) (151.4) 75.7 (151.1) (590.9 as % of GDP (1.9) (0.9) 0.3 (0.4) (1.2 C. PSB (ActuarialDeficit) = A + B 1,017.5 1,623.2 914.0 1,224.3 552.9 as YOof GDP 11.1 9.5 3.5 3.3 1.1 BudgetDeficit(accrual), % GDP 1.o 3.1 1.9 1.1 0.a Hiddendeficit, YOGDP 10.1 6.4 1.6 2.2 1.1 Wemorandum Items ClonventionalBudget Deficit (cash), % GDP 0.1 1.9 1.8 1.4 0.C 3DP, BYRbln 9,134 17,173 26,138 36,565 49,445 Exchangerate, (period average) 933 1,383 1.784 I - 2,075 2,16 Source: World Bank staffestimatesbased on MoF, NBB, Ministry of Economy, MSA, andIMFdata. 1.23 Improvedmacroeconomic policies resulted in lower inflation and gradual de-dollarization. Inflation (CPI-based) in Belarus remained the highest in the region and fell from three-digit numbers in 2000 to 18.1 percent in 2004." The reduction in inflation was due to the policy o f positive real interest rates, pushed by the NBB, as well as the unification of the exchange rate and the related stabilization o f 17 ''For d e f ~ t i o n sand cross-country comparisons, see Freinkman et al. (2003). 18Owing to the data limitations, we estimate the hidden deficit on the basis of an incomplete list o f quasi-fiscal operations. Still, we believe that ow aggregates reflect the actual scale o f the macroeconomic adjustment that took lace in2000-04. The persistence of high inflation rates during the second growth episode was to a large extent due to the supply shocks and, in particular, to the adjustments in utility prices. For example, according to the IMF, in 2002, when these adjustments were particularly strong, more than a third of the overall CPI increase o f 35 percent (e-o-p) was caused by the combined impact of deregulations and other supply shocks. Monetary authorities managed to accommodate these shocks to minimize the output effects arising from the tariff adjustment (IMF, 2003). 14 the market for foreign exchange. Inaddition, during 2004 a slowdown in inflation was supported by the cessation o f NBB direct financing o f the budget deficit. A tighter monetary policy also resulted in the reduction inboth seigniorage and the inflation tax (Figure 1.5). The decline in the burden o f the inflation tax on the real sector and households was most significant - from about 16 percent o f GDP in 1998-99 to less than 1percent in 2004. Figure 1.5: Seigniorage and Inflation Tax inBelarus, 1995-2004 (of%, GDP) 20.0 180 ................................................................. A - J1 16.0 i ..................... .h I 140 $.-7................. /!.......+................................... ' ................................... ~ 120 Seigniorage 100 +InflationTax 8 0 6 0 4 0 2 0 0 0 1995 1996 1997 1998 1999 2000 2001 2002 2003 2004 Source: World Bank Staff estimates. 1.24 More responsible monetary and foreign exchange policies led to a growth in money demand and to a reduction in the level o f dollarization (Figure 1.6). Dollarization declined by one-third relative to its peak o f 60 percent in2000. However, it still remains higher than inmost CIS countries. E lure 1.6: Dollarization: Foreign Currency Deposits/M3,1997-2004 (YO) 60 .................................. ........................................ 50 ............. .................... 40 +Russia +Ukraine 30 ................... 20 10 ..................................................... 0 4 1997 1998 1999 2000 2001 2002 2003 2004 Sources:NBB,NBU,NBK, IFS. 15 1.25 The level o f monetizationhas been growing gradually from 2000 but still i s very low, at about 11 percent in 2004 (Figure 1.7). This differs substantially from several other countries in the region, which started from approximately the same level o f monetizationbut progressedmuch hrther than Belarus. For example, the level o f monetization inUkraine in 1997 was 13.3 percent o f GDP and it increased to 36.4 percent in2004. The highest level o f monetization inBelarus (13 percent GDP in 1998) has not yet been reached again after its sharp decline in 1999-2000. Figure 1.7: Monetization (M2/GDP), 1997-2004 (YO) 45 ................................................................................. 40 +Belarus 35 +Russia 30 ................................................... ..... ...... +Ukraine 25 *Kazakhstar 20 ++Poland 15 --CLithuania 10 ................................................................................ 1997 1998 1999 2000 2001 2002 2003 2004 Source: World Bank Staff calculations on IFS data. 1.26 While the change inmacroeconomicpolicies undertakeninBelarus in2000-01 was aimed at some restoration of macroeconomic discipline, it simultaneously emphasized the accelerating growth in real wages, thus leading to a significant erosion of the earlier cost advantages. The domestic price parity with Russia was restored in 2000. In2001 the average wage in Belarus reached its highest level to date relative to Russia (80 percent). This coincided with a major slowdown in growth in Belarus in 2000-02. Changes in the macroeconomic environment and the related evolution in incentives forced exporters to gradually adjust their strategy and move to a market niche with higher quality and price levels. A new acceleration o f growth took place in 2003, in part in response to strong Russian growth at that time (which was associated with the strengthening o f the Russian ruble and the rapid growth in Russian real wages). However, as we show in the following chapters, the most recent growth episode in Belarus (2003-04) differs qualitatively from the growth o f the late 1990s because it i s supported more strongly by bothreal improvements inperformance at the micro level and investments in upgradingthe existing export capacity. 1.27 Overall, the distinguishing feature of the second growth model i s related to the expanded opportunities and the improvements in incentives at the enterprise level for investment and stronger performance. The level o f investments in industry (without energy) increased from 4.4 percent o f GDP in 1996 to 5.4 percent in2000 and to 5.7 percent in2003. c. STRUCTUREAND SOURCESOF GROWTH (SNAVIEW) 1.28 By period, the rate of growth of different components of aggregate demand varied, but the highest rates of growth during both periods were in domestic household consumption. The rates o f 16 growth in public consumption slowed down substantially during the second phase, while the rates o f growth in gross capital formation more than doubled and the rates o f growth in imports of goods and services increased almost four fold (Table 1.5). The differences in the dynamics o f particular components o f aggregate expenditures reflect the different roles they play duringthe two periods o f economic growth. Table 1.5: GDP Growth, Average Annual GrowthRates, 1996-2004 (%) 1996-2000 2001-04 1996-2004 Gross domestic product 6.3 6.9 6.6 Total consumption o f goods and services 8.3 9.4 8.8 Household consumption 9.7 12.4 10.9 Public consumption 4.5 0.9 2.9 General government 4.8 1.o 3.1 Consumption o fpublic organizations 3.0 0.4 1.8 Gross capital formation 5.1 12.1 8.2 Gross fixed capital formation 5.0 10.9 7.6 Exports o f goods and services 9.0 10.7 9.7 Imports o f goods and services 3.O 12.4 7.1 Source: World Bank staff calculations on MSA data. 1.29 The drivers of growth have been changing over time, but the role of domestidprivate consumption has been the most significant. Table 1.6 presents the breakdown of economic growth by expenditure category during the two periods o f growth. Domestic demand was the major driver o f growth duringboth growth phases (Figure 1.8). It is worth mentioning that statistical discrepancy was rather high and negative during the first phase, indicating considerable under-estimation o f imports, and thus even a smaller contributiono fnet exports. Household consumption Public consumption General government Consumption o fpublic organizations Gross capital formation Gross fixed capital formation Changes ininventories Net exports Exports of goods and services Imports o f goods and services Statistical discrepancy Net exports and statistical discrepancy Total domestic demand 17 - Figure 1.8: Contributionto GDP Growth, Expenditure-SideView, 1997-2004 1.8 A. Breakdownof DemandGrowth(Percent contribution) Total domestic demand =Net exports +Gross domestic product -C- Statistical discrepancy -12 ' 1997 1998 1999 2000 2001 2002 2003 2004 Source: World Bank staff calculations on MSA data. Figure 1.8 B. Breakdownof DemandGrowth (Percentcontribution) =Total domestic demand Imports - =Exports o f goods and services -+Gross domestic product -+- Statistical discrepancy -6- / 1997 1998 1999 2000 2001 2002 2003 2004 Source: World Bank staff calculations on MSA data. 1.30 Within domestic demand, household consumption was the major contributor to growth. The consumption growth, inturn, has been driven by increases inthe real purchasing power of households as a result o f increases inreal wages and other incomes. Productivity growth while strong was not sufficient to matchthis real income expansion (Figure 1.9). 18 Figure1.9:LaborProductivity andWage Growth, 1995-2004 180 ......... ............ ......... ..-. ....... I 160 140 t Labor productlvl Growth. 60 .................................................................................... cWage(FOREX) ~ 40 ...................................................................................... ! I growth.. I 10 I.................................................................................... I I 0 4 I 1995 1996 1997 1998 1999 2000 2001 2001 2003 2004 *Labor productivity here i s measured as GDP per employee. **Forex based wage i s estimated through a currency basket that consists (50:50) o f US$ and euros. Source: World Bank staff calculations. 1.31 Rapid growth in real incomes has also led to substantial growth in consumer imports, especially during the second phase. Consumer imports in 2004 almost doubled as compared with 2000. However, the share of imported goods inhousehold (HH) consumption of goods and services fell from 16.4 percent in2000 to 13.1 percent in2004.*' Official data on consumer imports are somewhat higher, but they also support the conclusion of adecliningshare of consumer imports inprivate consumption (Table 1.7). Table 1.7: Consumer GoodsImportsinHouseholdConsumptioninBelarus,2000-04 US$m 2000 2001 2002 2003 2004 Zmoorts, total WITS, COMTRADE 8,492.4 8,286.4 9,092.3 11,558.0 15,443.8 Ministry of Statistics 8,646.2 8,286.4 9,092.3 11,558.0 16,345.5 NBB (FOB prices) 7,524.6 8,140.8 8,879.0 11,328.5 15,982.5 Consumer goods imuorts WITS, COMTRADEDEC 878.1 1,181.2 1,021.5 1,300.4 1,649.0 Ministry of Statistics 1,560.9 1,908.3 2,437.4 Exchangerate,BYR/US$ 933.5 1,382.7 1,783.6 2,075.0 2,163.7 HHconsumption,BYRbn 5,011.9 9,531.2 15,113.8 20,331.8 27,157.4 HHconsumption,US$ m 5,369.1 6,892.9 8,473.6 9,798.5 12,551.2 Consumptiongoods imports/HHconsumption, % (BEC) 16.4 17.1 12.1 13.3 13.1 Consumptiongoods imports/HHconsumption, % (MSA) 18.4 19.5 19.4 Sources: MSA, NBB, WITS/COMTRADE, World Bank staff estimates. 1.32 In general, as noted above, while average growth in HHconsumption duringboth periods was high and rather similar (9.7 and 12.4 percent, respectively), average growth in imports of goods and services increased from 3 percent during 1996-2000 to 12.4 percent in2001-04. However, the analysis of trade developments (Chapter 4) suggests that the overall growth in imports was driven not by consumer imports but by intermediary goods. The government also usedvarious administrative instruments to slow down an increasein consumer imports. At the same time, inthe secondperiod, higher import growth was 2oSee Chapter 4 for a detailed explanation o f these estimates. 19 balanced somewhat by the increased exports o f goods (especially, refinery products) and services, thus partially cushioning the negative impact o fthe expansion inconsumption on the external balance. 1.33 The role of gross capitalformation(GCF)was moderateduringthe first periodofgrowth, but it increased during the second period. After 2001, GCF contributed substantially to economic growth, mostly because o f the growth in fixed capital investments. While the first growth phase had been based primarily on an increase in the utilization o f idle and under-utilized production capacities, the more recent periodexhibits signs o f more investment-based growth. This issue i s firther elaboratedinChapter 2. 1.34 Fromthe view of nationalaccounts, net exports contributedpositivelyto growth during the first period and negatively during the second period. However,this observationunderestimatesthe actual role of exports in the recent growth. As SNA data suggest, net exports have been the second major contributor to growth during 1996-2000, but economic growth after 2000 has not been export driven. Despite a strong export expansion, imports have been growing at an even higher rate, so that the contribution o f net exports to GDP growth has been negative. However, this shouldnot be interpreted as a low contribution o f export-oriented sectors to growth. In fact, most o f the overall growth in industrywas generated by exports, and during 2001-2004 the growth in manufacturing exports by far exceeded the growth inindustrial output (63.2 versus 37 percent, respectively). 1.35 I t is worth highlightingtwo specific channels through which export expansion contributed to the growth in domestic demand/consumptionand thus indirectly to overall GDP growth. First, export expansion created room for additional import financing, while some o f these imported inputs were used for the additional production o f goods and services to meet domestic demand. Second, exporters appear to be a major source o f the financing o f growth in domestic demand. A large share o f export proceeds was used on taxes, wages, and other domestic spending. Overall, while statistically the contribution o f net exports to GDP growth was negative during 2001-04, one could claim that, when accounting for indirect effects, Belarus would not be able to sustain its high growth rates without o f the strong export growth.21 1.36 The role of workers' remittancesis likelyto be more significant than is usually acknowledged. And balance of payments remittances that are higher than reported could be a primary source of financing additionalconsumerimports.While atleast400,000 Belarusians are estimated to have beenworking abroad (mostly inRussia), the reportedflow o fremittances is modest (US285 million or 1.2percent o f GDP in 2004). The recent analysis o f remittances generatedby Armenian workers in Russia suggests that the average annualcashtransfer made by these workers is about US$2,500 (Roberts, 2004). For Belarusthe same per capita capacity for remittances would result in an annual flow o f US$1 billion, which is more than twice the above official estimates. This suggests that about 2.5 percent o f GDP inremittances may remain unreported, andthis income could primarilybe used for financing additional consumer imports through the shuttle trade and other informal trade channels, as well as being a source o fadditional foreign cashholdingsbyresidents. 1.37 During the second period of growth the domestic savings-investment gap began to widen, Belarus inherited a high level of both national savings and investment rates. In 1992, national savings accounted for almost 36 percent of GDP, and national investments accounted for almost 32 percent. Both ratios fell considerably duringthe transition. The decline in savings was much more pronounced (by more than 40 percent in real terms in 1992-96), which resulted in the emergence o f the domestic savings- investmentgap (3.4 percent of GDP in 1996). The gap declinedconsiderably in 1999-2000 butthen began to widen again (Figure 1.10). The gap reached 4.2 percent of GDP in 2003 and the preliminary data for 2004 suggest its further widening to over 5 percent o f GDP. 1.38 FDI has been playing a modest role in bridging the gap. While the domestic savings- investment gap is fairly common duringtransition, inBelarus it failed to attract sizable amounts o f FDIto 21I t i s worth noting that Russia has been showing a somewhat similar pattern o f growth since 2002: a strong overall export growth but a modest (albeit positive) contribution o f net exports to GDP growth (Ahrend, 2004b). 20 finance the gap and had to rely on other less advantageous forms o f foreign savings. The country's cumulative FDIper capita for the period 1989-2003 was US$200, as compared to the CEEBS average o f US$2,112 and the CIS average o f US$292.22Inmore advanced transition economies (including Hungary, Poland, and the Baltic states), FDI was largely responsible for financing the current account deficit and boosting export growth. FDI has also represented an important source o f foreign exchange reserves. Overall, in the transition period FDIhas been an important determinant o f both short-term and long-term growth prospects. Figure1.10:Domestic Savings,Investmentandthe Gap, 1996-2004 (% GDP) ............... Source: MSA. 1.39 The pattern of changes in the structure of nominal GDP by sector in Belarus is similar to that in other transition economiesbut the magnitude of these changes is somewhat different.As in other transition economies, especially those considered as over-industrialized, the share o f industry in Belarus' GDP fell while the share o f services increased (Table 1.8). The reduction in the share o f agriculture has also been inline with the developments in other CEEBSs. At the same time, the reduction inthe share ofindustryinGDP during 1996-04 was relatively small (only 1.6 p.p.) andthe increase inthe share o f services relatively moderate (5.3 p.p.). Moreover, in 2000-04 these trends were reversed - the share o f industryactually increased while the share o f services declined. However, it i s worth noting that changes in the nominal GDP structure are not the most informative in the environment of changing relative prices. T )le 1.8:GDPby Sector, 1996-2004(in % ofnominalGDP at f :tor costs) 1996- 2001- 1996- 1996 1997 1998 1999 2000 2001 2002 2003 2004 2000 2004 2004 change change change Industry 32.8 34.3 33.4 31.9 31.0 29.9 29.6 30.8 31.2 -1.80 1.30 -1.60 Agriculture and forestry 17.0 15.4 13.9 14.6 14.2 11.9 11.8 10.2 11.0 -2.80 -0.90 -6.00 Construction 5.3 6.3 6.7 6.7 7.5 6.7 6.8 7.2 7.6 2.20 0.90 2.30 Services, etc. 44.9 44.0 46.0 46.8 47.3 51.5 51.9 51.8 50.2 2.40 -1.30 5.30 Total 100 100 100 100 100 100 100 100 100 Source: MSA. 22EBRD(2004). 21 1.40 Industry continues to contribute most to economic growth, while the importance of the service sector's contribution fellsomewhat duringthe secondgrowthperiod. Inboth phases, industry contributed to about 50 percent o f economic growth on average (Figure 1.11). The second major contributor was services, accounting for about 47 percent o f economic growth during 1996-2004. However, the role o f services in GDP growth has been declining since 2002. This is a most unusual pattern that reflects the specifics o f the Belarusian growth structure, which relies heavily on traditional manufacturing. Within the services sector the largest contributors were trade and catering. The contribution o f agriculture and forestry to GDP growth was negative during 1996-99 but became positive from 2000 onwards. However, it remained rather moderate (especially, as compared with the resources that it absorbs) (see Chapter 6) and it fluctuated inresponse to variations inweather conditions. Figure1.11:Contribution to GDP Growth, Production-SideView, 1996-2004 (in YO) 1596 1997 1598 1999 1003 1001 2002 2W 2004 Source: World Bank staff calculations based on M S A data. 1.41 The growth of wages and employment benefits was high. The average real wage grew at a much higher rate o f 12 percent a year than the GDP. The average real wage for 2003 was 146 percent higher than that in 1995, while the GDP was only 59.8 percent higher. The economy-wide wage bill increased by 142 percent in real terms. The share o f wages in GDP grew steadily from 42.8 percent in 1995 to 46.7 percent in 2002 before declining to 43.7 percent in 2003. These numbers confirm that labor received major benefits from the recent growth: 53 percent o f the total GDP increase between 1995 and 2003 was derived from growth inlabor earnings, with about the same impact o f wages on GDP registered inbothsub-periods (1996-00 and2000-03).23Moreover, the secondperiodshowed a slight accelerationin the rate o fwage bill growth-both inthe aggregate and for all sectors except agriculture and industry. 1.42 The sectoral breakdown o fthe above indicators i s presented inTable 1.9. There was a major labor restructuring resulting in an employment shift from agriculture to services, construction, and transport. Total employment in agriculture and forestry declined by 40 percent. In fact, such restructuring was unparalleled in the CIS countries24and had positive longer-term growth and poverty implications, since agriculture in the CIS tends to be a low-productivity sector with large hidden unemployment. Labor 23To ensure the statistical consistency o f this calculation, both GDP and the wage bill have been deflated with the GDP deflator. 24Four other CIS countries registered falling employment in agriculture: Moldova (-24 percent), Russia (-21 percent), Uzbekistan (-24 percent), and Armenia (-9 percent). However, Belarus far exceeds those countries inlabor shedding inthe sector. 22 shedding in Belarusian agriculture took place at a time when agriculture had the lowest wages and the lowest wage bill growth among all economic sectors?' Table 1.9: Wages andEmployment, 1995-2003 Monthly Wage Ernployrnent/Contingent Wage Bill:Real Growth 2003 (thousand Real Growth 2003 Real Growth 1 Indicator BYR) 1995-2003 (x) (000) 1995-2003(%) 1995-2003 (%) Labor force -- _ _ 6,142 5 -- Total employment 251 146 4,339 -1.6 142 Non-employed labor force -- -- 1,802 25.2 -- Agriculture and Forestry 145 125.5 521 -40 35.3 Industry 277 137.8 1,159 -4.7 126.6 Construction 311 119.7 321 6.3 133.5 Transport and 285 126.8 329 6 140.4 Communications Services and other 248 149.1 2,010 17.4 192.4 Including: Credit, Finance and Insurance 467 114.8 58 25 168.4 Public Administration 374 132.6 136 35.9 216 Health and Social Security 224 159.6 325 13.3 194 Education, Culture and Arts 242 172.8 541 10.8 202.4 Memo: Registered I unemployment -- 136.1 - 3.9 -- Employment Real Wage Bill 2000195 2003I00 2003/95 2000195 2003100 2003195 -- ~~ Labor force 0.5 0.8 0.6 -_ -- Total employment 0.1 -0.8 -0.2 11.4 12.1 11.7 Non-employed labor force 1.7 4.8 2.9 _ _ -- -- Agriculture and Forestry -5.4 -7.4 -6.2 5.3 1.4 3.8 Industry 0.2 -1.9 -0.6 12.6 7.7 10.8 Construction 0.6 1 0.8 10 13.2 11.2 Transport and Communications 0.5 1.1 0.7 9.3 15.6 11.6 Services and other 2.4 1.4 2 13 16.7 14.4 Including: Credit, Finance and Insurance 4.7 -0.2 2.8 13.8 12.1 13.1 Public Administration 6.4 0 3.9 14 18 15.5 Health and Social Security 2.6 -0.1 1.6 11.9 18.8 14.4 Education, Culture and Arts 2.2 -0.2 1.3 13.1 17.8 14.8 Sources: MSA, World Bank staff estimates. 25 As in most transition and developing countries, the accuracy o f wage estimates in agriculture is lower than elsewhere owing to the occurrence o f in-kindpayments and proprietor's surplus. Under these conditions, the better way to single out labor share in output would be to calculate the labor surplus rather than wages. N o such data are available for Belarus, however. 23 1.43 As the data show, real wages have grown inall sectors and wage growth was more or less equally distributed among the sectors. The cross-sectoral variation in wages remains low. Excluding agriculture, the gap between sectors with the highest and lowest average wage (finance, and education and culture, respectively) was 127 percent, which i s quite moderate by CIS standards. For example, the gap between the same sectors inArmenia was more than 400 percent.26 1.44 The highest wage growth for the entire period was recorded in the lowest-paying divisions o f the public sector (health, and education and culture). However, health and education continue to pay the lowest wages, with the exception o f agriculture. The largest sector o f the economy - industry (which employs over a quarter o f labor) - showed a growth inreal wages that was close to average. 1.45 The largest increases in employment occurred in high-paying sectors such as finance and public adrrrrmstration, which also exhibited the fastest growth inwage bills.However, these sectors are still very small, employing 1.3 and3.1 percent o f workers, respectively. This uniformity o f wage growth inBelarus points to the preservation o f significant centrallyestablishedrestrictions onwage setting inthe enterprisesector. 1.46 The equitable character o f wage growth in Belarus i s a bit unusual for the CIS. In many CIS countries, including, for example, Russia and Armenia, overall economic expansion and wage bill growth had a rather narrow basis in selected sectors and did not lead to a sizable increase in the real wage bill in the largest sectors o f the economy. 1.47 Overall, economic growth inBelarus was associated with fairly stable employment and a growing share o f people in the labor force who either did not choose to work or who worked abroada2' Total employment in the economy has declined by 1.6 percent, while the labor force has increased by 5.0 percent. As a result, the domestically non-employed labor force has surged by one-quarter. Official unemployment was very small (only 2.2 percent o f the labor force in2003) and stable. By period, except for transport and communications, employment growth rates were lower during 2001-03 than during 1996-2000. Inthe second period, five sectors showed a decline in the number o f workers: agriculture, industry,finance, health, andeducation, butonly agriculturalemployment declined duringthe first period. 1.48 On the aggregate, the wage and employment features o f economic growth inBelarus helped to reduce the incidence o fpoverty and to increasethe average standardo f living. They have also been an important factor insustaininggrowthovertheperiod.Lowpovertyincidenceandlowincomedifferentiationhelpedstrengthenthe domestic demand and also helpedshape it so that iti srelatively easy for localproducers to meet. D. ROLEOFSTATE SUPPORT 1.49 The complicated and pervasive system of state support to the real sector i s a fundamental , feature of the Belarus economic model. The government has been pursuingan activist industrial policy, under which most large enterprises have been in a position to negotiate with the government a case-by- case package o f incentives and benefits to support their rehabilitation and development programs. This has resulted in a system o f state support that i s too costly and too segmented and i s non-transparent, with too many programs and beneficiaries. Inspite o f various attempts o f the government in recent years to streamline, quantify and access its effectiveness, little change has been achieved. *'World 26 Bank (2002a). Although the precise number o f Belarus workers abroad i s not known, the Ministry o f Labor estimates that about 400,000 Belarusians have been working abroad, mostly in Russia. This may account for a considerable share o f people included inthe non-employed labor force. 24 1.50 The currentsystemhas a major distortive effect on enterpriseincentives. The coexistence of a highnominal tax burden and massive tax benefits and subsidies for those enterprises that are either less efficient or well-connected undermines competition and stimulus for productivity improvements. 1.51 The main forms of state support to the enterprise sector are the following: budget subsidies and loans, tax exemptions, tax credits (including the restructuring o f tax arrears), government guarantees on commercial credits, directed credit programs administered by the NBB, capital subsidies and grants, etc. A separate type o f subsidy relates to annual bank recapitalization, which helps the state banks to deal with the financial consequences o fdirected lending. Owing to the fragmentednature o fthe data available, it is difficult to provide accurate aggregate estimates of state support. The government has not yet established a comprehensive monitoring system and tends to considerably underestimate the total volumes o f public funds that are made available to the enterprise sector through various subsidy and grant channels. 1.52 Table 1.10 presents our estimates for the incidence o f subsidies in the Belarusian economy. The table contains two different indicators ofthe aggregate state support: (i) the total (gross) financial flow to the enterprise sector, which i s the amount o f funds allocated through various government decisions; and (ii) the net resource transfer to the enterprise sector (net subsidy). The latter amount i s smaller, reflecting the fact that a substantial portion o f government assistance i s provided in the form o f highly concessional directed credits, including tax credits.'* Given that the level o frepayments o f such credits remains relatively high, the net subsidy i s indeed smaller than the gross level of government intervention^.^' 1.53 Both measuresshow no significant decline inthe incidenceof state subsidies inBelarus.The total annual amount o f funds that the government allocates to the real sector (including state-owned banks) i s still about 10 percent o f GDP. In 2001-04, the estimated annual net subsidy amounted on average to 6 percent of GDP. This is somewhat lower than that prior to 2001 but i s still excessively high. It is comparable with total national public spending on education (6.3 percent o f GDP in 2004). Agriculture remains the sector that i s the most heavily subsidized (see Chapter 6). 1.54 Moreover, the above estimates reflect only the level o f producer subsidies and do not account for the existing subsidies to consumers (mostly inutilities and transportation) or for directed credits on housing construction that are also aimed at households. Consumer subsidies amounted to an additional 1.9 percent o f GDP in 2004, which is a decline from 2.9 percent o f GDP in 1999, owing to increases incost recovery in these sectors. The housing credits on average amounted to about 1percent o f GDP in2000-04. 1.55 During 2000-04, some positive changes took place in relation to state support via tax benefits. This was partially due to the pressure fiom Russia inthe course o f negotiations on equalizing conditions for businesses in the two countries.30This resulted in a gradual reduction in the amount o f individual tax exemptions and benefits (from 2.1 percent o f GDP in 2000 to 0.5 percent of GDP in2004) and the replacement o f the exemptions and benefits with the restructuringo f tax credits and tax arrears. In addition, the accumulation o f tax arrears has slowed down considerably. Hence, the overall state support through tax expenditures was reduced from 3.0 percent o f GDP in 2001 to 1.3 percent of GDP in 2004. Yet in 2004 the total value o f the tax benefits received by the enterprise sector was estimated at 5.8 28 Inmost cases, lessthan half o fsuch credits were granted at the NBBrefinance rate, while the rest were granted at rates that were between one-quarter and one-half o f the NBB refinance rate. 29 We estimated the implicit subsidy in such programs using a difference in interest rates between those available under commercialborrowing and those established under the directed credit programs. 30 By Presidential Edict #11 fiom April 19, 2002 individual tax exemptions'were abolished and the procedure for obtaining state support via tax benefits was streamlined. 25 percent of the total tax revenues of the enlarged government (excluding the personal income tax), down from 12.7 percent in2000. I 1999* 2000 2001 1 2002 I 2003 I 2004 1. Total tax benefits %GDP 2.6 2.2 2.0 1.3 - Individualtax 2.4 3.0 exemptions 55.1 190.2 173.5 201.0 171.2 252.2 %GDP 1.8 2.1 1.o 0.8 0.5 0.5 - Tax credits 2.1 30.4 83.6 143.7 244.5 214.6 %GDP 0.1 0.3 0.5 0.5 0.7 0.4 - Tax restructuring 7.5 6.1 34.1 71.2 225.8 273.8 %GDP 0.2 0.1 0.2 0.3 0.6 0.6 - Tax arrears, includingSocial ProtectionFund 9.4 47.1 151.2 154.3 88.0 -92.2 %GDP 0.3 0.5 0.9 0.6 0.2 -0.2 2. Budgetsubsidies, incl from EBFs 195.2 547.0 898.1 1050.7 1811.7 2493.0 %GDP 6.5 6.0 5.2 4.0 5.0 5.0 A. Producersubsidies 109.3 287.3 425.3 468.5 1034.5 1558.9 B.Consumer subsidies 85.9 259.7 472.8 582.2 777.2 934.1 3. Total investmentgrants, includingfromEBFs 53.7 160.5 297.3 409.6 634.8 802.7 %GDP 1.8 1.8 1.7 1.6 1.7 1.6 4. Totalbudgetcredits, includingfrom EBFs 4.4 57.0 202.5 344.0 380.6 309.6 %GDP 0.1 0.6 1.2 1.3 1.o 0.6 5. Bankingsectorrecommendedcredits** 28.0 258.2 443.3 433.1 847.6 1,636.7 %GDP 0.9 2.8 2.6 1.7 2.3 3.3 A. Producercredit 140.8 232.9 185.6 516.0 1,069.4 B. Consumer credit (housing) 117.3 210.4 247.4 331.6 567.3 6. Bankrecapitalizationprogram 68 27 367 561 517 %GDP 0.7 0.2 1.4 1.5 1.o 7. Budgetspendingonrepaymentofguaranteed credits(called guarantees) 6.8 99.5 9.3 10.4 %GDP 0.0 0.4 0.0 0.0 9.5 9.4 10.6 9.9 5.9 6.4 6.4 5 3 Memo: Creditsissuedwith government guarantees, stock at the endof the year 181.7 132.9 270.8 631.8 %GDP 1.1 0.5 0.7 1.3 Onlypartialdatawere available for 1999.**Allocatedunder decisionsof the PresidentandCouncilofMinisters. Source: WorldBankstaffestimatesbasedonMOF,NBB, Ministryof Economy, MSA, andIMFdata. 1.56 However, the above reduction was compensated by an increase in subsidization through other channels, including the growth in banking sector's recommended lending and budget subsidies to agriculture. The costs of bank recapitalization in 2002-04 were also much higher than in the earlier period. 1.57 The current system of support has a major negative impact on credit markets. The total amount of credit allocated through direct government interventions in 2001-04 (NBB directed credit programs, budget loans, and credits issued with government guarantees), amounted on average to about a quarter of all of the annual commercial bank credit in the economy. This crowds out proper commercial 26 credit and makes borrowing much more expensive for those that cannot participate in government programs, including small private firms. 1.58 In general, the system of state support lacks consistency, transparency and strategic vision. It is both widely dispersed among numerous recipients and highly concentrated ("picking-up winners"). In2004, as reported by the Ministry of Economy, state support inthe amount of about BYR 1.9 trillion has been provided to 3,651 enterprises in the real sector. In 2004, 74 different presidential and governmental decisions on granting state support were issued (a reduction from 133 decisions in 2003). Some enterprises have been able to receive state support through different programs and from different sources (the budget, off-budget funds, the banking sector, etc.), and many o f the largest firms have been receiving state assistance annually. This further undermines the transparency and accountability o f the system. The provision o f individual state support clearly favors large enterprises (both SOEs and former SOEs). This creates additional disadvantages for new private entry, including firms with foreign capital. 1.59 The system of government support to the real sector requires a comprehensive reform. The first step should be to undertake a thorough inventory o f all subsidization programs (both explicit and implicit) and to concentrate all information in one agency (possibly inthe form o f a registry or database). At the moment, the aggregate estimates of the state support that the government has been using are considerably lower than the estimates inTable 1.10. For example, the Ministry o f Economy reported that total support in 2004 was below 4 percent o f GDP, which i s about 60 percent less than in more realistic estimates presented in the table. The reason for such a downward bias relates to the fact that the government analysis tends to ignore some important programs, including bank recapitalization and spending from the innovation funds and other off-budget sectoral funds. This undermines the efficiency of the government analysis and generates an underestimation o f the scale o f the problem. 1.60 A strategic analysis of the existing system should be undertaken to address several key questions o f government policy inthis area. What i s the actual amount o f net resource transfers to various sectors o f the economy via all types o f state support programs? I s this amount affordable for the economy at present and inthe near future? What are the expected outcomes o f these interventions? What indicators should be used to measure these outcomes? Are these outcomes the best achievable through the currently used instruments and channels? Are these instruments inconformity with the internationalrules (WTO in the first instance)? 1.61 An analysis o fthe mechanisms and the scope o f state support i s crucial to assessing the efficiency o f resource allocation in the economy, and to understanding the nature and sustainability o f economic growth inBelarus. It i s also an important part o f the integration agenda for Belarus (WTO accession talks, CIS integration initiatives, etc.). The favorable external environment o f the last several years helped the government to keep state support at the fairly high level. While some forms and mechanisms o f subsidization were modified, no real pressure emerged to streamline the system and make substantial cuts in the aggregate level of subsidization. Worrisome trends in the liquidity of the banking sector in the autumn o f 2004 should be considered as an indication that the system may be reaching its affordable limits . 1.62 The priority directions for reforming the existing system of state support could be summarized as follows: 0 Reducing the scope o f state support and introducing an annual ceiling for aggregate support and medium-term targets for its reduction 0 Phasing out implicit forms o f subsidization, which still remain outside o f the state budget, such as tax expenditure 27 e Improving the accounting and reporting o f state support, including through its more comprehensive reflectioninbudget reports 0 Replacing budget subsidies with non-distortingtypes o f government development spending inthe real sector - expenditures on training, R&D and other forms o f innovation support, export promotion, infrastructure, the financing o f social and environmental liabilities o f enterprises, etc. 0 Introducing competitive mechanisms for the allocation o f budget support, including through matching grant mechanisms to encourage enterprise spending on, for example, particular areas o f R&D, export promotion, and stafftraining. 1.63 Overall, a simultaneous reduction in the scope o f state support and the level o f the tax burden could bringabout substantial welfare gains and should be considered as a priority policy objective. E. CONCLUSIONS:MAJOR MACROECONOMIC THECURRENT GROWTH RISKS OF STRATEGY 1.64 There are serious risks associated with the continuation o f the current growth strategy. A summary o f major weaknesses o f the current macroeconomic position, based on a Flow o f Funds analysis of the recent period o f economic growth, i s provided inBox 1.5. Similar serious risks and other important risks are also highlighted inthis section. Box 1.5: SomeWeaknessesof the ExistingMacroeconomicFramework as Highlightedinthe Flows-of-FundsAnalysis A high level o f redistribution through the enlarged government budget indicates a heavy tax burden and excessive government interventions. Government spending is disproportionally concentrated in the financing o f social spending and housing investments, while less finding i s available for public investment ininfrastructure. The level o f subsidization remains high, especially inagriculture. The high share of intermediary product in gross output indicates an under-developed service sector, as well as a relatively low level of value added inindustry. The profit'wage ratio is low, which hampers both savings and investments inthe real sector. The fmancial sector remains under-developed, even inrelationto the modest savings level. Source: World Bank staff analysis. 1.65 Low internationalreserves. While Belarus' debt and debt service indicators remain remarkably the extremely low level o f reserves inthe context o f a de facto pegged exchange rate poses a severe macroeconomic risk. This i s especially the case with a continued moderate current account deficit to be financed without significant FDI and no access to international capital markets. Under these circumstances, a negative external shock (e.g., the drying up o f financing from Russia, a loss o f competitiveness, or a weaker demand in key markets) would imply a disorderly balance o f payments adjustment (through either depreciation or the rationing o f imports, or both) and potentially significant output costs. A similar negative shock could also emerge from a sudden turnaround o f relatively fragile expectations on inflation and the exchange rate within Belarus that would cause the demand for foreign exchange to expand and the trigger significant pressures on the exchange rate. Box 1.6presents the results o f simulating the potential effects o f such a shock on economic performance. 31However, the structure of external debt becomes a concern. In2004, about 74 percent o f total debt was short-term obligations (up from 53 percent in 2001). The short-term debt was four times higher than international reserves in 2004. 28 1.66 The high concentration of non-oilproduct exports in a single and rather unstable market such as Russia.The Belarusianeconomy's successisvery dependent on external markets, butitsprimary market i s too oil-dependent and thus potentially unstable. To date, the economy has demonstrated only a limited capacity for export diversification (Chapter 4). A crisis in exports to Russia could thus cause a major problem because the economy does not have sufficient flexibility for the reorganization and redirection o f trade, An erosion o f the current Belarusian comparative advantage in Russian markets may occur either because o f unexpected political shifts or because of economic reasons. Inparticular, a major potential threat could come from a future higher pace o f restructuring in the Russian (mostly private) corporate sector relative to the restructuring rate that Belarusian SOEs could afford. A related risk to competitiveness may derive from the continued government pressure to increase wages without allowing for a significant adjustment inemployment. Russia's WTO accession is likely to lead to a gradual erosion inthe implicitpreferential treatment of Belarusian goods by Russia, and would also accelerate a need to address the existing asymmetry in Russia-Belarus trade relations (such as implicit subsidies for Belarusianexporters and trade restrictions on Russianexports to Belarus). Box 1.6: Balance of PaymentsVulnerability A stress-test scenario was constructed to examine the effects o f a 30 percent drop inBelarusianexports to Russia in2006 (relative to the baselineprojection). The immediate effect o f the shock would be a significant worsening o f the current account deficit to around 7 percent o f GDP. Assuming that Belarus' access to external financing would remain constrained, while existing foreign reserves equivalent to 0.6 months o f imports prior to the shock would provide only a meager cushon, this would leave few choices for dealing with the shock. Although such a shock could easily fully deplete the stock o f foreign reserves available (and still leave a significant unfinanced gap), it i s assumed that the authorities would not allow this to happen. Instead, an absolute minimum level o f foreign reserves equivalent to 0.3 months o f imports would be maintained. The remaining financing gap would have to be closed by a combination o f building-upexternal arrears (estimated to reach 2.4 percent o f GDP in2006) and imposing M e r restrictions on import growth. It is expected that import restrictions are likely to become a serious constraint for the real sector, slowing down economic growth. The medium-term effects of the shock would be lower export and import growth when compared with the baseline and the building-up o f external arrears that may persist for few years after the shock. Although external debt ratios would remain relatively low, there would likely be an increase in the relative dependence o n short-term credits as most o f the external financing available would come inthe form o f shorter maturities. Given the already high level o f short-term debt and reserves even lower than in the baseline, the economy would become much more vulnerable to yet another shock. The likelihood of a disorderly adjustment would increase, resulting in slowing down o f economic growth, and reversals in the recent years' favorable tendencies in the demand for rubles, thus leading to higher inflation. Source:IMF staff analysis. 1.67 The largesize of the government.An important part o fthe success o f Belarusiangrowth derives from the strong government capacity for revenue collection, including for taxing various economic rents and using these revenues in a way that i s supportive o f expansion in domestic demand. In the existing growth model, the high level o f government spending plays a central role. Thus, deterioration in the government's ability to extract these rents and/or redistribute them at the existing level o f efficiency could hurt domestic demand, output, and budget revenues, thus triggering a spiral of declining output and revenue levels. 1.68 The tax burden is substantially higher than in neighboring countries. This puts Belarusian producers at a competitive disadvantage. For example, in 2003 the total explicit tax burden in Belarus 29 amounted to 44.7 percent o f GDP compared to 34.7 percent in Russia (Figure 1.12). This difference was largely a result o f two groups o f taxes: payroll taxes (they are 5 pap.higher inBelarus than inRussia) and "other taxes'' which include turnover taxes and taxes to extrabudgetary funds (they are 7.4 pap.higher in Belarus). Another main difference in the tax structure relates to a natural resource tax, which plays a much more prominent role inRussia (but this i s compensated by a higher sales tax, property tax and VAT inBelarus). This also points to the inefficiencies inthe tax structure inBelarus, whichreliestoo much on the taxes that are known to have the most distortive effect on incentives in the real sector.32 These inefficiencies in taxation further aggravate the impact o f the hightax burden on enterprises. The Program o f Socio-economic Development for 2001-05 stipulates a reduction inthe level o f resource centralization bythe state from 47.7 percent in2000 to 45 percent, and a reduction inthe tax burden (excluding taxes to the SPF) from 32.7 to 30.1 percent during the same period. However, cross-country comparisons suggest that progress in this area has been insufficient and that the targets are not ambitious enough. Figure1.12:Tax BurdeninBelarusandinthe RussianFederation,2003 ("Aof GDP) ............................................................................ .................................................................... ............................................................ ............. ................................................. .......................... ................................ .......................................... ................................................................. A Includes turnover taxes and EBFs. AA BetweenBelarus andRussia. Source: WB Staff calculations basedon data fromthe MoFs (Republic of Belarus and Russian Federation). 1.69 The highconcentrationofthe output andtax basefurther aggravates the above-mentionedrisks. The Belarusian economy i s dominated by large SOEs: output, exports and tax proceeds are very concentrated (see also Chapter 2). One hundred industrial enterprises (less than 5 percent o f the total number) produced 59 percent o f the industrial output in 2003 and their share increased to 68 percent in 2004. The concentration of production implies a heavy concentration o f the tax base. The one hundred largest taxpayers contributed 27 percent o f total tax proceeds in 2003, and the preliminary data for 2004 suggest that this share increased to one-third (Table 1.11). Both budget revenues and foreign exchange proceeds depend heavily on the operations o f a limited number o f exporters, which in turn are highly 32Turnover taxes were largely eliminated inmost transition economies. 30 dependent on business conditions at the single or limited number o f external markets. This multiplies the vulnerability o f the system. Table 1.11:Tax ConcentrationinBelarus: Sharesof 10,50 and 100Taxpayers inTotalProceedsof ConsolidatedBudget,1999-2003 (YO) 1999 2000 2001 2002 2003 10 13.6 13.3 14.1 13.4 12.5 I50 24.6 25.2 24.9 24.5 22.6 100 29.4 30.1 29.6 29.2 27.0 Source: Ministryfor Taxes and Contributions. 1.70 State support to the economy remains extensive and pervasive and is far from being effective in spite of various attempts by the government to streamline, quantify and access its effectiveness. While some forms and mechanisms o f subsidization were modified, no serious pressure emerged for streamlining the system and making substantial cuts in the aggregate level o f subsidization. Worrisome trends in the liquidity o f the banking sector in the second part o f 2004 are an indication that the situation in this area requires immediate attention. A simultaneous reduction in the scope o f state support and the tax burden could bring about substantial welfare gains and should be considered as a priority policy objective. 1.71 The weak financial sector. Vulnerabilities in the banking sector largely relate to the high incidence o f directed lending and more generally to excessive government intervention in banks' decisions on credit allocation. The banking loan portfolio i s rather fkagile. Any erosion in the competitiveness of the real sector would lead to a rapid worsening in the share of non-performing loans, which would require government intervention to prop up the banking system. In the past three years, government spending on bank recapitalization amounted on average to 1.3 percent o f GDP per annum. However, the experience of CEE countries in the 1990s suggests that the fiscal costs o f a full-scale banking crisis could be much higher than this.33The recent analysis undertaken under the FSAP (2004) suggests that the key systemic vulnerability for the banking sector i s linked to the government's ability to continue to provide support to the state banks, in the form o f both liquidity and equity. As loans to priority sectors or enterprises are often provided on the basis o f government recommendations, an inadequate assessment of the capacity for repayment could exist, especially when there i s an explicit government guarantee. As long as the government remains in a position to promptly honor its guarantees when they are called upon, andor to recapitalize the systemically important banks, the system i s exposed to credit, market, or liquidity shocks only to a limited extent. Deterioration in the government's fiscal position would limit the possibility o f providing further such support to banks, which could potentially lead to a systemic financial crisis. 1.72 The FSAP team conducted various stress tests to analyze the degree o f vulnerability o f commercial banks in Belarus. The stress tests found that Belarusian banks are vulnerable to credit and liquidity shocks and that the special features of the economy (a large share o f loss-making enterprises, a large share o f foreign-currency-denominated loans, and a large share o f assets with long-term maturities) could substantially amplify the impact o f these shocks. The analysis showed that the banks would be able to withstand a separate credit risk shock. The banks, as well, were found to be sufficiently capitalized to withstand the direct effects o f a substantial volatility in either the exchange rate or the interest rate. However, simultaneous shocks to the credit quality, the exchange rate, and the interest rate would have a substantial impact on the capital position o f banks, especially the six largest banks which account for 85 percent o f total banking assets inBelarus. The combined shock would reduce the capital adequacy ratio o f 33The total public costs ofbank restructuring inHungary amountedto about 13 percent of GDP, while similar costs inbothBulgariaandthe CzechRepublic exceeded20 percentofGDP (Tang et al., 2000). 31 these banks by a factor of two. A capital injection of approximately BYR610billion (about 1.4percent o f GDP) would be requiredto restore the capital adequacy o fthese banks. 1.73 The current demographic trends represent the major long-term risk for Belarus. Belarus has a population that i s o f an older age and that has been shrinkmg since 1994. Existing demographic forecasts show a significant increase in the share o f the elderly population o f from 21 to 28 percent between 1995 and 2025 and a deterioration o f the ratio o f the working age population to elderly o f from 2.7: 1in 1995 to 2:1 in 2020 and to around 1.5:1 in 2040. This trend will continue to build pressures on the pension system. This poses an even greater challenge for a shift to a different growth model that would be less labor-intensive. The demographic problems could become especially difficult if Russia (which i s facing similar demographic problems) would switch, as many expect, to a much more proactive immigration policy. 1.74 Developments in the pension system represent a major fiscal risk. The combination of demographic trends and government social policies generate significant fiscal pressures on the country's pension system. At the moment the old age pension benefits are relatively high, on average about 43-44 percent o f the average wage. The existing pension system i s not capable o f supporting this level o f benefits inthe future. This i s because o f growing demographic pressures, which are aggravated by a need to reduce the level o f payroll taxation that i s increasingly damaging the country's competitiveness. As estimated by the IMF, without reforms the Pension Funddeficit would grow rapidly and reach 1.8 percent o f GDP by 2008.34Thus, the pension systemrequires a comprehensive reform, which would include a rise in the retirement age, adjustments to the existing system of pension indexation, a strengthening of the incentives for a delayed retirement, the removal o f the Pension Fund's responsibility for financing non- pensionbenefits, and the introduction of a supplementary non-government social insurance. 1.75 In sum, Belarus faces the choice of maintainingits current growth strategy and gradually losing steam, or facilitating sustainable growth by reorienting policies toward ensuring a stable macroeconomic environment and lowering the size of the government. While the recent growth performance appears to have reduced the urgency o f making this choice, Belarus' small open economy lacks the flexibility to withstand large shocks, and relies on external markets too closely to leave much room for complacency. In addition, the beneficial effects o f even wide-ranging and well-sequenced structural reforms will become available with a significant lag, which implies a need to launch such reforms at an early date, while the economy i s still stable and generates growth. Further delay would imply the loss of an opportunity to launch reforms at a minimal cost, since the benign external environment may change. 34IMF(2003b). 32 CHAPTER2 INDUSTRIAL PERFORMANCE:PRODUCTIVITY, COMPETITIVENESS,AND MEDIUM-TERMISKS R 2.1 Industry is the critical sector o f the Belamsian economy. Its performance largely defines overall economic trends in the country, while its importance exceeds by far the nominal share o f the sector in output (30 percent of GDP) and employment (26 percent o fjobs). More accurate measures o f industry's role relate to the sector's contribution to the consolidated budget revenues (52 percent in 2003) and to exports o f goods and services (53 percent). The industrial contribution to the recent GDP growth also exceeded its GDP share: in 1996-2000, more than 51percent o f the overall GDP growth was generatedby industry,andthis share amounted to about 42 percent in2001-03 (see Chapter 1).Moreover, the country's elite has a strong self-perception o f the Belamsian economy as one with longer-term comparative advantages inmanufacturing. Table 2.1: IndustrialStructure, Shares of Selected Sub-sectorsin TotalIndustrialOutput, 1990-2003 (Percent oftotal) 1990 1995 2000 2003 Total Industry 100 100 100 100 of which: Mining 2.1 5.5 4.8 6.3 Manufacturing 97.9 94.5 95.2 93.7 Shares of individual sub-sectors: Electricpower 2.6 13.8 7.1 7.3 Fuelindustry 4.6 4.3 16.2 16.7 Ferrousmetallurgy 0.9 2.4 2.9 3.5 Chemicaland petrochemical 9.0 14.3 12.5 12.1 Machineryandmetalworking 34.2 23.3 20.5 21.8 Logging, woodworking, pulp andpaper 4.4 5.3 5.0 5.4 Constructionmaterials 3.7 5.1 3.4 4.1 Light industry 17.2 8.0 8.4 6.3 Textile 10.4 4.4 4.2 2.9 Clothing 4.7 1.3 2.1 2.0 Leather, fur and footwear 2.1 2.3 2.1 1.4 Foodindustry 14.9 17.0 17.3 17.2 Foodprocessing 5.6 6.8 8.9 8.1 Meat anddairy 9.0 10.0 8.0 8.5 Fisherv 0.2 0.2 0.4 0.6 Source: MSA. 33 A. PECULIARITIESOF THE INDUSTRIAL STRUCTURE 2.2 The following specific features o f the industrial structure are critical to an understanding o f the recent trends inindustrial performance as well as the prospects for future overall economic growth. 2.3 The limitedavailabilityof localenergy sources andother primaryresources.Belarus does not have any significant primary resources, except for potash fertilizers. The country i s heavily dependent on energy imports (almost exclusively from Russia). The share o f net energy imports in overall energy consumption amounted to 87 percent in2003. 2.4 Traditional manufacturing is the core of the existing industrial structure. The country's historical specialization in the FSU was in various types o f machinery (including trucks, tractors, mainframe computers, television sets, refrigerators, and other consumer durables), chemicals and refinery products, garments and processed foods. This traditional industrial structure has remained surprisingly unchanged, given the transitional shocks of the last 15 years (Table 2.1).35In contrast to most economies in transition, Belarus continued to operate practically all of the inherited medium and large enterprises, while new entry was limited. 2.5 Highindustrialconcentration. The industrial structure is dominated by giant firms. In2004, the ten largest companies produced 36 percent o f the total industrial output, while the 50 largest produced 59 percent. And this level of concentration had changed very little since the Soviet era. Companies with more than 1,000 employees contribute over two-thirds of the total industrial production and employ about 73 percent o f the industrial labor (Table 2.2). Their output share has remained practically unchanged since 1991. The 20 largest exporters are a source o f more than half o f the percent o f all exports, and more than 80 percent o fnon-CIS exports. Table 2.2: Distributionof IndustrialEnterprisesby Size (Percent of total) Shares o f enterprises o f different size <100 employees > 1001employees 1991 1998 2000 2004 1991 1998 2000 2004 Number o f enterprises 42.7 43.2 38.8 40.6 12.7 7.9 8.2 7.6 Output inproducer prices 2.6 4.2 2.9 2.5 66.5 63.7 65.5 68.9 Industrial employment 2.6 5.7 5.1 3.6 70.7 58.0 58.0 72.8 Note: Individual entrepreneurs with no legal entity are not included in officially published data. According to the MSA, the inclusion of such enterprises will result in a higher share o f enterprises with less than 100 employees in total output and employment, about 7 and 11percent, respectively, in2004. Source: MSA. 2.6 At the same time, less than 6 percent o f industrial labor is employed by companies that have less than 100 employees. Their combined share in industrial output i s less than 3 percent, which is practically the same level as that in 1991. Even in the relatively more competitive sectors (machinery, wood processing, construction materials), the largest five to six firms generate 25 percent or more o f the total 35The main changes inthe industrial structure occurred before 1995 and included a sharp decline in the textile and garment industry, as well as in machinery, which were the sectors that were most affected by both demand contraction and stronger competition with non-FSU imports. At the same time, inthe course o f the 1990s, the shares of the power, fuel andpetrochemical sectors increased. 34 sectoral output. In contrast to the experience o f other economies in transition (World Bank, 2002b), growth inthe Belarusianindustrywas not driven by the expansion o f SMEs and new entry ingeneral. 2.7 Export orientation. Belarusianindustryi s highlyregionally integrated. Traditional Soviet era ties with Russian customers and suppliers are especially close. This i s largely a reflection o f the fact that the large traditional enterprises continue to dominate a relatively small but open economy. Fifty-three percent o f the total industrial output was exported in 2003. Exports to Russia made up 60 percent of total manufacturing exports. Taking into account the local production of industrial inputs for exporters, about two-thirds o f Belarusian industry works for external markets. Table 2.3 presents the data on export dependence (including dependence on exports to Russia) for a number o f leadingexport products. Table 2.3: Share of Exports to Russiain TotalNationalOutput (q) and inTotal Exports (s) for Specific IndustrialProducts, 1996-2003 (YO) Product Description 1996 1999 2001 2003 Trucks 9 53.4 82.1 91.1 74.9 S 76.3 87.2 87.9 75.1 Tractors 9 18.3 42.7 49.7 42.4 S 24.6 54.4 60.1 47.1 TV Sets 9 45.5 58.8 65.6 77.4 S 92.7 98.0 99.4 98.1 Refrigerators and freezers 9 57.3 56.2 47.9 69.6 S 79.7 71.6 61.4 79.3 Stoves and ranges 9 57.4 72.0 77.4 77.4 S 82.7 87.0 87.0 86.2 Ironand steel 9 18.0 19.7 14.5 33.9 S 22.6 21.2 16.7 40.3 Footwear 9 10.3 9.8 34.9 36.9 S 89.8 89.3 97.3 96.5 Synthetic filament yam 4 20.0 35.8 30.3 30.3 S 45.4 73.1 62.2 51.0 N e w pneumatic tires, of rubber 9 70.6 75.2 70.0 67.4 S 85.0 85.7 86.7 79.8 Ethylene 9 27.7 42.4 61.1 44.6 S 41.5 64.7 73.8 50.6 Mineral or chemical fertilizers 9 29.6 22.6 16.3 7.6 S 44.8 42.8 27.1 14.0 Beer 9 17.9 18.3 21.3 13.4 S 98.7 99.7 98.8 99.4 Pork 9 2.2 7.1 23.4 11.2 S 99.0 99.9 100.0 100.0 Source: MSA. 2.8 Predominance of state ownership. The pace o f privatization in Belarusian industry has been slow. In 2004 only 18 enterprises held in republican ownership were privatized (Figure 2.1). The current government strategy has been focused on the corporatization o f medium and large enterprises, with partial 35 privatization while preserving state control.36While about two-thirds o f all industrial enterprises could be considered private or mostly private, these are mostly small firms with a combined share in total output that was less than 20 percent in 2004. The state remains in full control of 34 percent o f enterprises, which produce about 82 percent o f output and employ 74 percent o f labor (Table 2.4). About one-fourth o f these firms (8.8 percent o f the total number) are the largest Belarusian enterprises, in which some privatization has taken place, but in which only a small minority o f shares has been divested, while the state has kept the controlling stake. The dominance o f SOEs largely explains the prevailing low profit margins in the sector. Table2.4: Ownership Structure inIndustryin2004 (YO) Numberof enterprises Output Employment Total industry 100 100 100 1. State ownership 25.1 37.0 41.5 -- municipal republican 9.7 34.0 35.9 15.4 3.0 5.6 2. Mixedownerslup, w/o foreign participation 8.8 44.6 32.1 3. Private ownership 66.1 18.4 26.4 - olw with foreign participation 4.9 6.4 6.0 Source: MSA. Figure2.1: Privatizationand Corporatizationof EnterprisesHeldinRepublicanOwnership, AnnualNumberof Enterprises, 1991-2004 50 4 P Industry, lransformd total JSCWIth less than 50% Of s t m b owned by state p1 JSCWIth PmrB than 50% Of 6tmkLI owned by state P Allenetlon Other prlvatizatlons 1SS'l- lSSS 2000 2001 2002 2003 2004 lSS8 aY. Source: Ministry o f Economy. 36 The state owns more than 50percent of shares inabout half ofthe more than 800joint stock companies (JSCs) that emerged inthe course o f the corporatization process. 36 2.9 Low profitability. The level o f profitability remains depressed, which i s a reflection o f several factors: (i)soft budget constraints and a high share o f loss-making enterprises; (ii)a wage and employment policy that inflates labor costs; and (iii) an excessive tax burden with a number o f turnover taxes. The average profit margin in industry declined from 17.1 percent in 1999 to 10.5 percent in 2002. The average probability increased somewhat in2003-04 to 15.3 percent, but it remains low. The policy o f targeted wage increases and informal restrictions on labor shedding results in rather a low profitlwage ratio, which on average has been below 10 percent (Figure 2.2). This reduces the investment opportunities o f the enterprise sector and undermines its longer-tern competitiveness. In comparison, the profitlwage ratio inRussian industryamounted to about 50 percent in2002-03. Figure 2.2: Profit/Wage Ratio inIndustry, 1999-2003 (YO) 0.0 I I I I I 1999 2000 2001 2002 2003 I Source: World Bank staff estimates based on MSA data. 2.10 High tax burden. As mentioned in Chapter 1, the Belarusian economy i s characterized by the high overall tax burden. Moreover, this tax burden is more or less unevenly distributed across the economy with industrybeing especially heavily taxed. Table 2.5 shows that in2002-03 taxes amountedto about 60 percent of the value added created in industry.This represents a modest decline of 10 percentage points relative to 2000, despite various government decisions aimed at a reduction inthe tax pressure. The current taxation burden remains excessively high and represents an additional risk for industrial competitiveness. Industry is, on average, over-taxed even on a net basis (i.e., even due to subsidies and tax exemptions). 2.11 As discussed above, the problem o f the Belarusian taxation system relates not to the rates o f regular business taxes (which are reasonable) but to the highincidence of turnover taxes3' and highpayroll taxes. These factors do not merely push up the overall taxation burden; they also make its structure distorted and excessively proportional to sale values instead o f measures o f profitability and value added. As seen from Table 2.5, the tax burden expressed as a percentage o f sales shows a high degree o f inter- temporal stability. Moreover, the tadsales ratio shows much less cross-sectoral variation than the tax-to- value added ratio. The later indicates a cross-sectoral inequality in taxation - sectors with low profit margins (such as machinery and food processing) are especially heavily taxed under the current system. Moreover, since the application o f both taxes and subsidies i s highly discretionary, it i s likely that effective taxation varies considerably among individual sub-sectors. 37 About 30 percent o f all taxes paidby industry in2002-03 were turnover based. 37 Table 2.5: Tax BurdenbyIndustrialSub-sector,2000-03 (YO) Taxes as a YOof sales Taxes as a YOof value added Change Change 2000 2001 2002 2003 2000-03 2000 2001 2002 2003 2000-03 NationalEconomy 14.7 14.9 15.3 15.8 1.1 33.1 31.7 28.8 29.0 -4.0 Industry 16.8 16.7 16.7 17.0 0.2 70.0 67.4 60.1 58.9 -11.1 Power industry 16.8 18.7 19.6 18.7 1.9 68.1 55.4 72.3 62.5 -5.7 Fuelindustry 20.2 18.4 21.1 20.1 -0.1 89.2 78.6 73.8 86.0 -3.2 Ferrous metallurgy 14.5 13.9 11.4 12.0 -2.5 61.3 78.8 45.1 40.4 -20.9 Non-ferrousmetallurgy 17.5 15.4 20.1 18.4 0.9 71.2 50.7 61.3 40.9 -30.3 Chemical andpetrochemicalindustry 15.6 13.8 13.9 15.5 -0.1 49.9 47.4 44.9 44.8 -5.1 Machinery and metalworking 18.2 17.7 17.4 18.1 -0.1 80.4 81.4 63.7 65.5 -14.8 Timber, woodworking, pulpandpaper 20.1 19.4 19.5 20.2 0.1 69.6 60.1 55.4 48.1 -21.5 Constructionmaterials 18.0 21.6 20.3 19.6 1.6 59.0 53.4 46.2 41.1 -17.9 Light Industry 17.2 17.2 17.4 17.6 0.4 61.0 65.7 58.8 48.7 -12.3 Foodindustry 13.9 14.0 13.2 13.2 -0.7 92.3 92.9 71.8 71.1 -21.3 Other 15.3 16.6 15.6 15.4 0.1 52.1 50.4 41.1 44.0 -8.1 Memo:Total taxes b/ 26.5 26.3 26.8 27.3 0.9 59.7 55.9 50.4 50.3 -9.6 aiProducer taxes, excluding PIT, excises, and tax penalties. b'Actually paid, including PIT, excises and other taxes paid by consumers. Source: Volchok (2005). 2.12 Inadditionto regular taxes, the industryis subject to additionalquasi-fiscal taxationthat includes, for example: 0 Spending on maintaining social assets (1.4 percent of GDP in200338) 0 Cross-subsidizing households and other consumers inthe power sector (2003 total costs amounted to 0.13 percent of GDP39) 0 Supplying agricultural farms with inputs(motor fuels, fertilizers) at subsidized prices. 38 This number relates to the whole economy, not just industry. However, it is believed that industrial enterprises finance the main share o f this total. In addition to the direct costs, the excessive social liabilities o f enterprises in Belarus are believed to reduce their flexibility and adjustment potential. 39 This does not reflect the remaining cross-subsidization in heating and other utilities. It is worth noting the considerable decline inthe burden o f cross-subsidization inelectricity, which exceeded 0.4 percent o f GDP in2000. 38 B. INDUSTRIAL PERFORMANCE 2.13 According to official statistics, the period since 1996 has been quite successful for industrial development in Belarus. The average rate o f industrial growth for 1996-2003 amounted to 8.7 percent (Table 2.6). A highrate o f industrial output growth in2004 (by 15.6 percent) resulted in an increase inthe average growth figure for the period '1996-2004 to 9.4 percent. Since 2001 industrial performance has improved further and become more balanced. In particular, the relationship between growth in productivity, wages and investment has become much less distorted. Moreover, industrial growth has been accompanied by noticeable improvements in efficiency, as seen in the positive dynamics o f both labor productivity and unit energy consumption. Table 2.6: Summary Indicators of IndustrialDevelopment, 1996-2003 1996-2003 1996-2000 2001-03 Average growth rate 8.7 10.4 5.8 Average growth inproductivity 7.3 6.4 8.8 Average profitability for the period 13.1 14.2 11.1 Growth inaverage real wage 12.1 13.5 9.8 Average investment growth 7.1 4.4 11.7 Average change inunit energy consumption -5.9 -6.4 -5.1 Memo: Endperiodindustrial employment, 1995=100 89.8 97.8 89.8 Endperiod unit energy consumption, 1995=100 61.6 72.0 61.6 Note: Data on energy consumption refer to the overall energy consumption inthe economy. Source: World Bank staff estimates based on MSA data. 2.14 After 1999 industrial growth become concentrated in machinery and food processing. These two sectors contributed about 60 percent to total industrial growth in 1999-2003. Further significant contributions were made by the oil processing, chemicals, and wood processing sub-sectors (Figure 2.3). Figure2.3: SectoralContributions to IndustrialGrowth, 1999-2003 (%) 11.1% Machineryand metalworking 8.7 Fuelindustry 3'9.9% 0Timber,woodworhg, pulpandpaper 0Foodindustry 18.7% Chemicaland petrochemicalindustry 7.8% 13.8% Other I I I Source: World Bank staff estimates based on M S A data. 39 2.15 Despite continued labor shedding in the machinery sector, it remains by far the largest industrial sub-sector by employment. Together with food processing, these two sub-sectors employed about half o f the total industrial labor in 2003. A strong expansion in such labor-intensive sectors, accompanied by strong real wage growth, had a profound impact on the overall trend inthe recovery o f household incomes. 2.16 Inaddition to a relatively highshare of total labor concentrated inthe fast-growing sectors, two more factors helpedto ensure that the benefits o frecent growth were broadly shared: 0 The wage policy encouraged a relatively highshare o f labor inthe total value added. Until2002, the real industrial wage grew more rapidly than productivity (Figure 2.4).40 0 The income policy emphasized restrictions on income differentiation within the real sector, including explicit and quite low limits on the wage differential between management and floor labor. Figure 2.4: Wages and Productivity inIndustry, 1995-2004 (1995=100) 300 250 i+Labor productivity, 1995= 100 200 150 &Average monthly real wage (Rbl), 1995 = 100 100 F -+-Average monthly real wage 50 (ForEx), 1995 = 100 0 1995 1996 1997 1998 1999 2000 2001 2002 2003 2004 I Source: World Bank staff estimates basedon MSA data. 2.17 Inturn, the highgrowthinrealincomes witha limitedincreaseinincome inequality fut,;d a growth in domestic demand that became animportantadditionalfactor insustaining growth inthe periodafter 1999. c. ALTERNATIVEINDICATORS GROWTH OF 2.18 The official data on Belarusian growth are often met with considerable skepticism. The skeptics usually point to the weaknesses in the existing index o f industrial production, as well as to the administrative pressure on state controlled enterprises (which are expected to meet output targets) which may create incentives to distort statistical rep~rting.~' 2.19 This section uses the alternative survey data4*to explore the question o f the broader reliability of the official growth estimates. To what extent do the official data reflect at least the overall trend in 40However, as seen from Figure 2.5, in 1996-99, real wage growth measured in foreign exchange was much slower than measured in constant rubels. As discussed below in this chapter, this played a critical role for maintaining the competitiveness o f Belarusian industry inRussia, its core market. 41See IMF (2005~). 42These results are based o n Gotovsky and Zheltkov (2004). 40 industrial dynamics? Do the alternative data support the claim that Belarusian industry has been going through an extended period o f economic expansion? 2.20 The alternative dataset i s based on the quarterly mailed-in survey o f business conditions that has been undertaken by the Research Institute o f the Belarusian Ministry o f Economy since April 1994.43The main block o f the survey contains 15 qualitative questions on economic dynamics, which are formulated inline with the standard European meth~dologyThe~ survey sample includes 904 industrial enterprises . ~ (more than 40 percent o f their overall number). The average quarterly return amounts to about 300 filled questionnaires. In contrast to the established European practice, however, the survey in Belarus i s not a part of the regular state system o f statistical monitoring. Enterprises participate inthe survey on an entirely voluntary basis. It would be worth incorporatingthis kindo f survey into the Belarus state statistical system and thus expand the availability o f such information for policymakers and experts. 2.21 Insummary, the comparison ofthe survey results with the official growthdata suggests a fairly high correlation in identified growth trends. While the official growth data are likely to be somewhat biased, they appear to reflect the directiodsign o f economic dynamics reasonably well. This means that there are substantial reasons to believe that economic growth inBelarus i s real and is not just a "paper phenomenon generated by statistical manipulations." 2.22 The integral measure o f growth inthe alternative survey is the balance between positive answers (those who report that their output increasedinthe latest period) andnegative answers (those who experienced a decline inoutput). Figure 2.5 presentsboththe official andthe alternative growthmeasures.Their comparison reveals a strong correlation inthe time series. Bothmeasurespointto: (i) a drastic change ineconomic dynamics &om 1995 to 1996; (ii) years o f high growth in 1997-99; (iii) visible slowdown in 2000-02; and (iv) new growth a acceleration in2003. At the same time, it is worth mentioningthat the alternative measure suggests significantly lower growth in2001-02(less than2 percent compared to about 5 percent inthe official data). Figure2.5: TrendsinIndustrial OutputAccording to Official and Survey Data 20 40 51 -Real growth, leftaxis 01 20 5 10 +Surveydata. rightaxis 0 0 5 01 1 -2 " 1-4.7 -3 5 0 Source: Gotovsky and Zheltkov (2004). 43 A somewhat similar industrial survey, but with a stronger focus on the enterprises' financial performance, was also runby the National Bank o f Belarus since 2000. For the time period for which both survey results are available, their results regarding maintrends inindustrialperformance are broadly consistent. 44 The questionnaire was developed with methodological support from the OECD Department o f Statistics. It is similar to the questionnaires used inRussia and Ukraine, which provides for comparability o f the respective survey results. 41 2.23 Another important data-related issue concerns to the economic nature o f growth in Belarus. T o what extent was the observed growth driven by changes in economic fundamentals (such as the strengthening o f demand)? Or, alternatively, could output growth be primarily a result o f administrative pressure, which, instead o f leading to growth in sales and earnings, led mostly to accumulation o f inventories and waste o f inputs? Figure 2.6 suggests that the dynamics o f output and demand were strongly correlated (i.e., that industrial output in Belarus has been reacting to actual changes in demand, not just to government pressures to produce more). The only significant deviation relates to the period 2000-02, when output continued to expand despite a noticeable compression in demand. This inconsistency between output and demand led to a considerable inventory accumulation during that period. Figure 2.6: ChangesinOutput, Demand andInventoriesAccordingto Survey Data (balance of answers) -output +Demand -A- Stocks Source: Gotovsky and Zheltkov (2004). 2.24 A comparative analysis o f similar business surveys in Russia, Ukraine, and Belarus provides additional confidence in the alternative growth data.45Enterprises inboth Russia and Ukraine operate in a much more liberal economic environment than in Belarus. They do not face any significant administrative pressure to inflate output, which in Belarus could, as one may claim, distort even the replies provided to the non-official survey. The comparison o f the survey data from the three countries, however, reveals a number o f similarities inmanagers' responses. 2.25 In particular, according to the surveys, enterprise managers in these three countries share perceptions o f the common regional market and face largely similar growth barriers. Their responses to growth challenges show similarity as well, despite significant differences in the national business environments. There i s no evidence that responses obtained inthe Belarusian survey differ intheir quality because of, for example, either potential differences in the qualifications o f respondents or differences in their incentive frameworks. Inparticular, inall three countries the following i s seen: 0 There i s a similar strong correlationbetween the output and demand indicators. 0 Management's satisfaction with its company's output level i s dominated by attained capacity utilization. 0 The leading growth constraints relate to a shortage o f working capital, taxation, insufficient demand, and customer non-payments. At the same time there i s little concern about shortages either o f equipment or skilled labor. 45Russiansurveys are conducted by the Institute of Economic Transition (Moscow), while those inUkraine are conducted by the Statistical ResearchInstitute (Kiev). 42 D. GROWTHDRIVERS 2.26 Our combined analysis o f survey results in Russia, Ukraine, and Belarus also helps to clarify the role o f external factors, including the role o f development inRussia, intriggering and sustaining industrial growth in Belarus. Combining this analysis with other findings, including those on trade performance in Chapter 4, we conclude that the role o f external markets was critical in triggering the initial growth in Belarus in the second half o f the 1990s. However, more recently the interaction between external and domestic factors has been more complicated. It i s clear that the role o f domestic demand has become more important in sustaining growth after 2000. Overall, growth in Belarus for the entire period 1996-2004 cannot be explained by external factors alone. 2.27 Table 2.7 shows cross-sectoral differences in growth rates depending on the dominant markets o f each industrial sub-sector. The industry i s divided into four groups o f sub-sectors: (i)domestically oriented; (ii)mostly domestically oriented with a large share o f CIS exports; (iii) oriented toward mostly CIS markets; and (iv) mostly oriented toward non-CIS markets. The table 2.7 suggests a major convergence in growth rates among various sectors after 2000 (except for power generation in group 1). However, inthe second part o f the 1990s the growth rates were highly uneven-the sectors that are mostly CIS oriented over-performed compared to the rest o f the economy. Table 2.7: Indicesof Total Output by Industrial Sectors, 1996-2003 (Inpercenttothe previousyear) 1996 1997 1998 1999 2000 2001 2002 2003 1995- 2000 1995- 2000 -03 2003 Industry,total 103.5 118.8 112.4 110.3 107.8 105.9 104.5 107.1 164.3 118.5 194.8 OrientedtowardInternalMarket: ElectricPower 98 106 93 105 97 99 103 100.9 98.4 102.9 101.2 Orientedtoward InternalMarket witha significant 103.3 122.1 118.2 111.6 105.5 109.2 04.5 108.0 175.5 123.2 216.2 CIS Market Share: Food 105 121 119 114 107 110 104 107 184.4 122.4 225.7 Building Materials 96 126 115 101 98 105 107 112 137.7 125.8 173.3 Oriented toward CIS Market: 105.9 127.5 118.5 114.7 111.2 108.2 04.4 107.1 204.1 121.0 247.0 Machineryand Metalworking 102 126 116 116 115 111 106 108 198.9 127.1 252.7 Light 112 127 123 111 105 100.9 98 104 203.9 102.8 209.7 Logging, Woodworking, 114 135 122 116 106 107 106 107 230.9 121.4 280.2 PulpandPaper Orientedtoward Non-CISMarket: 106.9 118.0 107.9 104.5 109.8 105.6 106.2 107.3 156.2 120.3 187.9 Fuel 95 99 100.6 102 115 105 111 107 111.0 124.7 138.4 Ferrous Metallurgy 123 135 115 100 110 107 106 106 210.1 120.2 252.5 Chemical and Petrochemical 107 119 108 107 103 106 99.97 108 151.6 114.4 173.5 Source; GotovskyandZheltkov (2004). 2.28 Figure 2.7 presents the comparable dynamics o f industrial growth inRussia, Ukraine, and Belarus, generated from the managers' responses to similar enterprise surveys in the three countries. It shows a 43 strong correlation ( ~ 0 . 8 1 5 )for industrial dynamics inRussia and Ukraine. At the same time, correlation between growth in Belarus and growth inRussia i s much weaker (r=0.321), while the correlationbetween Belarus and Ukraine i s negative (r=-0.372). The major difference relates to the period 1996-98, when Belarusian industry experienced a fairly strong growth while in Ukraine and Russia the balance o f responses remained mostly negative, which at best indicates a slowdown in decline, but not a recovery. Similarly, the evolution o f industrial demand in the three countries does not show any significant correlation for the entire period o f 1996-2004. Figure 2.7: IndustrialGrowth inBelarus, Russia, and Ukraine (balance of answers) 60 j -Belarus -o- Russia +Ukraine -40 .........;........->. ........;.........I.. L... ....... ...... ...... .......-,. ;.. .;. .....-. -50 Source: GotovskyandZheltkov (2004). 2.29 Overall, the comparative analysis suggests that the R ~ s s i a / c I Sdemand could be considered a ~ ~ driver for Belarusian industrial growth only in particular periods (such as 1997-first half o f 1998, and 2002-03), but not for the entire period o f 1996-2004. Belarus appears to employ other growth factors that are somehow independent o f Russian economic dynamics. Moreover, the economic expansion in Belarus in 1996-99 took place against the broadly depressed situation in its main export market in Russia and without much diversification into other more dynamic markets. Such a growth episode should be seen as something unusual, and deserves a more detailed explanation. 2.30 The explanation of this early growth puzzle suggested by this report links it to a simultaneous effect o ftwo groups o f factors: 0 An active political reintegration with Russia, which resulted in improved market access, as discussedinChapter 4 0 A change in government policies through the real depreciation o f the rube1 and an expansion in interest rates and other implicit subsidies that were (on a net basis) beneficial for at least a part of the leading exporter^.^' 46RussiaandUkraine accountedfor 96 percentof the totalBelamsianexportto the CIS in2003-04. 47For example, domesticcredit doubledin 1998, from 18 to 35 percentof GDP. 44 2.31 As shown in Chapter 1, the government policy o f the late 1990swas destabilizing and led to an acceleration o f inflation and significant real depreciation. At the same time, it resulted in a substantial decline in the price level o f Belarusian producers relative to those in Russia (Figure 2.8). For the period 1996-99, the average producer price ratio for Belarusian and Russian markets was at about 60 percent of i t s level in both 1995 and 2000. This price advantage appears to be fundamental in explaining Belarusian growth at that time. Ina situation o f continued stagnation inthe Russian economy, Russianconsumers had a strong preference for familiar low-cost, low-quality Belarusian goods. It i s worth noting, however, that these price advantages were not based on an advantage inproductivity, butprimarily on wages. Figure2.8: Dynamics of Relative Producer Prices inBelarus,Ukraine, and Russia, 1995-2004 (December 1995 = 100%) .-. -'*"Belarus US$price -. 'Russia US$ prices 150 -.C- Belarus/Russia pnce ratio 100 -"+"Ulcraine US$ 50 .-.. */" - ................................. prices +I+UkraineRussia 1995 1996 1997 1998 1999 2000 2001 2002 2003 2004 Source: Gotovskyand Zheltkov (2004). 2.32 Soft macroeconomic policies in the second part of the 1990s were complemented by massive government interventions aimedat slowing downnominal growth inbothwages anddomestic prices. These wage andprice controls further consolidated the cost/price advantages of Belarusian producers inCIS markets. At its lowpoint in1998,the averagewage inBelams amounted to only 30percent o fthat inRussia (Figure 2.9). Figure2.9: Relative Consumer Prices and Wages inBelarus and Russia (Annual Average, Russia= 100%) 90 .. I 1 80 ............................. 70 ........................ BelamsRussia wage ratio 60 -- 50 BelarusRussia 40 CPIratio 30 20 10 1 " i n 1995 1996 1997 1998 1999 2000 2001 2002 2003 2004 Source: Gotovskyand Zheltkov (2004). 45 2.33 There were two important effects o f such a government policy for the enterprise sector. First, it led to the formation o f a specific export strategy. Inthe environment o f government-imposed cost control and low investments, it appears quite logical for exporters to concentrate their efforts in the market niche o f low quality, low price goods, namely, to move to the niche that i s traditional for low and low-medium income developing countries. Indeed, in the second part o f the 1990s the prevailing average wages, estimated at the market exchange rate, were comparable to industrial wages in China. This export strategy collapsed as soon as the government exercisedpressure toward a considerable real wage growth. 2.34 The second effect proved to be much more sustainable. It relates to securing a considerable share o f the large Russian market and thus establishing a first-mover competitive advantage. When Russia started to grow after the 1998 crisis, the Belarusian industry was well positioned to benefit from this growth. In the environment o f the growing Russian market it was easier for established Belarusian exporters to defend their market share and their expand export volumes relative to the barriers that a new entry from other countries to this market had been facing. Inother words, the scale o f the cost and market advantages accumulated before 2000 was sufficiently large to support further export growth to Russia in 2000-04(see also Box 2.1). I Box 2.1: MinskTractor Plant: A Typical Story of Transitional Survival The trends inthe performance o f the Minsk Tractor Plant (MTZ) are a good illustrationo f the environment inwhich the largest Belarusian industrial companies have been operating. The MTZ is one o f the largest and best known companies inthe country. In 1990 it produced about 100,000 tractors a year, or about a quarter o f the entire USSR production. It was apparently one o f the best Soviet plants o f this type, and even before 1991 the MTZ exported a noticeable share in its tractors outside o f the FSU (mostly to Eastern European and developing countries). The company was severely hitby a demand shock o f the early 199Os, when the demand for agricultural machinery inthe FSU dried up almost entirely. Nevertheless, in the first part o f the 1990s, the MTZ performed better than similar FSU companies because o f two primaryfactors: (i) the existence o f its establishedcustomer base outside o f the CIS; and (ii) some Russian orders within the CIS bilateral agreements (tractors-for-energy deals). By 1995 production by a factor o f lo), butthe company preservedmost o fits operational capacity. had declined four fold (inthe rest of the CIS, where 11major tractor plants were operating, the total output declined The process o f re-integration with Russia (and the associated expansion o f barter agreements) and the more recent Russian growth have been most beneficial to the MTZ. Exports to Russia increased from 6,300 tractors in 1995 to 9,700 in 1998 and 13,600 in 2004. The overall production o f tractors increased by about 50 percent in 1995-2004 and reached about 35,000 units a year. (During the same period the production o f tractors in Russia declined by an additional 200 percent.) Almost 30 percent o f the output was exported to the non-CIS market, with sales to 66 countries overall. In2002 the MTZ employed about 20,000 workers, two-thirds o f its pre-transition labor force. The MTZ has been affected by government policies in a number o f ways. On the one hand, it has clearly been i major beneficiary o f stronger bilateral cooperation with Russia, which provided a critical level o f demand support On the other hand, the company has been taxed heavily through both export proceeds surrender requirements anc requirements to supply tractors to local farms at low regulated prices. However, the company managed to receive partial compensation for the latter losses through government subsidies, including through various tax benefits. The net effect o f all these distortive interventions to date has been positive for the company in the sense that it has survived the transition much more successfully than all of its competitors in the FSU. In2002 its share in total CIh tractor production amounted to about 60 percent, whereas it was only about 25 percent in 1990. The companj I remains World fully state-owned, without any clear prospects for privatization. Source: Bank staff analysis. 2.35 In summary, the early growth was triggered by the simultaneous effect of three factors - privileged access to the Russian market, temporary cost advantages, and subsidies to exporters. The effect o f these factors was significant largely because of the low capacity utilization in 1995. Inthe years o f early 46 growth, capacity utilization in industrygrew rapidly from 37 percent in 1995 to 53 percent in 1999 (Table 2.8):' Table2.8: Capacity UtilizationinIndustry,1995-2003(YO) 1995 1999 2001 2003 Industry,total 37.2 52.9 47.7 49.5 ofwhich: fuel 30.9 40.1 57.8 54.2 ferrous metallurgy 55.5 88.1 91.3 93.9 chemicalandpetrochemical 44.1 63.2 68 67.6 machineryandmetalworking 26.3 41.2 47.7 52.6 logging, woodworking, pulp andpaper 49.1 70.5 80.3 88.8 constructionmaterials 42.3 57.9 72.4 80.7 light 40.1 53 44.3 44.9 food 42.8 54.7 48.3 55.6 Source: Ministry o f Economy. 2.36 All of these factors, which have gradually been declining, are still effective and have helped sustain growth inrecent years. Inthe more recent period, growth received fkther support from additional factors such as the following: 0 A drasticallyimprovedexternalenvironment. This reflects primarily the growth inoil prices, which benefited Belarus directly (expansion in oil processing exports), and especially indirectly, accelerating Russian growth and Russian demand, This also includes a number of secondary factors, such as improved external prices for metals and fertilizers (both relatively important export items for Belarus) and the rise inthe volume of Russianremittances. Specific protectionist measures recently adopted by Russiahave also provided to be beneficial to Belarusianexporters. 0 The strengthening of domestic demand. The government budget and wage policies became an important source o f a steadily rising domestic demand. The existing trade regime helped to limit growth in consumer imports and ensure that domestic producers, especially in the consumer sector, became the main beneficiaries of the growth indomestic demand. 0 An accelerated restructuringof domestic enterprises, driven by competitive pressures at both external and internal markets and facilitated by certain domestic macroeconomic stabilization. With all caveats the enterprise sector was able to generate productivity and export growth. 2.37 The role o f improvements in the global economic environment remains generally underappreciated in the discussions on the sources o f recent economic growth in Belarus. In fact, a number of developing economies have experienced a significant improvement in their economic performance relative to the period o f 1999-2002. After the 1999 financial crisis, these countries experience an acceleration in growth, driven by stronger export and trade trends (helped by commodity price increases). The point i s that while Belarus currently has been benefiting from the positive global economic developments, a potential global slowdown i s likely to be as important for Belarus as for many other small developing middle income economies. Inthe future such global market parameters as commodity prices, the real value o f the dollar, US. deficits, and the prevailing international interest rates will become increasingly important for Belarus' economic prospects. 48 Inmost industries(except food andlight) growth incapacity utilizationcontinued after 1999.However, the rate o f this growth has slowed down (excluding energy). As shown below in this chapter, industrial growth is receiving stronger support from growth ininvestments and relatively less support from improvements incapacity utilization. 47 2.38 In our view, the above provides sufficient evidence that the Belarusian puzzle has a fairly conventional economic explanation. Belarus had and still has significant comparative advantages in its main export market. However, this poses a question that i s central to this report: H o w stable are these advantages and how large i s the risk that they may be eroded quickly? The rest o f this chapter provides some analysis that i s relevant to this question. The chapter concludes with a matrix o f the main risks for the existing growth model. E. EMPLOYMENT PRODUCTIVITYTRENDS AND 2.39 The ongoing economic growth inBelarushasnot been accompaniedby aparallel growth inemployment. Infact, thetotalregisteredemploymentin2004remainedsomewhatlowerthanits 1996level, whenthe economy startedto recover after the crisis inthe early 1990s. Relative to its pre-transition level in 1990, the economy lost about 16 percent of jobs by 2004, while the decline in industrial employment in 1990-2004 amounted to 28 percent (Figure 2. 10). Moreover, in2000-03, the economy was still losingjobs (at an average rate of 1percent a year). The tendency toward reduction in the number of jobs in industry maintained in 2004. In addition, the numberofreportedworlang hours didnotincrease. Figure 2.10: Labor Market Trends inBelarus, 1990-2004 I - +Total \ I I 70i / I I Source: World Bank staff estimates basedonMSA data. 2.40 Employment dynamics in the early period o f transition in Belarus were not so different from the trends in other transition economies. While the Belarusian economy experienced less reform (including privatization, shifts in the industrial structure, changes in the direction o f trade, and the associated real sector restructuring such as, social asset divestiture), broad changes in employment in the 1990s showed some similarity to those inother countries intransition, as can be seen inthe following: Job losses early in transition were considerable but still were smaller than the decline in output, and, thus productivity had initially deteriorated Employment structures showed a shift from industryto services Within the industry labor re-allocated from the sub-sectors that experienced negative price and demand shocks (machinery, textiles and garments) to those that benefited from the initial macroeconomic liberalization (such as energy and metallurgy). 2.41 The CEE experience to date with respect to employment has varied considerably. For the 1989- 2002 period, total job losses ranged from 10 percent (the Czech Republic) to more than 30 percent 48 (Bulgaria, Estonia). In manufacturing the job loss was in general more significant and more uniform (it amounted on average to about 40 percent), with even the best performing countries (such as the Czech Republic) losing about 30 percent o f their pre-reform manufacturingempl~yment.~' 2.42 Against this background the actual scale o f employment contraction in Belarus appears to be within the range observed elsewhere intran~ition.~'Similarly, the Belarus experience o f growth without job creation has not been uncommon in the CEE (Figure 2.11). At the same time, the employment developments inBelarus differ considerably from those o f its neighbors inthe following aspects: 0 Despite the loss o f about 800,000 jobs since 1990, the level o f registered unemployment remains low (about 100,000 unemployed or 2 percent o f the labor force).51 This i s explained primarily by labor migration. As estimated by the Ministry o f Labor and Social Policy, at least 400,000 Belarusians have been working abroad, mostly in Russia. The Union Treaty provides Belarusian citizens with a better access to the Russian labor market than the rest o f the CIS. Declining population and participation levels, as well as an increase in informal employment, helps explain the gap between actualjob loss and low unemployment levels. 0 Changes inthe employment structure inBelarus after 1995 have been much smaller than inother transition economies. The most remarkable feature o f labor trends in Belarus i s the preservation o f high employment in industry. The active reallocation o f labor from industry to services was very pronounced in other transition economies through the entire 1990s, but in Belarus this process practically stopped in 1995. Industrial employment in 2003 was only 4 percent below the 1995 level, while inRussia, Ukraine and Kazakhstan this decline amounted to 15-25 percent. The share o f labor employed in industry i s still about 27 percent in Belarus, while it declined (from the same initial level o f above 30 percent) to about 20 percent inboth Russia andUkraine. 2002 Levels Relativeto the LowestPointin 1994-96,(EmploymentMinimum=loo) Figure2.11:EmploymentGrowthinSelectedTransitionEconomies, I I120.0q---- I 1. T Source: Staff estimates based on Economic Survey of Europe, 2004, PI 3.1. 49Economic Survey o f Europe, 2004, No. 1. I t is worth noting that inthis area Belarus has beencloser to date to the countries that managed to avoid a major contraction oftheir labor market. Inaddition to the Czech Republic, this group includes the Slovak Republic, Slovenia, and Romania. "Registeredunemploymentexceeded8percentinpracticallyallCEEeconomiesin2002,whileinsomecountries (Poland, Croatia) it was closer to 20 percent. 49 2.43 The comparison between employment contraction in Belarusian industry and employment contraction in CEE countries, where industrial restructuring has been largely completed, may indicate that in Belarus the industrial sector is still characterized by considerable job hoarding to a magnitude of 15 percent o f pre-transition employment in the sector (Le., up to 250,000 employees). Recent growth helped utilize some o f this excess labor, but it still falls short o f its full utilization. This potential over- employment represents about 6 percent o f current national employment. This i s significant, but i s not o f an unbearable magnitude for a potential future labor adjustment that may be required. If industrial restructuring i s accelerated and this amount o f industrial labor indeed becomes redundant within the sector, most o f it could be absorbed by the service and SME sectors if proper enabling policies are in place. 2.44 Trends in employment and productivity within the industrial sector o f Belarus since the early transition show patterns that are broadly similar to those in Russia, its main trade partner. As in Russia (Ahrend, 2004b), three distinct stages could be identified in the evolution o f productivity trends in Belarus: 0 Before 1996, during the period o f industrial decline, the restructuring o f Belarusian enterprises was predominantly passive and was mostly driven by short-term survival strategies. This included, inter alia, attempts to reduce employment as output fell. However, the employment decline was lower than output contraction, and industrial productivity declined by about 20 percent. InRussia this period continueduntil 1998, the year o f the financial crisis. 0 Inthe period of early growth in 1997-99, the Belarusianeconomy underwent more expansion than true restructuring. Enterprises benefited from low labor and other inputcosts associated with real depreciation, and from low capacity utilization. This period showed modest recovery in industrial employment (about 4 percent), while labor productivity increased by more than 45 percent. InRussia this period occurred during 1999-2001. 0 It appears that after 2000 the average restructuring effort within Belarusian industry has increased. The easy gains from early growth were exhausted, real costs increased considerably, and parallel enterprise restructuring in Russia began to apply competitive pressure on Belarusian companies. This initiated a new round o f job cuts and other restructuring efforts such as additional investments in energy savings. Industrial employment declined by an additional 8.5 percent in2000-03, while labor productivity increased by an additional 40 percent. InRussia this period has been ongoing since 2002. 2.45 Overall, Belarusian industry demonstrated a significant, steady, and broad improvement in productivity (Figure 2.12). Industrial productivity practically doubled during the period 1996-2003. All output growth in the sector derived from productivity improvements (Table 2.9). At the same time, at the sub-sectoral level performance varied, and the variation in employment, productivity and wage trends was considerable. As can be seen from Figure 2.12, the sub-sectors that apparently faced the strongest competitive pressures (machinery, construction materials, and apparel) became the leaders in productivity improvement in 1999-2003. They over-performed compared to the sectors that are more resource- dependent, such as fuel, chemicals, and metals. 50 Figure2.12: Employment andProductivityGrowthbyIndustrialSub-sector, 1999-2003 (Yo) Per cent 50 Emlovmentzrowth . I I ProdwMygrowth 00 50 00 50 0 PY Source:World Bank staffestimatesbasedon MSA data. 2.46 To what extent can the observed inter-sectoral variation in wages and employment be explained by differences in efficiency? This is an important question, one which could shed light on the severity o f the remaining barriers to labor mobility inthe economy and to economic resource reallocation in general. Table 2.9: Decompositionof GrowthinIndustrialOutput:Contributionsof Employment and ProductivityFactorsto SectoralGrowth, 1997-2003 (YO) ~ 1997-99 2000-03 1997-2003 Employment Productivity Employment Productivity Employment Productivity Growth Growth Growth Growth Growth Growth 103.9 141.6 91.4 139.8 94.9 197.9 Source: World Bank staff estimates. 2.47 At a relatively aggregated level (16 industrial sub-sectors) it appears that despite the well-known administrative interference in enterprises' decisions on firing, hiring, and wage setting, there has been considerable room in Belarus for labor mobility in response to market signals. Labor generally moved fkom the less productive to the more productive sub-sectors, while the wage differential has been able to facilitate such reallocation by sending signals to market participants that are broadly consistent with differences in sector productivity. 51 2.48 In particular, since 1995 there has been a positive correlation between growth in sectoral employment and output. Employment declines were on average higher in sectors with a higher share o f loss-making enterprises. Wages grew more rapidly in sub-sectors with higher profitability. There was also a significant negative correlation between the higher initial productivity in 1995 and the consequent growth in productivity, which indicates a cross-sectoral productivity convergence (Figure 2.13). The cross-sectoral variation in labor productivity, measuredby a standard coefficient o f variation, declinedby about 50 percent between 1995 and 1999. Figure2.13: Productivity Trends inVarious IndustrialSub-sectors, 1995-2003(YO) Productivity Initialproductivitylewlsw. productivitygrowth growth 200311995 (by industrialsuhsector) 350 Leather 300 + 250 - Mach.build.&met.+ 200 - +1Printing PPme +others I 150. Constr. + A ail^^ 100 - + Glass -Woodt:al+ A Micro'biol. +Fer. Met. *Food 50 - + ElpowerChemical&P hem.etroc Fuel Flour A + 0 20 40 60 81 Initial (1995) productivity level (1) Source: World Bankstaffestimatesbasedon MSA data. 2.49 A major exemptionto these general trends relates to the power sector, where flat output dynamics was accompanied by a significant increase in employment relative to 1990 despite a major amount o f investments over the last ten years. This i s to a large extent explained by the government's priority policy to increase technical efficiency in the sector, which provided it with additional access to funding for modernization. At the same time, the power sector remains considerably over-staffed. Although since 1990 the volumes o f power generation have declined by about 50 percent, employment in the sub-sector has increasedby 50 percent, indicating a decline inproductivity that exceeds 125 percent. F. TRENDS UNITLABOR IN COSTS 2.50 While growth in productivity i s an important characteristic o f industrial growth in Belarus, the analysis o f the country's industrial competitiveness should also take the following into account: (i) parallel changes inthe level o freal wages and other components o f labor costs such as payroll taxation, i.e., trends inunitlabor costs (ULC); and(ii) developments inneighboring countries that have experienced somewhat similar trends inbothproductivity and wage growth. 2.51 We estimated the ULC for Belarusian industry in a format that i s fully comparable to the recent analysis by Ahrend (2004b) for Russia. This helps in evaluating the dynamics o frecent labor costs against trends prevailing inBelarus' major market. Inparticular, to reduce the effects relatedto real exchange rate movements, we follow Ahrend's approach o f measuring wages in Belarus in a hypothetical currency unit 52 that i s a 50:50 currency basket o f US.dollar and euro. This has the additional advantage o f being largely independent o f recent swings inthe euro-dollar exchange rates. 2.52 Table 2.10 provides U L C estimates for the period 1997-2003 by industrial sub-sector. It shows that the average ULC declined by about 100 percent in 1997-99, but then fully recoveredby 2001, driven by apolicy o f accelerated realwage growth andbyreal currency appreciation. The average ULCremained broadly unchanged in 2001-03 because o f the high productivity growth in this period, which largely matched the strong wage growth duringthe period. Table 2.10: DevelopmentsinUnitLabor CostsbyIndustry 1995-2003(1997=1) Industrial Sector 1995 1996 1997 1998 1999 2000 2001 2002 2003 Total industry 1.05 1.16 1.00 0.56 0.51 0.78 1-00 1.03 0.97 Electric power generation 0.92 1.04 1-00 0.57 0.57 1.03 1.74 1.76 1.60 Fuel 0.80 1.03 1.00 0.57 0.56 0.84 1.31 1.47 1.41 Ferrousmetals 0.95 1.25 1.00 0.61 0.51 0.90 1.25 1.09 1.12 Chemical 1.02 1.20 1.00 0.62 0.61 0.99 1.25 1.42 1.41 Petrochemical 1.23 1.08 1.00 0.63 0.60 0.91 1.10 1.31 0.99 Machine building and metal processing 1.17 1.25 1-00 0.53 0.47 0.69 0.81 0.81 0.76 Timber, wood processing,pulp and paper 1.19 1.22 1.00 0.54 0.48 0.67 0.81 0.85 0.8 1 Constructionmaterials 1.08 1.20 1.00 0.54 0.51 0.74 0.93 0.95 0.9 1 Glass andporcelain 1.20 1.34 1.00 0.54 0.56 0.86 1.04 1.11 1.02 Textiles 1.09 1.12 1-00 0.55 0.50 0.78 1.02 1.03 0.92 Apparel 1.12 1.17 1.00 0.55 0.54 0.77 0.90 0.89 0.8 1 Leather, fur and shoes 1.15 1.27 1.00 0.48 0.38 0.57 0.61 0.62 0.54 Food processing 0.97 1.15 1.00 0.55 0.47 0.70 0.95 1.04 0.96 Publishing 1.14 1.37 1.00 0.47 0.41 0.51 0.55 0.58 0.53 Source: World Bank staffestimates. 2.53 The post-1999 U L C recovery has been highly uneven across sub-sectors. It was strongest in the power, fuel, and chemicals sectors. In contrast, in the machinery, leather, apparel, and wood and timber sectors (i.e., sectors that export primarily to Russia) the U L C recovery was much weaker, and the current labor cost level remained significantly below its 1997 level. 2.54 Figure 2.14 presents the results o f comparisons o f U L C dynamics in Belarus and Russia. In Russia, U L C have fallen sharply since 1997. Despite a considerable recent wage growth, ULC in 2003 were still roughly 25 percent below the 1997 level. The post-crisis growth inULC in Belarus was much more rapid and much stronger than in Russia. As a result, when compared to 1997, the relative labor costs in 2003 in Belarusian industry were at least 20 percent higher than in Russia. This indicates a considerable erosion of the major competitive advantage o f the Belarusian economy. The deterioration o f the Belarusian position relative to Russian competitors was most significant in the food processing and construction materials sub- sector^.^^ 52 The erosion in industrial competitiveness in Belarus has been even hgher relative to the CEE economies, where inmost cases overall growthinunit labor costs in1998-2003, accordingto the World Bank database, didnot exceed 15-30 percent. Moreover, for such neighboring countries as Latvia and Lithuania, this growth was even smaller -- 53 Figure2.14: DevelopmentsinUnitLabor CostsinIndustry,Belarus andRussia, 1995-2003 Developmentsinunit labourcosts by industry Relativeto total industry, 1997=1 Belarus 1.0 0.8 0.6 0.4 0.2 I 0.0 1995 1996 1997 1998 1999 2000 2001 2002 2003 I Source: World Bank staff estimates; Ahrend (2004b). 2.55 Infact, the actual deterioration of the competitive position inBelarus relative to Russia has been even more significant than the above data may suggest if one takes into account the difference in the dynamics o f payroll taxation in the two countries. Russia introduced a considerable reduction in the average rate o f payroll taxation in 2001, which led to a decline inthe effective rate by about 8 p.p., from more than 40 percent on average in 1997-2000 to 32.7 percent in 2002 (World Bank, 2005~).InBelarus, in 1999-2003, the effective rate ofpayroll taxation inindustryremainedquite stable at an average level of about 36 percent o f reported wages. This brings the overall decline in Russian ULC relative to the Belarusian U L C to almost 30 percent. Moreover, in the short term the factor o f payroll taxation will become even more important as a driver o f the relative labor cost differential inthe two countries. This i s because in early 2005 Russia introduced a new drastic reduction in the average statutory payroll taxation rate o f 8 p.p. 2.56 Figure 2.15 presents the results o f a direct comparison o f labor productivity in Belarus and Russia for five industrial sub-sectors that are most exposed to competition inthe Russian market. The comparison shows that Belarus has higher productivity inlight industryand inconstruction materials, while Russia has higher productivity in machinery and in the wood and paper sub-sectors; the productivity level in food processing i s close. Except for light industry,these cross-country differences increased somewhat between 1999 and 2003. At the same time both countries show a strong and broad increase in US$-based labor productivity, helped by a significant real appreciation o f national currencies. What follows from this comparison i s that when one accounts for labor productivity on its own, there i s no evidence that Belarus i s losing its competitiveness in Russia. This means that the above indicated trends in ULC are driven less than 10 percent. (It i s worth noting, however, that the latter estimates are not fully comparable with those for Belarus because o f the difference inmethodology.) 54 primarily by differences inreal wage growth. This points once again to the importance o f wage policy in Belarus as a factor that in the last four to five years has been seriously undermining the country's international competitiveness. Figure 2.15: Labor Productivity in Selected Industrial Sub-sectors inBelarus and Russia, 1999 and 2003 (in current US%) 10.0 8.0 6.0 4.0 2.0 0.0 20.0 15.0 10.0 5.0 0.0 ~~ Source: World Bank staff estimates based o n data from MSA and Rosstat. 2.57 The above analysis suggests that the continuation o f the current policy o f rapid wage growth will inthe future holdmore risks relative to the period 2000-04 because a significantportiono fthe earlier cost advantage has been eroded. G. INVESTMENTAND FINANCIAL PERFORMANCE 2.58 The analysis o f investment performance i s an important factor in assessing the sustainability of recent growth. The level o f fixed capital investments (without stock accumulation) in Belarus, which has recently been in the range o f 22-23 percent o f GDP, does not appear low by regional standards (Figure 2.16). However, the country's investment structure i s quite unbalanced with a relatively low share (about 30 percent) o f total investments going into industry. At the same time, investments are heavily concentrated in the housing and utility sector (30-35 percent o f the total) and in transportation (10-15 percent). The latter are important investment areas,53but investments in these sectors cannot compensate for under-investment in industry, which at the moment i s a critical sector for sustaining Belarusian export 53At the same time, the existing level of government subsidies to housing construction i s excessive and cannot be justified from either a fiscal policy or a social policy perspective. 55 competitiveness. Industry's investment needs in order to renew and modernize its capital stock are quite high-- in2004 the degree ofthe depreciationo ffixed capital inindustrywas estimated at 62.2 percent. Figure2.16: FixedCapitalInvestmentsinSelectedTransitionEconomies, AverageAnnualLevels,as % of GDP 30.0 25.0 20.0 15.0 10.0 5.0 0.0 Sources: World Bank; MSA. 2.59 At the same time, the macroeconomic environment andincentive fkamework inBelarus, despite hgh rates o f economic growth, has not beensupportive of enterprise-level investments. Highinflation andexcessive discretionary government intervention (including through a highly segmented policy o f state support) have created an environment o funpredictability that rendered the development o f any investment strategy too risky. 2.60 Thus, it is not surprisingthat the industrial survey results show a considerable gap between the growth rates in output and investments (Figure 2.17). With the exception o f 1997, prior to 2002 the balance o f answers on investments remained negative. Such a gap appears to be rather unusual. For comparison, Figure 2.17 also presents similar results for Russia, where the industrial growth that started in 1999 was from the very beginning accompanied by a growth in enterprises' investments. A significant intensification o f the investment process in Belarus was observed only in 2003, when the traditional cost advantages o f exporters began to evaporate and the competitive pressures became more serious. This ultimately created incentives for modernization and investment. Figure2.17: ChangesinOutputandInvestmentsinIndustryinBelarusandRussia (Balance of Answers) Belarus Russia I ....... d+ I A , / I , I , 45 1I d 5 1996$9.7 1968 199920002001 2002 20 u : '?, ; - .............. .2 ...r...t.......... ...: ...................... 15 .3 ........................................ 0 Source: Gotovskyand Zheltkov (2004). 56 2.61 However, these survey results on the low enterprise investment activity before 2003 are inconsistent with the official investment reports, which show a significant increase in industrial investments in both 2000 and 2002 (Figure 2.18). H o w can these two sets o f data be reconciled? Inour view, the answer relates to a high concentration o f investments in industry: 30 percent o f the total investments in the sector in 2000 were made in the power, fuel, and metallurgy sub-sectors, which together account for less than 3 percent of the total number o f industrial firms in Belarus. In 2002 the investment share o f these sectors increased to 40 percent. The majority o f the investment growth prior to 2003 occurredinthese sub-sectors and didnot affect the mainpart o f industry. Figure2.18: Investment GrowthinIndustry,2000-03 (% of previousyear) 140.0 130.0 -+ Total industry 120.0 110.0 -+-.Power,fuel,metal 100.0 +Therestof 90.0 I 80.0 2000 2001 2002 2003 Source: World Bank staff estimates based on MSA data. 2.62 It is worth noting that the bulk o f industrial firms (about 97 percent o f their total number, which employ about 93 percent o f industrial labor) has been responsible for a modest amount o f investments - on average less than 4 percent o f GDP in 1999-2003. This share in fact declined between 2000 and 2002. This observation appears to be consistent with the prevailing negative perceptions o f managers about trends in their investment activity. A typical Belarusian enterprise, outside o f the energy and metallurgy sectors, was likely to be affected by considerable under-investments and didnot experience any noticeable improvements in investment levels before 2003. It i s worth mentioning that the investment level in industryhas been low despite the massive state credit and fiscal support aimed at enhancing investment performance. 2.63 Table 2.11 provides additional evidence o f the intensification and broadening o f investment activity in industryin 2003, especially in food, light.industry,chemicals and timber. It also suggests that in all o f the CIS-oriented export sectors except timber the 2003 relative level of investments in Belarusian industryexceeded that inRussia. 2.64 However, the recent increase in industrial investment cannot be interpreted as indicating that the investment level reached levels sufficient to retain a competitive edge, including in the Russian market, Russia may not be a good benchmark, as it i s considered an economy with a depressed level o f investments (Ahrend 2004b). The CEE countries that were the main beneficiaries o f FDIinflows, such as Estonia and the Czech and Slovak Republics, demonstrate investment levels that are at least 20 percent above those inBelarus. Because o f the differences inthe investment structures, this translates into an even higher gap inthe level o f industrialinvestments. 57 2.65 As mentioned in Chapter 1, the depressed level of FDI represents a serious disadvantage for Belarus. It not only reduces the overall level o f investments in the country at each particular moment o f time, but, more important, deprives the economy o f major dynamic benefits. FDI usually pushes up productivity in the host country by providing access to modem technology, management, and training. This access is particularly important for transition economies, where additional efforts are neededto bring the quality o f production up to international standards. The recent paper by Sabirianova, Svejnar and Terrel (2005) has shown that a large portion o f all productivity gains in Czech industrywas coming from foreign-owned firms. The CzechRepublic had opened up markets extensively to FDIearly intransition. Table 2.11: InvestmentIOutput RatioinIndustry,1999-2003(YO) I I Memo: Russia, 1999 2000 2001 2002 2003 II 2003 Industry 4.7 5.2 5.2 5.7 7.1 8.9 Power industry 7 7.4 7.9 9.7 11.9 10.5 Fuelindustry 6.9 4.4 6.2 8.9 9.9 25.8 Ferrous metallurgy 9.1 11.4 15.5 9.3 4.9 4.9 Non-ferrous metallurgy 9.4 4.5 5 3.4 4.5 9.9 Chemical and petrochemical industry 6.9 1.7 5.7 6.1 8.4 6.9 Machinery and metalworking 4.1 6.5 4.4 4.6 4.4 4.0 Timber, woodworking, pulp and paper 3.9 3.5 4.6 4.1 5.9 7.9 Construction materials 4.2 6.4 6.3 8.2 8.7 5.1 Light Industry 1.7 2.4 2.1 1.6 3 2.8 Food industry 3.3 2.9 3.6 4.3 7.3 6.4 Sources: World Bank staff calculations based on MSA data, Rosstat. 2.66 The weak investment performance inindustry, inour view, reflects a core wealmess o f the Belarusian economic model. It i s partially driven by the weak financial situation in the sector. At a more fundamental level, there seem to be a major incentive bottleneck for the strengthening o f real sector investments in an environment o f prevailing state ownership in large industry (which i s known worldwide for its propensity to under-invest) and hgh costs o f entry for the new private sector. The prevailing incentive framework for management i s excessively focused on attaining short-term growth targets and addressing the social priorities o fthe government. This leaves too little financial room for investments andlonger-term restructuring efforts. 2.67 Investment financing inBelarusian industry i s clearly weak. Because profit margins are low, own enterprise funding i s limited. At the same time, commercial credit i s generally less accessible and more expensive than in neighboring countries (see Chapter 1). Moreover, government interference in credit allocation puts those firms that are unable to participate for any reason in the directed credit programs in an especially difficult situation. Most o f the investment financing (95 percent on average during 2001-04) has come from domestic sources. Given the realities o f the macroeconomic framework, it would be difficult to raise the current investment level in Belarus without an expansion in foreign financing. Attracting FDIi s crucial not only for the usual technological and market diversification reasons, but also for the current financing needs. 2.68 The analysis o f cross-sectoral (within the industry) variations in performance suggests that government interventions create significant barriers to the efficient allocation o f finances and investments. Inparticular, the analysis reveals the following correlations between individual performanceindicators at the level o f the industrial sub-sectors: 0 There i s a positive correlationbetween real investment growth and output growth 0 However, the correlation between investmentgrowth and profitability i s negative, indicating that less profitable sectors were able to finance more investments 58 0 Moreover, the correlationbetween credit and output growth was negative as well, suggesting that credit allocation was biasedtoward the less financially successful sectors. 2.69 Combining the above findings with the analysis in the previous sections suggest that capital markets inBelarus remain much more over-regulated and distorted than the labor market. 2.70 Figure 2.19 illustrates an important structural imbalance in the Belarusian growth model, which reflects a reversed and generally unsustainable relationship among main performance indicators at the micro level. As follows from the 2004 industrial enterprise survey, recent growth in investments has been more widespread than growth in profits, confirming the gap between financial and investment performance. At the same time, productivity growth has by far outpaced growth ininvestments, but inturn it has been less common than growth in wages. It is clear that the economy cannot sustain this growth structure for an extended period, because in the long term wage growth should be backed by adequate productivity improvements, which have to be based on sufficient growth in investments and profits (to finance these investments). Figure2.19: Managers' Answers about Recent Changesinthe Performanceof Their Enterprises (balance between those who reported an increase and a decline) I 80 70 60 50 40 30 20 10 0 Average wage Labor Fixedcapital Gross pro& productivay investments I Source: IPM(2004). 2.71 Major adjustments in the growth structure at the micro level will be necessary to change the current growth proportions. An important pre-condition for such a change i s reduced government interference increditlcapital allocation. 2.72 L o w profitability represents an important source o f vulnerability for Belarusian industry. L o w profitability i s a basic indicator o f a low rate o f return on investments, which, other factors being equal, drives down the investment attractiveness o f the country. Table 2.12 presents two measures o fprofitability inthe sector: the measure used inthe standard MSA reports (based on the profitlcosts ratio) and another measure that corresponds to an established international tradition (based on the profidsales ratio). The table points to several conclusions, such as the following: 0 Profitability levels are in general low. Moreover, average profitability declined considerably in 1999-2002 despite a robust growth during the same period. This i s not entirely unexpected given that the prevailing incentive framework for large enterprises makes them more interested in attaining output targets and less concerned about profit maximizing 0 If accordingtotheinternationalmethodology,profitabilityisevenlowerthanwhatis measured presented inthe official reports. However, this alternative measure shows a less volatile dynamics o f the profit margin 0 There are two different groups o f industrial sub-sectors with fairly different levels o f profitability. The first group i s quite healthy financially and has profit margins above 15 percent. These are capital intensive, more resource-dependent sectors with primary markets outside the CIS. The 59 second group includes sub-sectors that experience financial difficulties and have their margins below 10 percent. These are labor-intensive sectors, which face major competitive pressures in both domestic and CIS markets 0 Profitability in industry has recently increased somewhat. While this increase i s broad-based to date, it has beenrather limited inthe second group of sub-sectors. Table 2.12: Profitability and Gross ProfitMargin, 1999-2004 (%) Profitabilitya/ Gross Profit Margin b/ Chan ge Change 1999- 1999- 1999 2000 2001 2002 2003 2004 2004 1999 2000 2001 2002 2003 2004 2004 Industry 17.1 15.8 10.9 10.5 12 15.3 -1.8 13 10.7 7.8 7.6 8.6 10.9 -2.1 Power industry 3.9 2.2 6 3 8.8 12.6 8.7 6.8 4.3 14.8 7.7 6.8 9.5 2.7 Fuel industry 46.3 64 33.8 34.5 29.7 30.8 -15.5 26.7 32.8 21.3 21.8 19.4 20.1 -6.6 Ferrous metallurgy 13.5 22.5 5.6 17.8 24 36.1 22.6 11.1 16.2 4.6 13.3 16.8 23.5 12.4 Non-ferrous metallurgy 41.5 24 17.3 18.2 28.9 24.1 -17.4 26.2 15.7 11.8 12.9 18 16.4 -9.9 Chemical and petrochemical industry 24.9 22.8 11.8 11 14.8 24.2 -0.7 18.7 15.8 8.9 8.5 11.1 17.2 -1.5 Machinery and metalworking 14.4 12.2 11.5 9.6 9.5 11.4 -3 9.6 8.4 7.9 6.8 6.8 8.3 -1.3 Timber, woodworking, pulpand paper 17.7 11.4 8.7 10.5 11 11.3 -6.4 13.3 8.1 6.4 7.6 7.9 8.3 -5 Construction materials 8.1 5.2 4.6 7.3 9.7 10.8 2.7 18.7 15.8 8.9 8.5 6.9 7.8 -10.9 Light Industry 22.6 14.3 6.1 4.6 4.3 5.4 -17.2 16.3 10 4.6 3.5 3.4 4.2 -12.1 Foodindustry 13.4 9.2 8.1 5.5 6 6.3 -7.1 9.6 6.2 5.5 3.8 4.2 4.5 -5.1 Other 10.7 12.2 6.3, 5.6 6.5 .. 7.8 -2.9 8.8 8.7 4.8 4.2 5 ,5.9 -2.9 aiGross prof to costs ratio, b'Gross profitto sales ratio. Source: Volchok (2005). 2.73 L o w average profitability reflects the fact that a significant portion o f industry i s loss-making. Figure 2.20 presents a trend inthe share o f loss-making enterprises in several sub-sectors. For the industry as a whole, the share was highest in2001 at a level o f 31.4 percent. Some noticeable improvements have occurred since then, yet the share o f loss-makers in 2003 (23.5 percent) was significantly higher than in 1999 (8.8 percent). Moreover, these statistics underestimate the incidence of losses, because they define a loss-maker on the basis of the value of profit before tax, while the common international practice for this purpose i s to use the "profit after taxes" criterion. The latter naturally would show a higher share o f loss- makers. The authorities switchedto the international definition in2004. 60 Figure 2.20: Shareof Loss-makingEnterprises,1999-2004 (YO) +Machinery & -m- Light Industry -o- Foodindustry Source: MSA. 2.74 In addition to growing external competition, another driver of declining profitability relates to excessive wage growth. The share of total labor costs (wages and payroll taxes) in total production costs increased by more than 50 percent in 1997-2002. This i s another reflection of the fact that wage growth by far outpaced productivity improvements. Figure2.21 shows a clear negative correlation between changes inprofitability and labor costs. 2.75 The analysis of other financial indicators confirms the above trends. The dynamics inliquidity and asset turnover ratios, as well as trends inenterprise areas, support the notion that the financial performance of industryimproved in 2003-04. But this improvement was insufficiently significant to bringabout a real change inthe current riskprofile of the sector. Figure 2.21: Profitability andLabor Costs inIndustry, 1997-2003 --t.profitmargin,% -+- labor costs intotal l o ? 1997 1998 '1999 2000 '2001 2002 2003 ' 1 Source: World Bank staff estimates basedon MSA data. 2.76 Overall, industry remains in a much more vulnerable financial situation than in 1999-2000. Moreover, the financial situation in two sub-sectors (light industry and food processing) i s of special concern. These are the sub-sectors in which about a quarter of total industrial labor is employed and are the sub-sectors most exposed to competition, including competition from domestic new entry. As seen 61 from the aggregated data, these industries are likely to accumulate a significant portion o f non-competitive enterprises, which may need much more radical restructuring (including the use o f bankruptcy mechanisms) than has been undertaken to date. At the same time, as indicated above, food processing i s affected by heavy tax pressure that i s inconsistent with the sector's financial weakness. H. COMPARATIVE ADVANTAGESOFBELARUSIANINDUSTRY: THERESULTSOFTHECOMPETITIVENESSSURVEY 2.77 The survey o f industrial competitiveness was undertaken by the Research Institute o f the Belarusian Ministry o f Economy (RIME) inthe second half o f 2004 as part o f the CEM preparation. The main objective o f the survey was to study the perceptions o f enterprise managers regarding: (i)the competitive advantages o f their products in different markets; (ii)the factors that drive the competitiveness o f Belarusian enterprises; and (iii) cross-sectoral differences incompetitiveness. 2.78 In all, 231 enterprises from eight main industrial sub-sectors located in all regions of Belarus participated in the mail-in survey. Out o f the country's top 100 enterprises, 25 were included in the sample. A more detailed description o f the survey methodology and results are presented in Gotovsky et al. (2005). 2.79 The survey results confirm the fact that Russia has been a dominating export market inBelarus: for about 50 percent o f firms inthe sample, a significant portion o f their total sales goes to Russia. Russia i s by far the most important external market. The second most important market i s Western Europe, where about 9 percent o f respondents direct a significant part o f their sales. As discussed in Chapter 4, while the overall volumes o f exports to Russia and to non-CIS countries are comparable, the number o f exporters to Russia i s much more numerous than the exporters to non-CIS markets. Non-CIS export is heavily concentrated in a limitednumber o f large companies, while a relatively large portion o f the export to Russia has been generated by small andmediumsize firms that remainincapable o fpenetrating other export markets. 2.80 Belarusian firms have recently been fairly successful in the Russian market. In 2003-04 Russia was the fastest growing market for Belarusian industry (for all sectors except light industry and chemicals). Figure 2.22 presents comparative estimates o f sale dynamics in different markets. These results may underestimate the scale o f the recent export expansion in Russia, because smaller enterprises were under-represented inthe sample, while, according to the survey a major growth inexports to Russia took place in those sub-sectors with smaller average firms (such as the construction materials and food industries). Combining these results with our earlier analysis o f unit labor costs once again points to the vulnerability o f recent high export growth rates: export growth rates to Russia were highest in the sub- sectors that exhibited the largest loss incompetitiveness relative to Russian producers. Figure 2.22: Changes in Sales inDifferent Markets (balance of answers as YOof total number of respondents) ..................... -10J Belarus Russia Ukraine & Eastern Western China, the rest of CIS Europe Europe Middle and Baltic and East, Asia, States dewloped Africa countries Source: Gotovsky, KhamchukovandKovalevskaya(2005). 62 2.81 Overall, most respondents believe that their products are competitive domestically and to some extent in Russia. However, with respect to other markets, the balance o f responses i s either close to zero (which points to an absence of competitive advantage) or negative. Table 2.13 summarizes managers' perceptions regarding the competitive advantages o f their products. The most interesting findings are the following: 0 The respondents believe that their main competitive advantages relate to quality and low costs. However, their quality i s lower relative to the products o f their European competitors, while the costs are higher relative to producers from the developing world. Only about one-third o f respondents have obtained the certification o fthe I S 0 9000 series 0 Belarusian firms consider their weak marketing capacity to be a strong comparative disadvantage inall markets 0 The respondents also believe that their firms have insufficient access to state procurement. It i s worth noting that they do not feel that intergovernmental agreements with Russia provide them with any competitive advantage inRussia's market. 2.82 Among the main determinants o f their competitiveness, the respondents emphasized the role o f cost factors, primarily those associated with low wages and low profit margins inBelarusian industry.The availability o f high-skilled labor inBelarus i s seen as significant only inrelation to the markets o f the CIS and developing countries. Technological advantages are important only in the CIS markets outside o f Russia. Inaddition, as could be expected, the respondents pointed to three factors that seriously undermine their competitiveness in all markets, namely: (i) the higher costs o f inputs and energy; (ii) highcost o f the borrowing; and (iii) the higher tax burden. Table 2.13: CompetitiveAdvantagesinIndustry by Markets (balance of answers as YOof total number of respondentswho marked the specific market) Belarus Russia Ukraine Eastem Westem China, and other Europe and Europe and Middle CIS Baltic States developed East, Asia, countries Africa 1. Low price level in comparison with competitors 34.1 7.1 17.5 12.2 17.9 -38.1 2. More high quality, nicely designed,product ergonomics 38.0 39.4 33.0 -5.6 -15.4 11.9 3. Wider variety ofproducts or/ or else a constantly renewable assortment 14.9 7.1 10.3 -18.9 -21.8 -38.1 4. Relativelylow expenditures duringproduct operation 18.8 22.4 26.8 8.9 -5.1 9.5 5. More developed sales and servicenetwork -11.1 -32.4 -24.7 -42.2 -48.7 -40.5 6. More active advertising, participation in exhibitions, fairs, web site 1.o -11.8 -11.3 -34.4 -38.5 -40.5 7. Use of more convenient payments scheme for consumers 26.0 2.9 -6.2 -21.1 -17.9 -28.6 8. Participation in supply programs inthe context of inter-states agreements -26.9 -42.4 -43.3 -51.1 -50.0 -47.6 9. Other competitive advantages of the product -3.8 -4.7 1.o -6.7 -5.1 -4.8 Source: Gotovsky, KhamchukovandKovalevskaya(2005). 2.83 The primary existing competitive advantages o f Belarusian industry in Russia and (to a lesser extent) elsewhere inthe CIS relate to cost factors as well as higher labor and management skills. However, it should be noted that the existing cosdprice advantage appears to erode rather quickly. The comparison o f the responses from similar 2004 and 2002 surveys suggests a drastic decline in the perceived importance o f this advantage relative to competitors from the CIS and Russia (Table 2.14). At the same time, the role o f quality-based advantages has increased somewhat. For the non-CIS markets, the relative 63 importance o f competitive advantages has been evolving in the opposite direction: the role o f quality- based advantages declining, while cost-based factors are becomingmore prominent. Table 2.14: Dynamicsof CompetitiveAdvantage inIndustry,2002 and 2004 (as YOof total number of respondentswho marked the specific market) Quality Price Belarus 2002 55.2 44.2 2004 57.7 55.8 Russia and the CIS 2002 48.0 70.0 2004' 56.4 40.1 Outside of the CIS 2002 62.9 37.1 2004' 31.4 41.9 'Answers are consolidated for two markets: Russia andUkrainehest o f CIS. 'Answers are consolidated for four markets: EasternEurope, Western Europe/other developed economies, and developing countries. Source: Gotovsky, Khamchukov and Kovalevskaya (2005). 2.84 The survey returns do not provide evidence that Belarusian exporters have been losing their market shares in Russia (except for light industry - textiles, garments, footwear). However, the survey data are somewhat worrisome concerning the current level o f competitiveness in Russia, especially inthe food processing and machinery sub-sectors - two sectors with highemployment. This may be interpreted as a problem for further export expansion in Russia. Export growth has been strong recently, but sustaining this rate o f export expansion could be difficult for exporters within the prevailing set o f business conditions. 2.85 Among various factors that hinder improvements in their competitiveness, respondents emphasized the high costs o f market penetration (for all markets except the domestic market) and difficulties in finding local partnershntennediaries. This again highlights the weak existing marketing capabilities in the sector (Table 2.15). Relative to the EU, the Russian market remains much more accessible for Belarusian firms because o f the differences in both standard requirements and the severity o f import restrictions. However, import restrictions in Ukraine and the rest o f the CIS (non-Russian) appear to be as bindingas inthe new EUmember countries. 2.86 The analysis at the sub-sectoral level points to two groups o f industrial sub-sectors that at the moment have a stronger competitive position and thus have more stable medium-term prospects: Sub-sectors that are involved in the processing o f primary commodities (oil and wood processing), which remain cost-competitive with a fully acceptable quality product Sub-sectors that are capable o f sustaining quality-based competition in their main markets (non- ferrous metallurgy, leading firms in machinery and construction materials), which i s partially based on recent improvements intheir marketing capabilities. 64 Table2.15: Factors that Hinder Growth in Competitiveness (as YOof total number of respondents who marked the specific factor-market pair) Belarus Russia Ukraine Eastern Western China, and Europe Europe Middle other and Baltic and East, CIS States developed Asia, countries Africa 1. Trade restrictions (tariffs, quotas, etc.) - 10.8 17.7 19.0 22.1 10.4 2. Strict technical requirements 5.6 4.8 4.8 17.3 24.7 7.4 (standards, sanitary requirements, etc.) 3. Difficulties in locating local 18.2 27.3 16.9 21.2 21.2 15.6 intermediaries and other partners 4. Technical inability to make products that are competitive inthis 13.0 14.3 5.6 18.2 26.0 9.5 market 5. Unacceptable payment terms 13.4 16.0 9.5 7.4 6.1 4.3 6. Highcompetition, highcosts of 11.3 29.9 17.7 29.4 34.6 21.6 market entry 7. Other 3.9 3 2.6 1.3 1.3 2.6 I Source: Gotovsky, Khamchukov and Kovalevskaya (2005). 2.87 The position o f other sectors (food processing, textiles and garments, chemicals) appears to be rather weak. Their dominating strategy continues to rely on l o w costs, while they have a very strong need to strengthentheir management and marketing capacities. The recent significant growth in food processing could be explained by the rapid growth in household incomes in both Belarus and Russia, which led to a substantial expansion o f its main markets. However, the sub-sector may find it difficult to preserve its market share inthe mediumterm. 2.88 The survey respondents estimated that on average about half o f their industrial capacity i s fully competitive. This share varies fi-om 40 percent in food processing to 87 percent in metallurgy. Given the current level o f capacity utilization (about two-thirds), this suggests that Belamsian industry has considerable reserves for further growth even without major investments in capacity expansion. Based on the survey data, such additional growth in industrial output could be estimated at 25 percent relative to its level as o f the middle o f 2004. But if the economy i s growing at a rate o f 8 percent, this capacity reserve would be fully exhausted inabout three years. I. MAIN R I S K S OF THE PREVAILING GROWTH STRATEGY 2.89 The following matrix summarizes the analysis in this chapter and Chapter 3 and 4 by identifying the main vulnerabilities o f the existing industrial growth strategy inBelarus. 65 Growth factors Risks Indicators I.Domesticfactors 1.Preservation of - Domestic savings are insufficient for - Depreciation of fixed capital i s inherited industrial modernization o fthe existing industrialbase high, including inexport-oriented base and - Profits are low, which limits opportunities for infrastructure investment and modernization -sectors Investment-savings gap i s - Poor investment image o f the country limits new considerable and widening entry, including foreign, which deprives the - Low level o f FDI economy o f many benefits related to innovation - Declining share o f capital and high- and flexibility skilled labor intensive goods in exports - Low profitability 2. Advancing - Low international reserves inthe context o f no - Low forex reserves macroeconomic access to international capital markets could cause - Highconcentration o f exports and stabilization balance o f payments problems taxes - Highconcentration o fboth taxes and export - Projecteddeficit o f the Social proceeds - the economy i s too dependent on the Protection Fund operations o f a limitednumber o f exporters, which inturnmakestheir marketsheavily concentrated -- Limitednew entry makes the economy inflexible. The viability o fhebanking sector is undermined bythe high incidence ofdirect lending - The pension systemi s incapable o f supporting the current level o f benefits inthe hture 3. Fiscal, wage and - Excessive labor cost growthundermines L C growth is high employment policies competitiveness -- UShare o f labor costs intotal aimed at growth in - An income policy aimed at artificially low production costs i s growing domestic demand income differentiation may facilitate the emigration - The trends in the pension system o f entrepreneurial and educated youth are unsustainable - Strong interest inemigration 4. Subsidies to - The current level of subsidizationisjust too high. -amonglevel of subsidies as percent youth; brain drain High leading domestic Itcreatestoo many risks for bothfiscal and -oHighshare of large industrial f GDP exporters banking systems - Too many recipients o f state support, which enterprises that receive state support undermines incentives for restructuring and -innovationwill -- Hightax burden Increasingpressure on the banking Belarus have to reduce its level o f system subsidizationas part o f its own WTO accession process. The latter could not be postponedfor too long becauseo f associated costs related to potential -economicmay isolation Russia be reluctant to support the existing asymmetry intrade regimes 5. Restriction on - Intensiveuse o f non-tariff instruments to - Share o f consumer imports inboth imports, especially of discourage consumer import, some o f which private consumption and total consumer goods violate the Customs Union agreement imports i s low - The different tax treatment for domestic and imported goods is not compatible with WTO rules - Non-reforming the trade regime poses a risko f deepening the country's international isolation 66 11.Russia-related factors 6. Cost and other - Costs are driven upby the wage policy, higher - Unit labor costs inBelarusian market advantages in taxes than inRussia, more expensive credit, and industry have been growing faster the Russian market the highcosts o f doing business than inRussia - The Russianeconomy is too oil-dependent and - Increased competitive pressures in thus is fundamentally riskyas aprimary export Russian market, including from market Russian producers - The economy shows difficulty inaccelerating - The values o f trade diversification export diversification- it would be a problemto indices are l o w re-direct exports to other markets if necessary - Indicators o f costs o f doing business show that Belarusian business faces considerable disadvantages 7. Preferential access - Russia's WTO accession would makeits trade - Belarusian share o fthe Russian to the Russianmarket regime and policies muchmore transparent and market for its key export products i s level - Failure declining to finalize the currency union with Russia - Ukraine is catching up inits and other integration initiatives machinery exports to Russia 8. Russian energy -- Russian Excessive energy dependency on Russia -- Reductionin Growth inimport prices o f gas subsidies and other domestic and export prices for gas and Russian energy transfers power are expected to grow subsidies - Discussion o f gas prices creates political tensions that might affect further economic integration 111.Other external factors 9. Benefits from the - Oil and other commodity prices will not remain - Terms-of-Trade index has been favorable external highforever favorable for Belarus and especially environment - The external market position o fBelarus is rather for Russia fragile - it depends too much on a limited number - Share o f largest exporters and main o f large exporters, which inturn depend too much export goods i s too high -onIfthe Belarusian economy fails to restructure, it a single market - Export diversificationis too low will lose its market share if; and elsewhere Russia 67 CHAPTER 3 ENTERPRISE RESTRUCTURINGININDUSTRY: DOTHEYDO IT DIFFERENTLY INBELARUSs4 3.1 This chapter summarizes the findings o f a new survey o f Belarusian enterprises, focused on industrial performance and restructuring (see Box 3.1 on this survey's methodology). It builds on work undertaken by the Institute o f Privatization and Management (IPM)between 2000 and 2004, including the earlier surveys. However, this analysis contains much more detailed information about performance and restructuring, and for the first time for Belarus covers simultaneously new private firms (de novo firms, for DNs), as well as state-owned firms (SOEs) and privatized former state-owned firms (FSOEs). Box 3.1: Methodology of the Survey The analysis is based on the enterprise survey conducted in2004, but it builds on two previous enterprise surveys by the IPMundertaken in2000 and 2003 and both covering 222 firms, 119 o f them SOEs and 103 FSOEs. The current survey is somewhat larger. It covers 402 industrial enterprises out o f an estimated total o f about 2,300 industrial enterprises in Belarus. Interms o f ownership structure, 23.1 percent o f the sample were SOEs, 48 percent FSOEs and 28.9 percent DNs. SOEs are enterprises whose legal status i s defined as a "unitary state-owned enterprise," while FSOEs are enterprises whose legal status i s other than that o f a unitary state-owned enterprise and which indicated that they had been established inthe process o f privatization. This category includes enterprises bought from the government andjoint stock companies inwhich the government still owns a stake, including a majority stake. Inour analysis we also attempt to distinguishbetween state and privately controlled enterprises inthis FSOE category. All other enterprises were includedinthe new private enterprise category. highly skewed -- 42.6 percent o f firms employ fewer than 100 people, produce 2.7 percent of industrial The sample i s not simply random because the firm size distribution in the Belarusian industrial sector i s output and provide only 1.2 percent o f industrial employment. Hence, the use of a random sample would lead to excessive concentration on small firms and would risk missing the large SOEs and FSOEs ir metallurgy, machine building, fuel, chemicals and petrochemicals. Thus, the methodology employed was structured random sampling to ensure adequate representation o f the largest firms o f particular interest This leads to some sectoral biases relative to the population o f firms. Some 17 percent o f firms in the sample are in the energy, fuel and chemical/petrochemical industry as against only 6.5 percent in the population. However, these three sectors produce 42 percent o f industrial output. Construction material: are also overrepresented - 12 percent in the sample compared with 5.8 percent in the population. Thi: overrepresentation necessarily leads to under-representation o f the remaining industries.Thus, 26 percen o f firms in the sample are in machinery and metalworking, as against 29 percent of the population; 11 percent are in forestry, wood, paper and pulp as against 15.5 percent; 18 percent are in light industry, a: against 21.2 percent; and 16percent are infood, as against 22.1 percent. ~~ 54 The material in this chapter has benefited from the background report o f the team led by Igor Pelipas and Sergei Pukovich from the Institute o f Privatization and Management (IPM). The team also administered the enterprise survey that constitutes the basis for the analysis inthe chapter. 68 3.2 A primary objective o f this chapter is to analyze changes inthe performance o f Belarusian firms in terms of conventional quantitative indicators such as profitability, sales growth, and international competitiveness, as reflected, for example, in factor productivity and export growth. Inaddition, given the issues o f transition, the chapter explores the refocusing o f exports from the former Soviet markets to Western markets and analyzes the extent o f firms' restructuring to fit the new incentives and constraints o f the market economy. Inthis analysis, we have four specific objectives: e To evaluate the extent o f improved performance and restructuring, particularly with reference to other transition economies at comparable stages o f development e To understand the relationship between the changes in quantifiable performance indicators and the variety o frestructuringactivities e To compare enterprise performance in different ownership groups, including, as separate categories, privatized enterprises and newly created firms 0 To explain the findings in terms o f the economic and business environment that could provide some impetus to policy reform. 3.3 As discussed inprevious chapters, inBelarus the government reacted to the economic declines o f the early transition by introducing policies aimed at strengthening its role inthe economy. From 1996, the government has reversed some of the earlier reforms and also slowed down further privatization, liberalization and institutional reforms. Economic policy has been aimed at increasing growth through managing aggregate demand, concentrating public resources in specific sectors and firms, and preserving o f significant government control over enterprises' day-to-day operations. The issue i s whether this policy environment has been conducive to fundamental improvements inenterprise performance. 3.4 Interms ofprivatization, early privatization occurred insome ofthe most efficient enterprises and was motivated by management's desire to escape government interference. By the end o f 1995 this bottom-up privatization had run its course and from that point the process was managed on a case-by-case basis fiom the top. Thus, in our survey's sample, the state share injoint stock companies (JSCs) privatized before 1996 averages 29 percent versus 83 percent in those established from 1996 onwards. 55 Managers instate-owned firms gradually gave up their aspirations to privatize their firms and learned to work inthe new environment, and thus there were almost no privatizations o f sound enterprises after 2000. However, from the late 1990s there was a trend to privatize firms that were performing badly in a commercial or financial sense. 3.5 The chapter consists o f four sections. Section A briefly summarizes the hypotheses to be explored and the approaches to the performance measurement inthe transition context. The following two sections present the survey findings with regard to enterprise performance and restructuring and the results o f testing our hypotheses about the determinants o f different enterprise behavior. The final section brings together the results o f the analysis and providespolicy conclusions. 55 Although the figures refer to the sample from the 2004 survey, they are instructive enough. No similar data (with breakdown for before and after the 1996 privatization) are available for the entire population. For the whole period under consideration (since 1991), according to the Ministry of Economy, as of January 1, 2005, out o f 618 JSCs created on the basis o f SOEs, the government holdings in the amount o f more than 50 percent of shares were registered at 369 companies (60 percent o f the total), out o f which 303 (50 percent o f the total) are JSCs with the residual state holdings exceeding 75 percent. 69 A. HYPOTHESES AND MEASUREMENT OFPERFORMANCE 3.6 The existing research literature can be summarized by two primary hypotheses about enterprise behavior in transition (Annex 3.1 presents more details on the lessons from the literature, Annex 3.2 provides details on the specification o f the hypotheses, and Annex 3.3 gives details on the results o f the survey.). The primary hypotheses are the following: Hypothesis 1:Privatejirms willperform "better" than state-ownedfirms. Hypothesis 2: De Novo (DN)jirms will perform better than either privatized or state-owned jirms. 3.7 Insituations where firms have changed ownership, the above canberephrased as, "that privatized firms will performbetter than state-owned firms." The basic argument i s that relative to state-owned firms private firms have superior corporate governance and better managerial incentives. The period o f time in question i s relevant here -- newly privatized firms may needtime to improve their performance. 3.8 At the same time, there are anumber o freasons for expectingbetter performance from new firms. The selection process that determines the foundation o f new firms will probably ensure that more market focused and entrepreneurial people will lead them from the outset, addressing many managerial problems. Perhaps most important, new firms should not face the problems o f restructuring to the new market scratch, they will not inherit the enormous list o f structural problems - over-manning, underinvestment, environment that is at the heart o f the transition problem for SOEs and FSOEs. Being created from poor quality control, weak marketing and financial control and all the other difficulties - which will beset SOEs and FSOEs. On the other hand, they will probably start fairly small and may find difficulties in achieving growth if they require external funding. The resulting absence o f economies o f scale may (at least initially) offset some o f their organizational advantages. It may also make it hard for them to compete inexport markets. 3.9 To analyze enterprise performance in Belarus, we need to define the variables o f interest and specify the hypotheses for empirical work. We first discuss the conventional measures o f enterprise performance before considering another crucial variable inthe transition context, namely, restructuring. 3.10 For firms in developed market economies there are three broad approaches to measuring performance. The first, it i s efficiency, best proxied by total factor productivity (TFP) or labor productivity (SL). The second i s profitability, measured by profits and usually normalized by some measure o f firm size such as assets (profit to assets ratio) or profit to sales ratio (PS). The third i s a measure o f financial performance such as Tobin's Q (book to asset ratio). It i s hard to use these in the transition context because they require more data than are usually available. For example, TFP can only be measured ifthere are good measures of capital input, a variable that was notoriously poorly measured under planning. Profits are also not good indicators o f performance inperiods o f rapid price change as occurs when prices have recently been liberalized. Moreover, company information about profitability i s often unreliable. The absence o f a capital market precludes the use o f financial measures altogether. Hence, studies o f performance intransition have tended to rely on labor productivity, or have been forced to consider other indicatorso f performance better suited to the questions raisedby the reformprocess. 3.11 Transition involves a move from one equilibrium level o f output and factor intensity to another based on new market prices. This process can be charted quantitatively (e.g., through sales, employment and investment). The three most commonly used measures o f performance in transition economies, in addition to labor productivity, have therefore been sales growth, employment growth (DEMP) and, given the importance of opening up to the global economy in the process, export growth (DEX), especially to western economies (DEX1).Inthe context of transition, with drops inoutput inthe early years o f reform, 70 sales (including exports) and productivity growth have probably been viewed as the principal indicators o f performance. 3.12 Employment growth i s more complicated because one might make different predictions about the impact o f ownership form on this growth. One might expect that faster output or productivity growth in a given sector in DN firms than that in privatized firms would be a consequence o f better management. However, current and former state-owned firms would almost certainly be over-manned. Hence, we would expect employment in such firms to fall, more or less regardless o f what was happening to output and sales. In contrast, DNs are likely to have entered the market below optimal scale, and hence will have a positive correlation between output and employment. 3.13 The transition process also involves a number o f managerial actions in order to change the way in which firms are organized. Earle and Estrin(1996) introduce a number o fbroad categories: 0 Depoliticization and reorientationo f firms away from rent-seeking. Breaking the linksbetween the firm and the state and refocusingthe objectives towards profits. 0 Long-term restructuring. This entails activities o f three types -- unbundling, organizational structure and investment. Since firms under planning were highly vertically integrated, but in ways that make little sense for market incentives, one would expect firm disintegration to be rather common, with numerous spin-offs o f workshops, service activities, logistics, etc. The divestiture o f social assets would also fall into this category. Changes in organizational structure would be needed to reorient a firm to meet the new demands o f the marketplace (for example, creating new divisions to address issues o f marketing, sales, finance, exports etc.) Finally, long-term restructuringmust involve investment infixed assets. 0 Short-term restructuring. As firms become more responsive to market signals, we expect to see changes in factor inputsand outputs reflecting new relative prices. This almost certainly implies reductions in employment and other earlier under-priced inputs (such as space, electricity, energy, and pollution). As a result o f these changes we expect to see increases in labor productivity and energy efficiency. 3.14 Many studies use survey questionnaires to obtain qualitative indicators o f progress in transition in these dimensions, as has been done in the Belarus survey. One then has a large vector o f qualitative variables about "restructuring" which can be used as an alternative measure o f performance o f firms. These qualitative indicators must then be aggregated to a single or a few measures o f the performance. As with employment, one must also be careful about the hypotheses. De novo firms will not require restructuring. This i s because they have been created from scratch to operate ina market environment. 3.15 One must also consider the relationship between restructuring and enterprise performance. In the long run, we would expect the two to be correlated, and we would expect restructuring to "cause" enhanced performance. However, in the short term there may be no positive relationship between restructuring and performance. Restructuring i s measured as a qualitative set o f indicators o f managerial activities across a range o f actions that might lead to improved performance. It i s necessary to be careful in interpretingresults usingthe restructuringmeasures, however, for the following reasons: 0 Managers' perceptions o f what i s needed and what needs to be done may be incorrect. Indeed, the worse the managers are, the more likely it i s for their judgments to be incorrect regarding the appropriate restructuring activities for improving company performance. 0 The amount o f restructuring undertaken i s correlated with both managerial activity and the scale of the problems to be overcome. Hence, one will observe more "restructuring" inworse firms, but this does not necessarily mean that performance inthese firms will be enhanced any more than in other firms. 0 Different firms will require different forms o f restructuring, and so any aggregate across a set o f activities will tend to rank a firm with highly focused narrow restructuring (which i s actually 71 addressing the core strategic problems o f the firm) below firms that are undertahng a small amount o f restructuringacross many areas inan unfocused way. B. ENTERPRISE PERFORMANCEAND RESTRUCTURINGINBELARUS 3.16 Before proceeding to analyze the differences in performance, we will describe the differences in various characteristics o f SOEs, FSOEs and DNs. The section i s intended to indicate the richness and quality o f the data collected in the survey before proceeding to the more formal hypothesis testing in the next section. Peculiaritiesof the IndustrialSector 3.17 The characteristics o f Belarusian firms in our sample are summarized in Table 3.1. We find that Belarusian firms are on average rather large, especially the SOEs, but even the DNs in our sample employ on average more than 140 workers. The numbers are large by the standards o f comparable surveys o f other transition economies at a comparable stage. Thus, Belka et al. (1995) report that SOEs in Poland on average employed 703 workers, FSOEs employed 1,007, ifthey were majority state owned but only 594 if they were privately held, and DNs employed 111.The comparable figures for Russia are close to those for Belarus, however. For example, Linz and Kmeger (1998) report that firms intheir Russian sample varied in size between less than 200 and more than 10,000 workers, although 80 percent of the sample were in the range o f 2,000 to 5,000 workers. Earle, Estrinand Leshchenko (1996), intheir sample o f Russian firms in 1994, also find comparable employment levels (the average employment in SOEs was around 3,000). These numbers alone suggest that only a very limited amount o f restructuring could have occurred in Belarus firms or employment would probably have declined on average rather more, as has occurred in Poland, Hungary and the Czech Republic (see Estrin, Gelb and Singh, 1995), although differences inthe industrial structure may also be relevant. Table 3.1: Characteristicsof the Enterprise Sample SampleAverage SOE FSOE DN Employment (2004) 594 1,237 565 146 % Exporting to: --- Russia Developedeconomies 25.1 Former socialist economies 35.1 70.6 Share of exports inrevenue 25.8 28.7 28.0 19.1 Years of service of general manager 12.1 17.6 12.4 7.4 % Firmswith ajoint venture 5.5 7.5 6.2 2.6 % Firmswhich are members of holdings 1.7 Source: IPM(2004). 3.18 This impression is strengthenedwhen we look at exports. Export shares remain quite low for what one might expect to be a small open economy (on average, less than 30 percent o f revenue for all categories), It i s disappointing, but perhaps not surprising given their size, that DNs export less than 20 percent o f their sales and SOEs have the largest export share (28.7 percent). In addition, there has been little progress in integrating into the world economy: only one-quarter o f firms export to developed Western economies. Exports to Russia and the former communist bloc still predominate. These figures are comparable to those in Earle, Estrin and Leshchenko (1996) for Russia in 1994, before any substantial restructuring hadtaken place. 3.19 There i s also evidence that managerial turnover has been very limited, which suggests that ownership changes have not been much associated with managerial changes. On average, managers have worked with their firms for more than 12 years, more than half o f them in the top post. Unsurprisingly, 72 managerialturnover i s particularly low inSOEs, where the average tenure i s nearly 18 years, but it i s also low inFSOEs, where managers have worked for the firms on average for 12.4 years, the majority of them in the senior position. Even in new firms turnover is fairly slow, with the average tenure exceeding 7 years. 3.20 It is often argued that restructuring, especially the introduction of new technology and the expansion of foreign trade, will be led through FDIandjoint ventures (see, for example, Estrin, Gelb and Singh, 1995). However, there i s little possibility of this inBelarus, where only around 5 percent of firms on average are in a joint venture. The comparable figure for Poland in 1994 was 14 percent (Belka et al. 1995). The proportion is slightly higher for SOEs and FSOEs and i s lower for DNs, perhaps indicating foreign firms' preference for arrangementswith larger enterprises. QuantitativeIndicatorsof Performance 3.21 The survey contains managers' responses to a number of questions about current and expected enterprise performance, some of which can be compared with the results of the 2000 survey. Box 3.2 compares findings from the 2000 and 2004 surveys. Box 3.2: Comparingthe Resultsof the 2000 and 2004 EnterpriseRestructuringSurveys Main trends inthe survey results could be summarized as follows: On average, the attitude o f respondents has become more positive. However, managers o f both SOEs and FSOEs became less positive inthe assessment o fthe current economic situation. The share o f enterprises indicating recent growth in output, production capacity, product diversity, exports and investments has increased. The share o f enterprises indicating a recent decline inemployment has substantially decreased. The assessment o f enterprise prospects didnot change much since 2000 and remains highly positive. The importance o f profits as a source o f financing has decreased for both SOEs and FSOEs. Inaddition, for both these groups the importance o f overdue liabilities as a source o f financing has increased. The importance o f subsidies as a source o f financing has declined drastically. At the same time, for SOEs the importance o f concessions and preferences granted by the govemment has increased. The importance o f bank loans has increased for both SOEs and FSOEs. The importance o f revenues associated with financial restructuring (asset sales and renting out) has increased for SOEs and FSOEs. Source: IPM(2004). 3.22 We find on average a slight improvement in managers' perceptions of the economic situation with 22.6 percent of managers in the sample providing a positive assessment of the situation, as against only 18.5 percent in 2000, while 27.3 percent in 2004, as against 37.9 percent in 2000 had a negative perception. However, only a minority of respondents took a positive view of the past: 45.3 percent saw some improvement over the past three years, slightly more than the 37.5 percent in 2000. And there was optimism for the future: 63.9 o f managers in 2004 expected improvements inthe economic situation over the next three years. However, the 2000 survey also indicated a similar optimism, which as we noted, was notjustified (the comparable figure then was 63.7!). 3.23 Overall, the balance of opinion about the current situation i s negative in SOEs and FSOEs but positive inDNs (Table 3.2). It seems likely that the overall improvement inopinion i s due to the inclusion in the 2004 survey of DN firms. Managers in these enterprises are markedly more positive about the current situation than their counterparts in the current and former SOEs (16.1 and 19.1 percent, respectively). 73 Table 3.2: DifferencesinAttitudes amongEnterpriseGroups, 2000 and2004 (As % ofthe sample) Assessment of the situation Sample average Formof ownership State-owned Former state- New private enterprise owned enterprise sector Assessment of the currentsituation Positive 2004 22.6 16.1 19.1 33.7 2000 18.5 17.6 19.4 Negative 2004 27.3 38.7 30.1 12 2000 37.9 38.7 36.9 Balance 2004 -4.7 -22.6 -11 21.7 2000 -19.4 -21.1 -17.5 Assessmentofthe situationinthe last2-3 years Improvement 2004 45.3 46.2 42 50 2000 37.5 37.3 37.9 Deterioration 2004 31.8 36.6 35.3 22.4 2000 44.4 44.1 44.7 Balance 2004 13.5 9.6 6.7 27.6 2000 -6.9 -6.8 -6.8 Assessmentof the enterpriseprospectsfor the next2-3 years Improvement 2004 63.9 62.3 63.2 66.4 2000 63.7 60.1 67.6 Deterioration 2004 11.7 9.7 14 9.5 2000 11.8 11.8 11.7 Balance 2004 52.2 52.6 49.2 56.9 2000 51.9 48.3 55.9 Source: IPM(2004). 3.24 Managers' assessment o f growth in the main performance indicators during the last two to three years i s ,reported in Table 3.3. Once again the situation i s somewhat mixed and unbalanced. Nearly 60 percent o f enterprises reported growth in sales, while only around 40 percent reported growth inexports and 30 percent inprofitability. Though approximately half o f the firms recorded labor productivity growth, more than three-quarters acknowledged growth inwages and only slightly more than one-third reported growth in investments. However, on the other side o f the balance sheet, we do not find evidence o f growth in tax arrears or customer liabilities. 3.25 There i s considerable variation inperformance by ownership type but for the most part not in the manner expected. We find that the incidence of growth in many performance indicators, according to the managers' responses, i s in fact higher in SOEs and FSOEs than in DNs.Thus, the incidence o f growth in sales, profitability, and investment, and especially exports and labor productivity, i s lower in new firms. This runs counter to our expectations from theory and the evidence ffom other economies where new firms have been more dynamic and faster growing (see, for example, Richter and Schaffer, 1996, on Russia, and Belka et al., 1995, on Poland). However, DNs inBelarus create relatively more jobs and face a better financing situation, with less growth in arrears and liabilities. Moreover, DNs appear to be more 74 profitable than other firms -- 66.4 percent o f firms reported that they made a profit in2003, and the lowest share o f loss-making firms was inDNs (13.8 percent as against 23 percent inthe other types o f enterprise). Table 3.3: PercentageofEnterprisesReportingRecent GrowthinMainPerformanceIndicators (% of the sample) Indicators Sample Formof ownership average SOE FSOE DN Employment 36.8 30.4 33.7 47.3 Sales 59.9 67.4 56.5 59.8 Export 41.3 48.9 46.1 26.8 Profitability 31.7 -34.8 32.1 28.6 Laborproductivity 51.4 63.0 58.5 29.5 Capitalinvestments 36.8 41.3 38.9 29.5 Average wage 76.6 83.7 77.7 68.8 Arrears insettlements with suppliers 24.2 30.4 29.0 10.7 Customers'liabilities 36.0 40.2 37.8 29.5 Arrears insettlementswith the banks 21.7 29.3 23.8 11.6 Source: IPM(2004). Sourcesof financing 2004 2000 Sample Formof ownership Sam Formof average Ple ownership SOE FSOE DN avera SOE FSOE ge 75 3.27 There are important differences in the sources o f investment financing by ownership type. De novo firms rely almost entirely on profits from sales and to a lesser extent on bank loans. However, there i s some evidence that they face discrimination from the banks (banks are rated as important sources o f finance by only 36.2 percent o f DNs as against 67.7 percent o f SOEs). Presumably because they have less to restructure or to sell assets, DNs are less able to finance investment through the sale or renting o f equipment, etc., and they are much less likely to obtain subsidies or exemptions and government preferences. Finally, DNs also appear to be less able to exploit deficiencies in the property rights system by accruing overdue arrears, for example to the budget, to suppliers, etc. Table 3.5: Use of Financial Resources by FirmType, 2004 (YOof total) Description Sample Form of ownership average SOE FSOE DN Investments inmachines and equipment 25.3 23.9 23.1 30.1 Design, development and introductionof new 12.6 10.2 10.3 18.1 products Expenditures on social needs and bonuses 11.7 12.7 11.3 11.8 Replenishment of the working capital 24.3 24.6 24.1 24.2 Repayment of debts 11.1 9.1 14.6 6.9 Other items 14.9 19.6 16.6 8.8 Total 100.0 100.0 100.0 100.0 Source: I P M (2004). 3.28 Former, and especially current, state ownership yields strong advantages in financing investment inBelarus, with superior access to bank lending, the possibility of selling or leasing unused assets, and a much enhanced ability to obtain government subsidies and to exploit soft budget constraints. The survey provides additional evidence on these issues. Overall, 39 percent o f firms still benefit from some form o f government support, down from 49 percent in 2000. These forms o f support are primarily tax concessions (15.9 percent), the writing o f f budget arrears (13.7 percent) and targeted budget financing and subsidies (8.2 percent). However, these benefits are enjoyed by more than half o f the SOEs (51.6 percent) and 44 percent o f the FSOEs, but by only 21.6 percent o f the DNs. For example, writing o f f budget arrears has benefited almost 24 percent o f SOEs but only 2.6 percent o f new firms. This may help to explain some o f the differences inperformance outcomes observed inTable 3.3. 3.29 Despite the less favorable business environment for new firms, the survey provides some evidence that, as expected, DNs are more dynamic than current and former state-owned enterprises. This can be seen in particular from their expenditure structure. Table 3.5 suggests that the most important uses o f funds inboth 2000 and 2004 for the entire sample and for each ownership category were investments and the formation o f working capital. Both shares increased between 2000 and 2004, partly at the expense o f social expenditures. However, DNs are found to use a higher proportion o f their finds on investments and on new product design and development than either SOEs or FSOEs. This i s consistent with the findings, mentioned earlier, that DNs are more profitable and create relatively morejobs. At the same time, all three types o f firms show similar levels of social expenditures, perhaps because these expenditures are largely mandated. 3.30 One of the important means for SOE restructuring i s via the divestiture of social assets ownedfinanced by the socialist enterprises. Estrin, Schaffer, and Singh (1997) undertook a study of this form o f restructuring for Poland and found that while SOEs had restructured only slightly, there was somewhat more restructuring among privatized firms, while de novo firms, given that they did not inherit such structures from the socialist era, had very few social assets. The level o f social provision was found to be quite high in Poland in 1993: for example, 34 percent of firms provided child care, 64 percent provided heath care, 52 percent provided housing or housing subsidies and 29 percent provided a cafeteria. There was considerable variation by ownership type. For example, 48 percent o f privatized firms and 65 76 percent o f SOEs, but only 3 percent o f DNs, provided housing or housing subsidies. Table 3.6 reveals that in Belarus the current levels of social provisions are higher than those inPoland inthe early 199Os, and that there has been almost no restructuring at all o f social assets since the fall o f communism in either state-owned or privatized firms. There are some differences between SOEs and FSOEs inthe structure o f the provision o f social assets: for example, SOEs provide on average more canteens and day care centers. Butthe differences that existed in 1991between these types o f firms remainunchanged in2004. Thus, the only area inwhich there has been any significant reduction in enterprise social assets i s inday care centers and nurseries, but this has declined considerably inboth SOEs and FSOEs. Overall, the provision o f social assets by enterprises remains remarkably similar to that in 1991, and there i s no evidence that privatization has motivated firms to divest social assets more rapidly than under state ownership. Table 3.6: Social Assets Owned by Enterprises (Share o f enterprises having social assets, %) Social infrastructureassets Formof ownership SOE FSOE 1991 At Dresent 1991 At Dresent Canteen, caf6 64.5 63.4 46.1 45.1 Holiday center, recuperation center 22.6 20.4 12.4 11.4 Cultural center, club 26.9 22.6 18.1 17.1 Information and education centers 5.4 3.2 4.7 3.6 Residential houses 47.3 44.1 30.6 32.1 Sport facilities 20.4 21.5 13.5 14.5 Health facilities 43.0 45.2 23.8 23.8 Day care centers, nurseries 47.3 18.3 28.5 11.4 Source: IPM(2004). QualitativeIndicators of Performance andRestructuring 3.3 1 The survey provides information about two broad categories o f restructuring. The first i s property restructuring (PR), which covers management responses about possible changes in financing investment and obtaining incremental funding, includingjoint ventures, issuance o f shares, sale o f assets, and splitting o f enterprises. The second i s strategic restructuring(SR), including cutting employment, introducing new products, improving staff training and discipline, improving product quality and creating new distribution channels. We report the results for the entire sample for each set o f restructuring measures in Annex Tables A3.1 and A3.3, respectively, and for the three ownership types inAnnex Tables A3.2 and A3.4. 3.32 Commencing with Table A3.1, we note that the average levels o f property restructuring are exceptionally low in Belarus. Of the 16 indicators o f restructuring, more than 80 percent o f firms report that they have taken no measures for half of them, and only for two measures (change in organizational structure and sale o f unnecessary assets) do more than half o f the firms report having taken some actions. Some 14 years after the start o f transition, measures have only been completed inmore than 10 percent o f firms in the same 2 o f the 16 actions. For most o f the remaining actions, measures have typically only been completed in2 or 3 percent o f firms. This seems consistent with the evidence on the restructuring o f social assets, noted inTable 3.6, which also indicates little or no change. 3.33 It i s hard to make cross-country comparisons when the indicators are for different restructuring activities, but these measures seem very low by the standards o f Poland as early as 1990 (see Pinto, Belka, and Krajewski, 1993), o f Hungary, Poland and the Czech Republic by 1993 (Estrin, Gelb, and Singh, 1995), and o f Russia in 1994 (Earle, Estrinand Leshchenko, 1996). For example, inRussia, on a scale o f 1 (no activity) to 5 (maximum activity), Russian SOEs in 1994 averaged around 2 in a set o f activities approximating to what i s called in this survey property restructuring and closer to 2.2 in elements o f strategic restructuring. These figures were argued to be low in comparison with Poland even a few years earlier, but they now appear rather highwith reference to the data for Belarus inTables A3.1 and A3.2. 77 3.34 It is also worrying that there appears little distinction inthe raw data among the different ownership types in terms o f property restructuring activities, as can be seen in Table A3.2. This i s in sharp contrast to Russia, where Earle, Estrinand Leshchenko (1996) found that privatized fm were doing more restructuring than SOEs. InBelarus, ifanything, SOEs seemto be slightlymore willing to introduce measuresofproperty restructuring than FSOEs, though the levels are very low everywhere. New f m s also appear to rarely introduceproperty-restructuringmeasures, though the reason maybe that they have lessneedor ability to do so thanthe other fmtypes becausethey donothavethe sameinheritance fromthe socialistera. 3.35 We find more evidence o f strategic restructuring in Table A3.3, with only 2 measures o f the 18 having been commenced by fewer than 50 percent o f firms, and 6 measures having been started by more than 90 percent o f firms. However, even here completion rates remain frustratingly low: in only 3 measures do more than 10 percent o f firms claim to have completed their restructuring. For the remainder, most claim to have started a variety o f strategic restructuring activities, although for a sizable minority the actions remain on the intentions list. Earle, Estrin and Leshchenko (1996) argue that many o f the components o f strategic restructuringinthis definition are easier to implement than property restructuring, which may explain the higher levels o f implementation. However, inBelarus the completion rates for such basic transition tasks as staff training, new distribution channels, and improved product quality remain disappointingly low despite so many years into the reform period. 3.36 If we turn to differences inrestructuringby firm types inTable A3.4, we find a much sharper distinction between DNs and the other enterprise types, and this i s almost certainly because the former do not need to restructure in many strategic areas. Thus, when we consider staff cuts, these have been implemented or completed in around 40 percent o f SOEs and 32 percent o f FSOEs but only 7 percent o f DNs, presumably because their labor forces were nearer to desired level from the beginning. Similarly, regarding the improvement o f the quality o f products, actions have been implemented or completed in 63 percent o f SOEs, 75 percent o f FSOEs but only 51 percent o f DNs. For changes in the remuneration system, the comparable figures are 62 percent, 55 percent and 39 percent. The differences between SOEs and FSOEs are less sharp, but there i s some evidence that, contrary to expectations, inmany areas SOEs are actually restructuring as much or more than privatized firms. Thus, 50 percent o f FSOEs have undertaken no measures to attract new investors as against 40 percent o f SOEs, and 35 percent have not changed their employment structure as against 26 percent o f SOEs. However, it i s necessary to control for other factors through multiple regressionmethods beforethis result can be confirmed. 3.37 Insummary, the descriptive data suggest arather weak enterprise performance inBelarus interms o f both the qualitative and the quantitative indicators o f restructuring. There i s also little evidence in the raw data o f differentiation among SOEs, FSOEs and DNs in terms o f performance and property restructuring. However, FSOEs and SOEs may be having a greater impact on restructuring the Belarus economy (for example, via exports), perhaps because o f their size and sectoral distribution. As expected, DNs appear to require less restructuring, especially strategic restructuring. These results may be due to the unusual business environment in Belarus whereby SOEs and to a lesser extent FSOEs are extensively controlled and supported by direct and indirect government subsidies. c. ENTERPRISE PERFORMANCE,RESTRUCTURINGAND OWNERSHIP: TESTS HYPOTHESES OF 3.38 In this section we use multiple regression methods to investigate whether different ownership forms actually affect enterprise performance and restructuring in the ways predicted when we control for other factors that might influence corporate behavior, including sector, region, size and a variety of other control variables. To recapitulate, if the institutional environment has been developed sufficiently and firms have been privatized in appropriate ways, we expect that privatized firms will perform better than state-owned firms, and that the performance o f de novo enterprises will be even better, except in areas as restructuring where DNs have much less to do. We test these hypotheses using versions o f equations (1) 78 and (2) (see Annex 3.2) with a variety o f indicators o f enterprise performance and restructuring, and a number o f different control variables (outlined indetail inAnnex 3.2 and Annex 3-3). Indicators of EnterprisePerformance 3.39 The indicators o f enterprise performance are broken down into four groups: a Enterprise productivity. Sales per worker (SL), and profitability (ratio o f profits to sales, PS). These are cross-section regressions inlevels, for which we use OLS. a Indicators o f export performance. We use the export to sales ratio (EXP) and the recent changes inexports (DEX) and inexports to the West (DEX1).The latter are limited dependent variables (taking the value of unity if exports increased recently and otherwise zero), so we estimate using probit methods. a Indicators o f change in company performance - changes in productivity (DSL) and employment (DEMP).The former is a limited dependent variable (taking the value o funityif sales per worker increased), so the estimation method i s probit, but OLS i s used for the employment change equation. a Indicators o f restructuring activity -- PRbeing the unweighted mean o f the property restructuring variables and SR the unweighted mean o f the strategic restructuring variables. These are estimated using probit. In some specifications PR and SR are also included as independent variables to explore the relationship between enterprise performance and restructuringactivity. FirmType Variables 3.40 Our hypotheses are focused on the sign and significance o f the firm type dummies -- DNs and FSOEs relative to SOEs. W e allow the latter to be subdivided further; hence the category of all former state-owned firms, including those with majority state ownership, are henceforth denoted PF, while privatized firms with majority private ownership are denoted PF1. SOEs are the omitted category in the regressions. ControlVariables 3.41 We control for size o f firms using employment (EMP) and for sector using industry dummy variables. Industry 1 i s machinery and metalworking; 2 i s timber, woodworking, pulp and paper; 3 i s construction materials; 4 i s light industry; and 5 i s the food sector. The omitted industry category i s "other." We control for region with a dummy variable GEO for firms locate inMinsk; all other regions are the omitted category. 3.42 Because enterprise performance may be enhanced by close collaboration with a foreign partner, we construct a dummy variable, JV, which takes the value unity ifthe firm i s a joint venture or has set up ajoint venture. W e control for managerial turnover with a dummy variable, LOS, which takes the value o f unity if the manager started working at the enterprise prior to 1996. We expect performance to be enhanced in firms with managers who have served for a shorter number o f years. 3.43 There i s a huge amount o f literature on the impact o f insider ownership (see Earle and Estrin, 1996; Djankov and Murrell, 2002). In general, it i s argued that relatively low levels o f managerial ownership can provide an alignment o f incentives between managers and owners and can enhance corporate performance. However, large insider stakes can act to slow bothrestructuring and improvements inperformance. We haveno evidence about the extent ofmanagerial ownership inBelarusianfirms, butif it were relatively low we would expect the impact o f managerial ownership to be benign. We use a dummy variable, MAN,which takes the value o funityifmanagers are owners o fthe firm. 3.44 If the institutional environment has been fundamentally reformed, we would expect soft budget constraints to undermine enterprise performance, directing management energies from satisfying 79 consumer demands to rent seeking. However, in a partially reformed environment, where resources are scarce and capital markets underdeveloped, soft budget constraints represent access to financial resources and hence may enhance the performance o f firms that receive them. We employ two dummy variables in our regressions: (i) which equals unity if the firm reports that any government subsidies are an SBC, important source o f enterprise funding, and (ii) SBCI, which equals unity if the state has granted the firm any type o f either budget or quasi-fiscal support. 3.45 Product market competition can to some extent offset soft budget constraints and force enterprises to improve their competitiveness. We control for this using the dummy variable COMP, which takes the value o f unity if managers perceive domestic or foreign competitors as being a considerable or major influence on their choices. Specification of Equations 3.46 There is an interesting and intuitively appealing relationship structure between the alternative measures o f enterprise performance. Thus we find that productivity and profitability are positively correlated, and that firms with higher labor productivity are more likely to have increased their exports to the West. It i s not clear whether this i s because these firms are more productive, or because they are larger. Productivity growth i s strongly correlated with a number o f other measures o f good performance, including high export shares and growth, including to the West, and restructuring (both PR and SR). Growth in exports to the West i s a particularly useful indicator o f Performance being the only measure correlated with almost all the others - SL, DSL, EXP, DEX and the restructuring variables. However, it i s not correlated with profitability or employment growth. Indeed, employment growth i s not correlated with any other performance measures, apart from the expected negative correlations with the two restructuring variables. Profitability i s a particularly poor indicator o f performance in Belarus, being associated with neither productivity nor employment growth, nor any export indicator or type o frestructuring. 3.47 We use a variety o f specifications inour regression analysis because o f collinearity between some of the exogenous variables. Inparticular, we findthat SOEs are significantly larger, and DNs significantly smaller, than FSOEs. For this reason, we report regressions that include and exclude the employment variables to establish that our results are not primarily driven by size differences. New firms are also concentrated inMinsk, and are more likely to havejoint ventures, but this does not appear to influence any o f our results, so we do not report regressions with these variables omitted. Similarly, SOEs are significantly more likely to face soft budget constraints, but this does not affect our regressionresults. 3.48 The regression results are reported in Annex Tables A3.5-A3.8. They contain regressions for measures o f company performance (SL and PS) in Table A3.5; export performance (EXP, DEX and DEX1) inTable A3.6; growth performance inTable A3.7 (DSL and DEMP); and restructuring (PR and SR) inTable A3.8. Eachtable contains up to three regressions to address causality and collinearity issues: (i)one excluding employment andrestructuringvariables, (ii)one excluding only the restructuring variables, and (iii)one with all independent variables included to explore the relationship between restructuringactivities and the performance measure inquestion. Results 3.49 We commence our testing o f the hypotheses by exploring the relationship between productivity and profitability and firmtypes (Table A3.5). The results are not affected inthe S L equation by controlling either for firm size or the restructuring variables. The most general and best fitting specification i s in column (3). The inclusion of the restructuring variables to the profit to sales ratio equation leads to a worsening inthe fit, so the best fitting PS regression i s incolumn (2). 3.50 The S L equation suggests that industry effects are significant in understanding productivity differences between firms, with enterprises in the timber, woodworking, pulp and paper industry significantly more productive. Moreover, monopoly power yields higher prices, and therefore higher 80 revenues and sales per worker, since COMP i s negatively associated with productivity. Interestingly, we find a positive incentive effect from managerial ownership; though the causality is not unambiguous: managers may have taken ownership stakes in more productive firms. However, no other controls influence productivity: inparticular, neither o f the two measures o f restructuringnor the existence o f JVs enhances enterprise productivity levels. When we turn to the central variables o f interest, however, the results are perverse. Privatization i s found not to improve productivity relative to continued state ownership and de novo firms are not more productive than state-owned ones. Most surprisingly, privatization when it takes the form o f majority control beingplaced inprivate hands i s actually found to be associated with lower productivity than state ownership. This result may perhaps be explained by the policy dating from the late 1990s to privatize more problematic enterprises. 3.5 1 The profit to sales equation fits somewhat less well than that of productivity. Almost no controls, including restructuring activity, soft budget constraints, size or managerial ownership, influence profitability. However, there are some significant industry effects: machinery and construction materials are less profitable. We find no significant difference between the profitability o f former state owned firms as a class, new firms or state-owned firms. However, firms that have been privatized fully (PFI) are more profitable. 3.52 The model explains export shares in Table A3.6 far better than PS or S L in Table A3.5, with goodness o f fit in excess o f 0.4. The probit regressions for export change and export change to the West also contain considerable significant explanation. Commencing with export shares, column (3) i s once again the best fitting form, though we do not identify any strongly significant association between exports and restructuringin any o f the equations. The equations suggest that larger firms export more, and exhibit faster growth o f exports and more o f an increase in their exports to the West. Length o f service seems to be a (negative) indicator o f managerial quality in that export shares are significantly lower in firms in which managers were appointed before 1996. There are also strong sectoral and regional effects. Being based inMinski s a significant disadvantage for all three measures o f export performance. 3.53 Export shares are higher in machinery and light industry, and export growth was significantly slower in food and construction materials. The sectors that have revealed potential export growth performance in exports to the West are timber, woodworking, pulp and paper, and the food industry. However, the current pattern o f exports may not be following the dictates o f the market. We find that export shares are positively related to both measures o f softness o f budget constraint, perhaps indicating that firms may need to be subsidized to maintain high levels o f exports. This result holds, even when we control for size o f firm. There i s also some weaker evidence that firms inreceipt o f soft budget constraints may be increasing exports to the West faster. 3.54 The firm type effects inTable A3.6 are once again largely contrary to expectations. Once we have controlled for all the other factors, we can find no evidence that privatized or new firms increase exports or exports to the West faster than state-owned firms. However, it i s interestingto note that once we control for size, sector, and the other factors o f relevance, we identify a positive significant relationship between export shares and new firms. 3.55 Table A3.7 presents indicators o f changes in enterprise productivity and employment. The employment growth equation contains few significant determinants. Surprisingly, restructuring i s not significantly related to DEMP, nor are size, soft budget constraints or product market competition. There are no effects from managerial quality or the presence o f JVs. The only significant control effects are sectoral (light industry and food industries reduced employment less) and via insider ownership. Interestingly, firms with managerial ownership made smaller cuts in employment. This i s consistent with the view that insiders act to slow the pace o f restructuring. As inseveral o f the previous regressions, there are no differences inemployment change according to firm ownership type. However, once again we find that FSOEs in which private owners hold a majority stake, increase employment significantly more than the other types o f firms. 81 3.56 The productivity growth equation i s interesting in that we find a significant association between strategic restructuring and productivity growth, while PR i s not significant. Moreover, soft budget constraints are again found to have a positive effect, while length o f managerial service has a negative effect. Productivity growth has been strongest in construction materials and light industry.Turningto firm type effects, we find no significant difference between FSOEs and SOEs, but DNs display significantly slower productivity growth. 3.57 Finally, we turn inTable A3.8 to restructuring itself as an indicator of enterprise performance. The results are weaker than one might have hoped -- restructuringi s not influenced by firm size, joint venture, location, or insider ownership. However, most o f the significant relationships that we find conform to expectations. Firms that are operating in more competitive product markets are more likely to restructure; managerial quality (the inverse o f length o f service) enhances restructuring; and there are some sectoral effects. However, there i s one apparently perverse result: namely, a positive rather than a negative association between softness o f budget constraints and property restructuring. While, as expected, de novo firms restructure less than SOEs and FSOEs, it i s also surprisingto identify that the PFls restructure less than state-owned firms. D. CONCLUSIONS 3.58 In summary, our equations are based on a specification that has been employed with success in most transition economies, including Poland (Belka et al., 1995) and Russia (Estrin, Earle and Leshchenko, 1996). However, the standard o f fit i s rather low inBelarus, which indicates that the standard controls used inequations o f this sort do not for the most part have the expected impact. As follows from a detailed analysis o f the results, variables such as company size, product market competition, joint venture, managerial quality, location, and insider ownership are rarely found to have a significant effect, though when they do it i s usually o f the predicted sign. This suggests that the determinants of company performance in Belarus, using a wide variety o f indicators, are not for the most part those that pertain in market economies or most other transitioneconomies. 3.59 However, we are still able to test our hypotheses about the impact o f different firm types on the variety o f performance measures. Hypothesis 1 - that privatized firms will perform better than state- owned ones - i s rejected in every equation: the coefficient o f PF i s never significant. However, when we separate out the group o f privatized firms that have non-state majority owners, a few significant results emerge but they are inconsistent. Private ownership o f former state owned firms i s associated with greater profitability and productivity growth but lower productivity levels and less property restructuring. 3.60 The results with respect to soft budget constraints are at first sight perverse. These are found to influence company performance in three areas -- export shares, productivity growth and property restructuring. However, in all three, soft budget constraints are found to improve rather than hinder firm performance. 3.61 The greatest disappointment concerns the results with respect to Hypothesis 2, which i s rejected in all the equations, though the transition literature predicts that new firms could be the motor o f resource reallocation and growth. For the most part, these are not found to perform differently from state-owned firms. There are four exceptions: exports, which are greater in DNs (when we control for other factors), and productivity growth, property restructuring and strategic restructuring, which are slower in DNs.The latter two mightbe down because such firms have less need o frestructuring. 3.62 Taken together, therefore, our sample suggests that Belarusian firms have made only very limited progress in many of the key elements o f enterprise restructuring, including integrating into the world economy through trade and investment and reorganizing companies to make them vibrant components o f the market economy. Though we do observe inChapter 2 that labor productivity has been increasing, this i s not associated with the reform-related features that played a major role in such adjustments in other transition economies. Rather, this growth probably derives from increases in external demand that also 82 reduce the pressure to address the problem of labor hoarding. Capacity utilization rose on average from 68.8 percent to 71.8 percent between 2002 and 2003 inthe sample. We will concentrate on three aspects o f these difficulties: the failure to integrate sufficiently into the world economy, the effects o f soft budget constraints, and the broader institutional environment for privatizedand new firms. 3.63 Studies of other transition economies (see, for example, Djankov and Murrell, 2002) suggest that foreign firms could have a very important role to play in enterprise restructuring. Foreign firms can provide new technologies, quick mechanisms for benefiting from the global division o f labor, including export growth, capital investments and managerial skills. Even if there are concerns about widespread foreign ownership, liberalizing economies in the Far East such as Vietnam have generated considerable gains from channeling foreign investments throughjoint ventures. InBelarus we findthe levels o f FDIand joint ventures to be very low, and inour equations we do not find that membership inajoint venture yields any benefit in terms of improved performance. This suggests that the policy environment i s particularly unattractive to potential foreign investors, and that the Belarus authorities have much to learn about how to exploit joint ventures to the benefit o f the host firms. 3.64 Contrary to expectations, we find that firms in receipt o f direct or indirect subsidy never perform significantly worse and sometimes perform better. One might interpret this result as indicating that soft budget constraints are effective in improving company performance. However, the reverse i s true. The Belarus economy has only moved partially in the direction o f the market. Firms are financially constrained, and financial instruments other than retained profits or sale o f inherited assets are virtually non-existent. Insuch a situation, resources from any source may under additional conditions help the firms inreceipt o f them to improve performance. InBelarus, it seems, two such conditions have been inplace. The first i s the fairly strict supervision over SOE and FSOE performance, which considerably reduced the costs o f asset stripping and the related non-appropriate use o f subsidies. The second i s a selection bias in bothprivatization (best firms remain non-privatized) and subsidization (best firms, due to their state status, have better access to state support). The only surprising result o f this situation i s how few o f the performance indicators are affected by soft budget constraints. Thus, for example, firms with access to soft government money do not show a higher growth inexports, let alone inexports to the West. 3.65 However, the real major impact o f soft budget constraints has to be seen not just on the subsidy recipients themselves, but on the economy-wide business dynamics. Massive subsidization undermines the most basic incentives to compete generated by the market economy. This may explain the limited effect o f market incentives in our equations: it i s possible that soft budget constraints are allowing firms to ignore profitable opportunities and to fail to react to unprofitable ones, thereby reducing the overall fit and economic explanation o f the equations. 3.66 The refutation o f Hypotheses 1 and 2 i s the strongest indication in the study that the Belarusian institutional environment has not yet taken a form that can encourage the emergence o f a market economy. We have found that, for the most part, privatization has no effect on company performance. This could occur because the new owners were inappropriate, and there i s some evidence for this in that we find mixed performance effects when we restrict our attention to the subset o f private firms with majority private owners. However, the study does not indicate that the problem i s insider ownership. Managerial ownership i s rarely a significant factor in our equations, and it tends to improve performance. Alternatively, privatization may also have no impact because the new owners are not able to exercise effective corporate governance owing to weaknesses in the enforcement o f property rights, restrictions on the operations of product markets and the softness o f budget constraints. W e have no direct evidence for this, but the long length o f service o f managers, even in privatized firms, suggests that, unlike the situations in most other transition economies, in Belarus, owners have not been able to change management after privatization. The survey also suggests that private firms face less favorable business conditions and this unevenness distorts the results across ownership classes. 83 3.67 More generally, the fact that privatization i s not found to influence company performance, while soft budget constraints sometimes have a positive effect, cannot be interpreted as evidence against a reform strategy aimed at more privatization and equalization o f business conditions. Rather, the institutional environment in Belarus must be so poor that reforms that have been effective in other transition economies have failed to work. An important element o f this poor business environment i s sofi budget constraints, whose pervasiveness and disincentive effects probably provide much o f the explanation for the failure o f privatization. 3.68 An equal worry for the future path o f the economy is the refutation of Hypothesis 2. Our findings that new firms in Belarus rarely show any significant difference in performance from current and former state-owned firms are contrary to almost all o f the transition literature, which identifies new firms as the engine o f restructuring and growth. The results seem once again likely to be explained by the particular legal, institutional and business environment in which de novo firms operate in Belarus, and suggest that radical reformi s neededto free the potential o f entrepreneurship. 3.69 There has been emerging evidence that the path o f institutional development i s diverging between the CIS and CEE countries, particularly in the area o f property rights and institutions conducive to the emergence and growth o f a dynamic de novo sector (see Estrin, Meyer, and Bytchkova, 2005). Such institutions include a flexible capital market, a sound commercial code, the enforcement o fproperty rights, a limitation on regulations and bureaucracy-especially for SMEs-and relatively low levels o f corruption. The institutional differences with respect to the business and legal environment for new firms seem to be strongly associated with the rate o f the creation o f new enterprises and therefore with productivity and economic growth. Therefore, the weakness o f the de novo sector should be interpreted as a fundamental weakness o f the entire development paththat the Belarusian economy has been following. 3.70 A comparative analysis o f the performance indicators o f SOEs, FSOEs and DNs has clearly indicated improvements in the operations o f SOEs, which in some areas (such as higher growth o f output, expansion o fproduct range, and increases inexports, wages, profits and profitability) are developing more dynamically than the new private sector. Why i s this so, and what implications does this situationhave for the future o fthe Belarusian economy? 3.71 There are two major groups o f factors that seem to be forcing some restructuring o f SOEs (especially during the last two to three years). The first i s the strengthening o f administrative controls and monitoring over the enterprise sector. While controls are overwhelming, managers have very limited opportunities for asset stripping and their incentives are heavily focused on meeting growth targets. To achieve the administratively set production growth targets and to preserve the status quo, managers o f SOEs should undertake certainchanges inthese enterprises that will contribute to such growth. Because of the open economy, these changes should be appropriate interms o f the market rules existing inRussia or Europe. 3.72 The second group of factors concerns the increased domestic competition with the new private sector and with imports. BEEPS surveys by the World Bank and EBRD have revealed a serious shift towards the acknowledgement of the importance o f competition from imports in transition economies in 2002 as compared to 1999. It i s interesting to know that the magnitude o f these changes inthe perceptions o f Belarusian entrepreneurs i s much stronger than that o f their neighbors (Figure 3.1). 84 Figure3.1: Percent ofFirmsinSelectedCountriesRatingCompetitionfromImportsnot Important or only Slight1 mportant,in 1999 and 2002 100% 80% llPoland 60% 0 Ukraine 40% HRussia 20% CUI Belarus 0% 1999 2002 Source: World Bank BEEPS database. 3.73 And, finally, to recapitulate the issues raised above, the question i s that o f whether the empirical results in this chapter are in contradiction with the findings in Chapter 2, where it was shown that industrial output growth was real and most o f it stemmed from productivity improvements. Two interrelated but not identical aspects should be considered: an explanation of the current trends, and a vision for the future. With all caveats, restructuring, albeit rather limited, has taken place, including some unbundling. The pressure for this restructuring came from the two sources highlighted in Chapter 1 (administrative pressures and increased competition) and from support by government subsidies, investment grants, soft credits, etc. Moreover, some forms o f state support were explicitly linked to enterprise performance, such as tax restructuring (conditional on due payments o f current taxes) and tax exemptions (contingent to growth inoutput). The government has also supported the domestic demand for local industries in the consumer sector by a combination o f income policy and import restrictions (Chapters 1 and 4) and the foreign demand by lobbying industrial interests abroad. Inthe latter case, the government (MFA) exhibits a considerable capacity by regional standards. 3.74 While it i s not surprising that SOEs have restructured to a greater extent than DNs (because the latter do not need to restructure or do not need to restructure to a great extent), they also saw more restructuring than FSOEs. This apparent controversy regarding the conventional wisdom might be due to the better access of SOEs to subsidies, as well as the consequence o fthe "selectivity bias" (when the worst companies were privatized). All in all, the "restructuring," when undertaken, brought positive results in terms o f productivity gains: this i s supported by our empirical results, where a positive linkhas been found between SR and productivity increases. However, the problem i s that the overall restructuring has been slow and limited, and some important (basic) restructuring measures are yet to be implemented. As this report argues, accelerating restructuring inthe future may be increasingly difficult without serious changes inthe institutional and regulatory environments. For this purpose the right set o f incentives should be in place, and this i s impossible without depoliticization - a completely missingelement inthe transformation o f the industrial sector inBelarus to date. 3.75 Future economic results would depend primarily on the nature o f the interaction between the state (former state) and the new private enterprise sectors and also on securing a level playing field for these 85 sectors. Further developments in the situation will also depend on whether the SOEs will pursue development strategies that are more typical for the private sector or whether the private sector will adjusts to the existing economic situation and begins to mimic behavior that i s more typical of SOEs. 86 ANNEX 3.1:LESSONSFROMTHEENTERPRISE RESTRUCTURINGANALYSISINTRANSITION A considerable amount of researchhas been carried out on the subject of the comparative performance o f different enterprise groups in transition (see Megginson and Netter, 2001). The basic argument i s that, relative to SOEs, private firms have superior corporate governance via the role o f external owners in monitoring managerial performance. Managerial incentives in private firms to operate in ways that improve corporate value are also believed to be stronger because o f the following: Managerial markets that reward efficiency and punishpoor performance Managerial payment schemes such as stock option plans that align managerial and owner incentives Effective monitoring, often driven through competition in stock exchanges and made highly transparent through stock market prices Effective bankruptcy laws that have an impact on private firms but not state-owned firms and that motivate resource reallocationaway from inefficient firms. Their absence can leadto "soft budget constraints" that additionally distort managerial incentives. The threat o f hostile takeovers whereby poorly functioning managers can be replaced through competitive bidsby alternative management teams. However, as Djankov and Murre11 (2002) note, transition adds three more factors to the evaluation o f the likely impact o f privatization. The first factor i s the way in which it matters how the firms are privatized. InWestern market economies, privatizationis almost always awarded to the highest bidder, either via the stock exchange or to a group o f strategic owners. The process o f transition was associated with some major innovations in privatization methods, including restitution, so-called "small privatization," management-employee buyouts, vouchers, certificates and other methods of "mass privatization." Different privatization methods can lead to different owners, governance structures, and managers and thus to different post-privatization performances. For example, it is often argued that management- employee buyouts lead to the entrenchment o f the existing managers and are therefore ineffective interms o f enhancing company performance and encouraging restructuring. The second factor i s to whom the firms are privatized, inthe sense o f the "majority" or dominant owner. For example, if the new owners are workers and mangers, it i s argued that they are less willing to restructure because their own jobs are at risk and are also less willing to invest because this will dilute their ownership (and therefore their ability to protect their employment and other non-commercial interests). However, it i s unclear whether one should hypothesize that insider ownership i s better than, worse than or equivalent to state ownership. Earle and Estrin(1996) argue that it should be better, because workers and managers have an incentive to improve efficiency since any improvements are reflected in their own returns. Others argue that insider ownership i s associated with nonprofit motives to such an extent that the situation will prove as bad as, or worse than, that under state ownership. Finally, the institutional environment i s relevant in determining the impact o f privatization. Problems will therefore arise if the institutional environment for the newly privatized firms i s too weak to support the improved corporate governance that private ownership i s meant to bring. For example, most of the incentives for managers outlined above rely on the operation o f either (i) an Anglo-Saxon type o f stock exchange, with competing groups o f private owners having both the information and the authority to intervene effectively in cases o f poor management, or (ii) a German type o f independent banking system (or some other form o f effective strategic owner such as a foreign firm). Either form o f governance relies on some key attributes of a market system. These attributes include the rule o f law; a commercial code which, for example, guarantees minority shareholder and debtors' rights; a bankruptcy code; a clear separation o f state and enterprise; accounting standards; transparency in the provision of information; a 87 liquid stock market; and a commercially sound banlung system. Privatization works through sharper incentives for managers, improved corporate governance, and access to private capital markets. However, in an environment inwhich managers are more easily able to achieve their own objectives through rent seeking, or inwhich property rights enforcement i s so weak that owners cannot prevent management from tunneling out assets (see, for example, Boycko, Shleifer, and Vishny, 1995; McMillan and Woodruff, 2002; Johnson et al., 2000), privatization cannot be guaranteed to improve company performance. Djankov and Murrell (2002) in their meta-analysis o f more than 100 studies o f transition find a clear distinction interms o f the impact o f privatization between the countries o f Central and Eastern Europe and the former Soviet Union. In the former,` most studies suggest that privatized firms display better performance than state-owned firms across a variety o f measures. However, few studies covering the FSU economies, notably Russia and Ukraine, can identify any significant differences in the performances o f state-owned and private firms. Djankov and Murrell suggest two reasons for this.First, privatization inthe FSU has typically led to widespread insider ownership that i s likely to militate against restructuring and improved performance. Second, the institutional environment was significantly weaker in the FSU, especially with respect to the enforcement o f property rights and the development o f a legal environment. A particular issue that has recurred in a number o f studies was the pervasiveness of soft budget constraints. It i s not clear how market incentives and improved capital market disciplines are intended to operate in an environment where firms can exploit the failure to enforce contracts and government subsidies to insure themselves against unfavorable outcomes from the market. Privatizationmay improve the corporate governance o f former SOEs provided the appropriate institutional arrangements have been set in place. However, former SOEs would face many problems for a number o f years in their attempts to restructure and enhance productivity and performance. Thus, there are several reasons to believe that the performance o fnew firms would be superior: 0 SOEs have excessive employment and old capital. It may take years to cut employment to appropriate levels and to invest in new equipment. The latter point depends on the method o f privatization and the institutional framework. It i s argued that outside owners are in a better position than workers or managers to put inextra money to finance investment. 0 Managers are often viewed as the key to improved performance. Changes in ownership only rarely lead to changes in management and often act to entrench existing managers, especially when existing managers acquire ownership rights. This will slow down restructuringbecause the skills required for successful management in the market economy are quite different to those in the plannedeconomy. 0 The "firms" themselves under socialism did not have many o f the functions o f independent Western enterprises, such as sales, marketing, distribution, supply, finance and investment. These functions typically resided elsewhere in the system (for example, with the central planners or ministries). The restructuring o f SOEs i s therefore a massive job (see Estrin et al., 1995). In many cases the inherited structures, attitudes and organizational cultures o f the old SOEs are so strong that such radical restructuring i s impossible or at least very slow to take effect. This may mean that it i s easier to satisfy the new demands o f the market economy through new organizations (see Kornai, 1990; Estrin, Meyer and Bytchkova, 2005). When we consider the structure o f supply in the planned economy, and the pattern o f demand in the new market economy's post-price liberalization, we find three major areas o f difference: (i)Plannedeconomies are "over-industrialized" andoften have large agricultural sectors reflecting residual underdevelopment. The service sector i s also under-represented, particularly in key areas that support the market economy (such as logistics or business services). Restructuringtherefore requires a shift inthe balance o f output from industryto 88 services, and it i s not clear whether this i s best done by enterprises currently operating primarily inthe manufacturingsector. Hence, this type o f restructuringwill probably rely disproportionately on the entry o f new firms. (ii) economiesdonothaveaproductionstructureconsistentwiththeircomparative Planned advantage at world prices. For most economies this implies a restructuring o f output towards exports, and perhaps also a change in trading partners towards the West, primarily the EU. It i s possible that this could be done by former SOEs, who might have the advantage o f scale, but the sclerosis o f institutions suggests that such restructuring would be hard to achieve. Once again, new entry seems a plausible route, although FDI and joint ventures between current and former SOEs and foreign firms may be an alternative way to integrate into the world economy. (iii) Planners "solved" the informational problems o f planning by allowing only very few firms to operate. Therefore, these firms were gigantic. Hence, when the market was created, market structure was highly imperfect and entry was concentrated insmall firms. The weak capital markets and poor property rights that typically prevailed (which meant that entry on a large scale was difficult) exacerbated this tendency. W e have seen that this problem remains an issue in Belarus, which still has remarkably few firms, and in which output and employment in the industrial sector are still heavily concentrated in a small number o f large firms. 89 ANNEX 3.2: SPECIFICATION OF HYPOTHESES Some studies have found it useful to separate the analysis o f quantitative performance and qualitative performance (restructuring), and to relate the former to the latter. We follow this approach in our work. We can summarize the discussion ina simple equation, x=f(Q a, (1) where Xis a vector of performance variables that includes measures o f quantitative performance (P) and o f restructuring (R); 0 i s ownership (three categories: SOE, FSOE and DN); and 2 i s a vector of control variables that may include restructuringifthe performance measures are quantitative. Inthis situation we therefore explore the relationship: P =F (R, 0,Z'). (2) Several control variables (2)have been employed extensively in the literature to control for other factors that might influence performance: 0 Enterprise size: large firms, which can exploit scale economies, may be more productive than smaller ones, especially in the industrial sector. Size can also bring pecuniary benefits: for example, lower input costs or higher prices because o f monopoly power. 0 Sector: different sectors have different technologies and therefore different capital intensities and factor productivities. They also have different market structures and therefore differences in monopoly power and price-cost margins. 0 Region: transition economies can have regionally fragmented markets, so that even for firms ina given sector, regional demand patterns or market structures may vary. 0 Other control variables used in this and other studies for the 2 vector are the presence o f a joint venture, the availability o f soft loans, the impact of competition and barter, proxies for managerial quality (e.g., duration o f service o f the general manager), and insider (managerial) ownership. 90 ANNEX 3.3: KEYRESULTSOFTHEENTERPRISE RESTRUCTURINGSURVEY Table A3.1: PropertyRestructuringMeasures(YOofthe sample) Descriptionof measures Total sample No Measures Measuresare Measureshave measures are implemented beencompleted intended Change o f the organizational structure (closure 42.8 14.6 21.4 19.4 o f some units; establishment o f new units) Transformation o f structural units into 79.8 8.8 3.5 4.3 independent legal entities Sale o f unnecessary assets 35.5 20.9 29.7 10.6 Renting out o f excessive assets 48.9 10.6 30.2 7.6 Rent or leasing of assets 54.9 15.6 16.1 9.6 Establishment o f a subsidiary company 80.6 5.8 2.8 8.3 Establishment o f ajoint venture 76.3 13.6 2.3 4.3 Sale o f subsidiaries, branches or stakes in 93.2 1.8 0.5 1.o subsidiaries or branches Splitting o f the enterprise into 2 or more 88.2 5.5 0.5 2.8 independent legal entities Transformation o f the enterprise into holding 90.4 5.3 0.5 1.o Liability prolongationor writing off 78.8 8.3 6.3 3.3 Debt equity swaps 87.2 5.0 2.8 1.8 Purchase o f stakes (shares) or entire enterprises 90.2 3.3 2.3 1.o Borrowing to pay back the existing debts 72.8 9.6 12.8 2.0 Sale o f stakes (shares) o f the own enterprise 81.4 8.1 4.3 3.0 Merger (joining up) with another enterprise 87.4 5.8 0.5 2.8 91 TableA3.2: PropertyRestructuringMeasures (by formof ownership, % of the sample) Descriptionof measures SOE FSOE DN Change o f the organizational 26.4 19.8 24.2 24.2 41.1 13.2 21.1 23.7 58.6 12.9 19.8 8.6 structure (closure o f some units; establishment o f new units) Transformation o f structural 73.6 12.1 7.7 78.4 7.4 5.3 5.3 87.1 8.6 3.4 units into independent legal entities Sale o f unnecessary assets 20.9 23.1 39.6 9.9 32.6 18.4 34.7 10.5 51.7 23.3 13.8 11.2 Renting out o f excessive assets 27.5 8.8 49.5 9.9 46.3 9.5 31.6 9.5 69.8 13.8 12.9 2.6 Rent or leasing o f assets 58.2 12.1 17.6 5.5 53.2 14.7 16.3 11.6 55.2 19.8 14.7 9.5 Establishment o f a subsidiary 67.0 7.7 2.2 18.7 82.1 4.2 2.6 7.9 88.8 6.9 3.4 0.9 company Establishment o f ajoint venture 75.8 13.2 2.2 4.4 74.2 15.8 1.1 3.7 80.2 10.3 4.3 5.2 Sale o f subsidiaries, branches or 89.0 2.2 1.1 93.7 1.1 1.6 95.7 2.6 1.7 stakes insubsidiaries or branches Splitting o f the enterprise into 2 84.6 3.3 4.4 88.4 5.8 3.2 90.5 6.9 1.7 0.9 or more independent legal entities Transformation o f the enterprise 87.9 3.3 1.1 91.6 5.3 0.5 0.5 90.5 6.9 0.9 1.7 into holding Liability prolongationor 65.9 11.0 8.8 7.7 80.0 8.4 5.3 2.6 87.1 6.0 6.0 0.9 writing o f f Debt equity swaps 84.6 2.2 2.2 4.4 85.8 7.4 2.1 1.1 91.4 3.4 4.3 0.9 Purchase o f stakes (shares) or 86.8 3.3 2.2 2.2 90.5 2.1 2.1 1.1 92.2 5.2 2.6 entire enterprises Borrowing to pay back the 60.4 12.1 17.6 5.5 72.6 9.5 13.7 0.5 82.8 7.8 7.8 1.7 existing debts Sale o f stakes (shares) o f the 83.5 6.6 3.3 72.6 11.6 7.9 4.2 94.0 3.4 1.7 0.9 own enterprise Merger (joining up) with 83.5 3.3 1.1 4.4 87.4 5.3 0.5 3.2 90.5 8.6 0.9 another entemrise 92 Table A3.3: Strategic RestructuringMeasures (% of the sample) Total sample Descriptionof measures No Measuresare Measuresare Measureshave measures intended implemented beencompleted Staff cuts 54.7 16.2 14.9 11.9 Change o fthe employment structure 36.3 32.1 22.6 4.7 Introduction o f the new forms o f goods 12.9 42.0 35.1 6.0 promotion Creation o f the new distribution 22.9 40.5 26.9 4.0 channels Attraction o f external investors 50.0 34.1 10.4 2.5 Procurement o f new equipment 12.2 40.0 36.1 9.2 Introduction o f new production 13.9 36.3 37.8 8.2 technologies IImprovement o f the quality o f products 5.5 24.1 59.7 8.7 services Expansion o f the range o f products 8.2 23.1 57.0 10.0 Taking unprofitable goods out o f 29.9 20.9 35.3 11.4 production Upgrading o f the existing products 11.2 24.9 53.2 7.5 Search for new market segments 6.5 39.1 49.3 3.0 Staff training 8.5 24.1 60.7 3.5 Improvement o f labor management 8.5 25.1 61.2 2.5 Change o fremuneration and 12.7 32.1 45.5 6.7 motivation schemes Strengthening o f labor discipline 8.5 13.4 69.2 6.7 Reduction o f social expenditures 45.8 17.9 27.6 5.0 Change o f staff evaluation system 26.9 32.8 32.1 3.7 93 Table A3.4: StrategicRestructuringMeasures(by formof ownership, % of the sample) Descriptionof measures SOE FSOE DN Staff cuts 35.5 19.4 21.5 18.3 52.3 13.5 18.7 13.5 74.1 18.1 3.4 4.3 Change o fthe employment 25.8 31.2 28.0 5.4 35.8 30.6 25.4 4.7 45.7 35.3 13.8 4.3 structure Introduction of the new forms o f 11.8 36.6 39.8 5.4 13.0 42.5 34.7 5.2 13.8 45.7 31.9 7.8 goods promotion Creation o fthe new distribution 24.7 36.6 29.0 1.1 21.2 40.9 25.4 5.2 24.1 43.1 27.6 4.3 channels Attraction o f external investors 39.8 41.9 9.7 3.2 50.3 35.2 8.8 2.6 57.8 25.9 13.8 1.7 Procurement o f new equipment 10.8 37.6 39.8 5.4 8.8 42.5 36.8 10.4 19.0 37.9 31.9 10.3 Introduction of new production 7.5 37.6 44.1 3.2 14.5 34.2 40.9 7.3 18.1 38.8 27.6 13.8 technologies Improvement o f the quality o f 4.3 26.9 60.2 3.2 3.6 20.7 68.4 6.2 9.5 27.6 44.8 17.2 products I services Expansion o f the range o f 5.4 19.4 63.4 8.6 6.2 22.8 63.2 6.2 13.8 26.7 41.4 17.2 products Taking unprofitable goods out of 21.5 28.0 38.7 7.5 25.9 18.1 42.0 11.4 43.1 19.8 21.6 14.7 production Upgrading o fthe existing 8.6 26.9 55.9 3.2 11.4 20.2 59.1 6.2 12.9 31.0 41.4 12.9 products Search for new market segments 5.4 35.5 51.6 2.2 5.2 37.8 52.3 3.1 9.5 44.0 42.2 3.4 Staff training 5.4 17.2 69.9 1.1 6.7 21.8 66.8 1.6 13.8 33.6 43.1 8.6 Improvement o f labor 5.4 20.4 66.7 1.1 5.7 23.8 66.8 1.6 15.5 31.0 47.4 5.2 management Change o f remunerationand 9.7 22.6 55.9 6.5 12.4 29.5 46.6 8.3 15.5 44.0 35.3 4.3 motivation schemes Strengthening o f labor discipline 4.3 8.6 72.0 10.8 4.7 7.8 80.8 4.7 18.1 26.7 47.4 6.9 Reduction o f social expenditures 40.9 12.9 33.3 5.4 42.5 18.1 29.5 6.2 55.2 21.6 19.8 2.6 Change o f staff evaluation 22.6 31.2 34.4 4.3 22.8 35.8 34.2 2.1 37.1 29.3 26.7 6.0 svstem 94 List of variables used in the regressionanalysis SL Sales per worker (productivity proxy) D S L Changes in Sales per worker (changes inproductivity proxy) EXP Exportto sales ratio DEX Recent changes inExport DEX1 Recent changes inExport to the West PS Profitability (profit to sales) DEMP Changes inEmployment PR Property restructuring SR Strategic restructuring DN D e novo PF FSOE with majority state ownership PF1 FSOEwith majority private ownership MAN Ownership of the firm by managers IND1 Machinery and metalworking industry IND2 Timber, woodworking, pulp and paper industry I N D 3 Construction materials industry rND4 Light industry I N D S Foodprocessing industry GEO Regional dummy: firms located inMinsk LOS Jv Length of service (managerial turnover) Joint venture SBC Soft budget constraints (important) SBC1 Soft budget constraints (present) COMP Competition EMP Employment 95 Table A3.5: Performance Equations:Productivity and ProfitabilityLevels Productivity (SL) Profitability(PS) (1) (2) (3) (1) (2) (3) DN 0.022 0.017 0.033 -0.107 -0.061 -0.044 0.203 0.154 0.245 -0.986 -0.519 -0.32 PF 0.106 0.104 0.178 -0.113 -0.143 -0.122 0.811 0.786 1.197 -0.876 -1.068 -0.792 PF1 -0.205* -0.207* -0.254** 0.182 0.261** 0.252* -1.828 -1.83 -2.008 1.598 2.202 1.858 MAN 0.194** 0.195** 0.173* 0.029 0.033 0.003 2.154 2.152 1.813 0.347 0.381 0.034 INDl 0.136 0.136 0.146 -0.178* -0.182* -0.111 1.428 1.423 1.412 -1.881 -1.917 -1.066 IND2 0.143* 0.142* 0.182** -0.124 -0.1 -0.022 1.823 1.811 2.185 -1.562 -1.245 -0.256 IND3 -0.034 -0.034 -0.04 -0.129 -0.136* -0.11 -0.427 -0.433 -0.463 -1.633 -1.681 -1.228 IND4 -0.006 -0.006 -0.016 -0.135 -0.088 -0.001 -0.069 -0.068 -0.171 -1.565 -1.016 -0.014 IND5 0.038 0.038 0.037 -0.077 -0.081 -0.03 1 0.453 0.444 0.405 -0.93 1 -0.959 -0.333 GEO -0.045 -0.046 -0.079 -0.013 -0.04 -0.105 -0.565 -0.568 -0.885 -0.161 -0.489 -1.119 LOS 0.045 0.043 0.025 -0.077 -0.078 -0.109 0.591 0.548 0.292 -1.037 -1.013 -1.276 JV -0.012 -0.012 -0.032 0.065 0.042 0.006 -0.174 -0.162 -0.397 0.933 0.588 0.078 SBC -0.052 -0.05 -0.093 0.003 0.023 0.049 -0.663 -0.637 -1.032 0.033 0.291 0.54 SBCl -0.095 -0.093 -0.068 0.052 0.035 0.055 -1.187 -1.152 -0.749 0.655 0.438 0.597 COMP -0.158** -0.158** -0.192** -0.038 -0.058 -0.032 -2.28 -2.26 -2.509 -0.567 -0.84 -0.414 EMP -0.013 -0.049 0.108 -0.082 -0.159 -0.538 1.329 -0.882 PR -0.017 -0.117 -195 -1.326 SR 0.012 0.045 0.142 0.513 R2 0.102 0.102 0.131 0.071 0.099 0.078 Figures below the estimated coefficients are t statistics.* Denotes significance at 10%level,** at5% level and*** at 1% level. 96 Table A3.6: PerformanceEquations:ExportLevels and RecentExportGrowth ChangeinExports ChangeinExportsto Exports(EXP) (DEX) the West (DEX1) (1) (2) (3) (1) (2) (1) (2) DN 0.162* 0.26*** 0.341 *** 0.284 0.302 0.707 0.225 1.806 2.683 3.118 0.927 0.869 1.429 0.368 PF 0.081 0.106 0.174 -0.019 -0.096 0.041 -0.493 0.747 0.946 1.408 -0.051 -0.217 0.08 -0.784 PF1 0.019 0.071 0.046 0.471 0.543 -0.674 -6.596 0.203 0.712 0.411 1.285 1.271 -0.88 0 MAN 0.067 0.07 0.055 -0.127 -0.143 -0.018 0.313 0.96 0.993 0.746 -0.52 -0.55 -0.043 0.606 INDl 0.267** * 0.292*** 0.253*** 0.049 -0.011 0.813 0.513 3.263 3.593 2.89 0.189 -0.039 1.385 0.733 IND2 0.047 0.077 0.09 -0.635* -0.557 1.431** 1.369* 0.695 1.135 1.268 -1.85 -1.411 2.133 1.775 IND3 -0.054 -0.03 -0.039 -0.725** -0.749* -4.757 -4.935 -0.786 -0.444 -0.53 -1.979 -1.952 0 0 IND4 0.278*** 0.231*** 0.233*** -0.339 -0.45 0.612 0.385 3.759 3.156 2.951 -1.179 -1.431 0.874 0.467 IND5 -0.019 -0.004 0.007 -0.914*** -0.98*** 1.367** 1.244 -0.277 -0.053 0.091 -2.796 -2.715 2.095 1.622 GEO -0.275*** -0.251*** -0.266*** -0.761*** -0.722*** -0.694* -0.527 -4.154 -3.654 -3.513 -3.65 -3.016 -1.878 -1.23 LOS -0.204*** -0.163** -0.222*** -0.232 -0.328 -0.253 -0.414 -3.25 -2.531 -3.187 -1.145 -1.475 -0.765 -1.056 Jv 0.014 -0.013 -0.039 -0.449 -0.236 -0.052 0.134 0.233 -0.224 -0.611 -1.586 -0.718 -0.122 0.232 SBC 0.144* 0.129* 0.102 0.297 0.283 0.344 0.472 1.769 1.953 1.352 0.83 1 0.656 0.85 0.937 SBCl 0.17** 0.114* 0.15** 0.246 0.19 .622* 0.617 2.555 1.678 2.025 1.117 0.764 1.695 1.351 COMP 0.082 0.111* 0.071 0.121 0.043 0.133 0.065 1.445 1.93 1.134 0.618 0.2 0.402 0.166 EMP 0.257*** 0.23*** o.ooo*** 0** o.ooo** 0 3.785 3.036 2.736 2.156 2.455 1.075 PR -0.091 -0.219 0.514 -1.22 -0.257 0.428 SR 0.097 0.931 * 0.629 1.376 1.948 0.72 R2 0.37 0.41 0.414 Figuresbelow the estimatedcoefficients are t statistics.* Denotes significance at 10% level,** at 5% level and*** at 1%level. 97 Table A3.7: PerformanceEquations:ProductivityandEmploymentGrowth Productivity Growth(DSL) EmploymentGrowth(DEMP) (1) (2) (1) (2) (3) DN -0.66** -0.569* 0.074 0.092 0.103 -2.256 -1.711 0.73 0.873 0.861' PF -0.116 -0.037 0.053 0.062 0.026 -0.3 17 -0.088 0.437 0.5 0.184 PF1 -0.252 -0.445 0.27** 0.277** 0.325*** -0.718 -1.089 2.533 2.579 2.68 MAN -0.213 -0.277 -0.141* -0.142* -0.144" -0.921 -1.115 -1.754 -1.764 -1.692 INDl 0.173 0.068 -0.094 -0.095 -0.078 0.642 0.215 -1.108 -1.113 -0.838 IND2 0.173 0.32 -0.008 -0.006 -0.027 0.529 0.837 -0,111 -0.084 -0.343 IND3 0.665** 0.668* 0.03 0.031 0.035 1.982 1.865 0.405 0.426 0.426 IND4 0.931*** 0.719** -0.18** -0.181 -0.157* 3.289 2.24 -2.33 -2.338 -1.86 INDS 0.43 1 0.502 -0.146* -0.144 -0.142* 1.419 1.483 -1.948 -1.917 -1.742 GEO -0.115 -0.106 0.031 0.032 0.046 -0.562 -0.449 0.415 0.427 0.564 LOS -.340* -0.274 0.065 0.073 0.085 -1.732 -1.239 0.939 1.041 1.118 JV -0.107 -0.379 -0.01 -0.013 -0.026 -0.392 -1.183 -0.161 -0.198 -0.361 SBC 0.357 -0.068 -0.041 -0.047 -0.046 1.058 -0.175 -0.578 -0.653 -0.566 SBCl 0.576*** 0.706*** -0.066 -0.072 -0.079 2.716 2.814 -0.898 -0.977 -0.96 COMP 0.236 0.127 -0.018 -0.02 0.027 1.285 0.608 -0.287 -0.321 0.392 EMP 0 0 0.047 0.069 0.831 0.698 0.635 0.827 PR -0.32 0.041 -0.407 0.516 SR 1.209*** -0.046 2.704 -0.592 R2 0.129 0.13 0.146 Figures below the estimated coefficients are t statistics. level and*** at * Denotessignificance at 10 percent level,** at5 percent 1percent level. 98 Table A3.8: PerformanceEquations:Property and Strategic Restructuring Property (PR) Strategic (SR) (1) (2) (3) (1) (2) (3) DN -0.206** -0.156 -0.24 -0.318*** -0.29*** -0.368 -2.142 -1.498 -0.643 -3.385 -2.78 -1.257 PF 0.147 0.118 0.126 0.024 -0.005 -0.005 1.263 0.954 0.292 0.205 -0.038 -0.0 12 PF1 -0.255** -0.202* -0.304 -0.149 -0.096 -0.138 -2.539 -1.868 -0.701 -1.463 -0.873 -0.387 MAN -0.1 -0.098 -0.141 -0.115 -0.1 -0.132 -1.365 -1.284 -0.475 -1.581 -1.3 -0.6 INDl -0.12 -0.121 -0.194 -0.012 -0.001 -0.004 -1.467 -1.447 -0.571 -0.144 -0.015 -0.015 IND2 -0.02 -0.009 -0.039 0.06 0.083 0.175 -0.283 -0.122 -0.09 0.877 1.166 0.533 IND3 -0.039 -0.025 -0.077 0.046 0.059 0.119 -0.55 -0.343 -0.174 0.661 0.804 0.374 IND4 0.052 0.044 0.096 0.223*** 0.217*** 0.363 0.704 0.595 0.272 3.028 2.87 1.302 IND5 0 0.012 0.048 0.085 0.085 0.155 0 0.159 0.124 1.199 1.152 0.519 GEO -0.046 -0.05 -0.067 -0.002 0.007 0.007 -0.662 -0.687 -0.254 -0.033 0.101 0.034 LOS -0.13 1** -0.116* -0.187 -0.103 -0.111 -0.144 -1.985 -1.697 -0.75 -1.604 -1.628 -0.749 Jv 0.065 0.042 0.085 0.032 0.004 0.008 1.056 0.654 0.252 0.509 0.066 0.03 SBC 0.152** 0.156** 0.235 0.089 0.094 0.2 2.244 2.155 0.662 1.34 1.328 0.613 SBC2 0.096 0.073 0.125 0.09 0.068 0.089 1.356 0.996 0.45 1.293 0.921 0.419 COMP 0.098* 0.098 0.157 0.137** 0.137** 0.187 1.656 1.586 0.649 2.328 2.208 1.022 EMP 0.128* 0 0.091 0 1.714 0.58 1.276 0.579 R2 0.233 0.247 0.227 0.222 Figures below the estimated coefficients are t statistics.* Denotessignificance at 10 percent level,** at 5 percent level and*** at 1percent level. 99 CHAPTER4 TRADEAND GROWTH 4.1 Belarus i s a small open economy with a merchandise trade turnover to GDP ratio o f 111percent on average for the period 1996-2004 (and 123 percent on average for 2001-04). This chapter describes Belarus' external trade developments and gives special attention to the recent changes in the geographic and commodity structure o f trade, to the role playedby price and non-price factors intrade growth, and to the factor intensity o f trade. To better understand Belarus' trade performance, the analysis i s based on comparisons with neighboring countries. The chapter also looks at the main features o f Belarus' trade regime and reviews the status o f the country's WTO negotiationprocess. A. OVERVIEWOFTRADEPERFORMANCE 4.2 Trade performance in the early years of independence. Belarus inherited an extensive and diversified industrial base and an educated labor force from the USSR. As a consequence o f its industrial structure (Belarus was an assembly line for the entire USSR), in the Soviet era, Belarus was highly dependent on trade in general and on inter-republican trade in particular. For Belarus, total and intra- republican trade as a percentage o f GNP was the highest among the former USSR republics and above that o f the Central and Eastern European C M E A members.56Prior to independence, Belarus specialized in the production and export o f chemicals, automotive and agricultural machinery and equipment, machine tools, and some agriculturalproducts (flax, potatoes, and meat). 4.3 Under the USSR, the geographical and commodity patterns o f Belarus' trade were highly distorted. Inthe USSR the Russian Federation was the focal trading partner, serving as the major export market and the most important sourcing market, especially for energy resources. 4.4 An analysis o f trade inthe CIS area during the first years o f independence is complicated by the limited reliability o f the available data.57Belarus' exports and imports contracted substantially during 1992-93 owing to a number o f factors (the breakup o f production links, macroeconomic instability, an adverse shock related to a sharp increase inthe relative prices o f energy and raw materials, etc.), but they began to recover in 1994-95. This early recovery was driven largely by the BYR depreciation and reintegration with Russia.58 4.5 Since 1996, Belarus' trade performance has been mixed. During the first period of growth (1996-2000) trade volumes fluctuated considerably. However, growth in exports was stronger on average than in imports, which led to improvements in trade and current account balances. Duringthe second period, expansion inboth exports and imports was quite strong, and 56Michalopoulos and T a n (1995). 57See Belkindas and Ivanova (1996) for an overview o f the problems o f foreign trade statistics in the CIS after the breakup of the USSR. 58For more on initial conditions and o n Belarus' trade inthe early years o f independence, see Bakanova and Vinhas De Souza (2002) and Bakanova et al. (2004). An analysis o f the role played by trade with Russia is presented in Section C o f thls chapter. 100 trade and current account deficits as a percent of GDP were relatively stable. The hike inimports in2004 ledto a sharp deteriorationinthe trade and current account deficits, to 9 and 4.6 percent o f GDP (Table 4.1 and Figure 4.1). Table 4.1:MerchandiseTrade Dynamics, 1996-2004 TJS$ mllllon . . 1996 2000 2004 200412000 Exports, f.0.b. 5,790 6,641 13,917 Exports index, 1996=100 100 115 240 210 Imports, f.0.b. 6,939 7,525 15,983 Imports index, 1996=100 100 108 230 212 Tradebalance -1149 -884 -2,066 Trade balance index, 1996=100 100 77 180 234 Memorandum items Trade balance, % GDP -8.0 -6.8 -9.0 -2.3 Current account, % GDP -3.6 -2.6 -4.6 -2.0 Source: NBB. Figure 4.1: MerchandiseExports, Imports and Figure 4.2: Trade in Services, 1996-2004 (US$ Trade Balance, 1996-2004 (US$ million) million) ,3Mo1 ................................................... almpans ownCB """ l9Ld IS37 1998 1999 1W ?MI XOl 1W3 ZOM Source:NBB. Source: NBB. 4.6 Belarus runs a strong positive balanceintrade in services, which compensatesin part for its negative balance in trade in merchandisegoods. Exports of services were fairly stable during 1996-98 and even contracted in 1999, largely because of the reduction in demand from Russia after the Russian crisis. Since 2000, growth rates for both exports and imports o f services have been high, and the surplus intrade in services amounted to 3.1 percent of GDP in2004, a 60 percent increase innominal terms as compared to 2000 (Figure4.2). 4.7 Given Belarus' strategic location between the EU and Russia, it is not surprising that transport services are the most important category, accounting for about 60 percent o f total 101 exports of services. Exports of transport services more than doubled during the period 1996-2004 and amounted to 4.4 percent of GDP in 2004 (as compared with 3.3 percent in 1996). To date, Belarus has been fairly successful in exploiting its location advantages: its export proceeds from transportation services (excluding the pipelines) as reflected in its balance of payments, grew in 1999-2003 at a rate that was 1.6 times higher than the growth in the non-energy trade between Russia and the EU. Within the category o f transport services, the most important services are pipeline, railway and cargo services. Pipeline transport services accounted for 36 percent o f total transport services inBelarusin2004 as comparedto over 50percent inUkraine. 4.8 Inthis section we willconcentrate onmerchandisetrade only. The policy issues related to trade in services are discussed later inthis chapter as part o f the analysis o f Belarus' WTO accession process. 4.9 Belarus' trade performancein a comparativeperspective.A better understanding o f Belarus' trade performance could be obtained by its comparison with other countries in the region (Table 4.2). A simple indicator o f openness (merchandise trade turnover in relation to GDP) suggests that Belarus i s a more open economy than neighboring countries, including Lithuania, which i s smaller in terms o f both size and population. Table4.2: Indicatorsof TradePerformance:Belarusand SelectedEuropeanCountries All data for 2003 inUS$million unless otherwise stated Belarus Ukraine Russia Poland Lithuania Germany EU-15 Exportofgoodsper capita, US$ 1022.7 490.9 947.7 1597.2 2217.2 9122.8 7622.0 Exportof goods, ratio to GDP, percent 56.7 47.9 31.4 29.1 42.0 31.4 27.6 Import of goods per capita, US$ 1150.2 480.2 530.4 1747.1 2710.6 7285.7 5794.3 Importof goods, ratioto GDP, percent 63.8 46.9 17.5 31.8 51.4 25.1 21.0 Trade balance, ratioto GDP, percent -7.1 1.05 13.8 -2.7 -9.4 6.3 6.6 Openness,percent 120.5 94.8 48.9 61.0 93.5 56.4 48.6 Export of goods growth,percent, average for 1996-2003 8.2 6.2 6.1 12.0 12.2 5.4 4.3 Importof goods growth, percent, average for 1996-2003 7.3 2.3 1.6 9.7 11.7 4.1 1.1 Shareofmanufacturing(groups5-8 excluding68, usingthe SIT( revision3) exports inexportofgoods, percent* 61.8 67.3 21.2 81.2 62.9 84.0 80.6 ShareofCIS inexportof goods, percent 54.6 27.5 14.1 6.7 17.0 2.5 1.8 NetFDIper capita, cumulativefor 1996-2003,US$ 193.6 117.0 18.0 1181.9 1015.6 -290.2 -1852.6 NetFDI, ratioto GDP, percent, averagefor 1996-2003 * 2002 for Ukraine. Sources: WITS/COMTRADE,DOTS, IFS, WDI, NBB, and World Bank staff calculations. 4.10 While for some indicators for the period under consideration Belarus outperformed its CIS neighbors (Russia and Ukraine), comparisons with Poland and Lithuania are less favorable. Thus, exports per capita and net FDI per capita, and rates o f exports growth are much lower in Belarus than in its western neighbors. Interms of trade deficit, only Lithuania has a larger deficit (in relation to GDP) but, however, unlike Belarus, Lithuania has better opportunities to finance the difficult with a much stronger FDIinflow. The share o fmanufacturing exports intotal exports for Belarusis highbutis somewhat lower than inLithuania and Ukraine and significantly lower than inPoland. The most striking difference relates to the share o f CIS countries in Belarusian exports, which indicates a much slower path o f foreign trade diversification and much stronger remaining ties with the FSUand, inparticular, with Russia. 4.11 Belarusretainedquite a highshare of CIS trade, buttrade diversificationoutsideofthe CIS markethasbeenongoing.Thus, the share of CIS exports fell from two-thirds o ftotal exports in 1996to 102 52.4 percent in 2004 (Figure 4.3). However, trade reorientation in Belarus i s taking place at a much slower pace than inother transitional economies, with the share of CIS intotal exports being almost twice as highas that inUkraine (26 percent), not to mentionLithuania (17 percent) and Poland (7 percent). Figure4.3: TradeReorientation: BelarusandNeighboringCountries, 1996-2003 Share of CIS In total exports. % 70 0 60 0 BLithuanla 50 0 mPoland 0Ukraine 40.0 0Belarus 30.0 20.0 10.0 0.0 1996 1997 1998 1999 2000 2001 2002 2003 I 1996 1997 1996 1999 2000 2001 2002 2003 Share of BJ-15 In total exports, % Share of W-15 In total Imports, % .._.-....--.. _. ... __ -. .- 70 0 60.0 60 0 50.0 50 0 40.0 40 0 rn Poland 30.0 0Ukraine 30 0 0Belarus 20 0 20.0 100 10.0 0 0 0.o 1996 1997 1998 1999 2000 2001 2002 2003 1996 1997 1998 1999 2000 2001 2002 2003 Sources: WITSICOMTRADE,DOTS, CISSTAT. 4.12 ForBelarus,Russiaremainsbyfar the major tradingpartner.Russia's share inBelarus' total exports fell from 65 percent in 1998 to 47 percent in 2004 (Le., still accounting for about half of total exports and about 90 percent of CIS exports)(Table 4.3). Russia's share in Belarus' imports, which increased from 55 percent in 1998 to 68 percent in 2004, i s even larger (Table 4.4). Another important trading partner of Belarus' in the CIS i s Ukraine. However, exports to Uhaine declined inboth absolute andrelative terms in2001-04, and are now below 4 percent ofthe total. 4.13 Both the EU-15 and the new EU members are Belarus' important non-CIS trading partners.The share of the EU-15 inBelarus' exports has beengrowing constantly and accounted for 24 percent o f total exports in 2004 (as compared to 6.8 percent in 1998 and 11.0 percent in 2001) (Table 4.3). This growth has accelerated recently. However, this pickup in exports to the EU should be treated with caution: most of the growth occurred at the expense of a sharp increase in exports of oil products, from US$545 million in 1998 to almost 3.6 billion in 2004. The total share o f refinery products in Belarus' total exports increased from 7.7 percent to 26.2 percent during this period. This was largely due to the very high growth in exports of refinery products to the United Kingdom, Germany and the Netherlands. For example, refinery products accounted for 94.4 percent of Belarus' total exports to the UnitedKingdomin2004 as compared to 12.8percent in 1998. 103 Table 4.3: GeographicalStructure of MerchandiseExports, 1998-2004 (YO) 1998 2000 2001 2002 2003 2004 2000412000 2004-2000 %change change otal 100 100 100 100 100 100 88 `IS 73.0 60.1 60.3 54.7 54.8 53.1 65.6 -7.0 Ukraine 5.5 7.6 5.7 3.4 3.5 3.9 -3.6 -3.7 Russia 65.2 50.7 53.2 49.6 49.3 47.0 73.9 -3.7 Others ofCIS 2.3 1.8 1.5 1.7 2.1 2.1 126.6 0 4 .ow 27.0 39.9 39.1 45.3 45.2 46.9 120.6 7.0 EU- 15 6.8 9.4 11.0 18.0 22.9 24.0 378 4 14.6 Germany 2.8 3.2 3.2 4.3 4.2 3.7 117.0 0.5 Great Britain 0.5 1.3 3.0 6.2 9.4 8.3 1096.7 7.0 Italy 1.0 1.o 1.1 1.6 1.4 1.0 88.0 0.0 New member 0.0 0.0 0.0 0.0 0.0 0.0 0.0 0.0 countries - 10 9.0 18.6 17.3 15.5 12.9 12.7 28.2 -5.9 Latvia 2.4 6.4 6.6 6.5 3.5 2.4 -30.2 -4.0 Lithuania 2.2 4.8 3.7 3.2 2.7 2.6 2.2 -2.2 Poland 2.6 3.8 3.3 3.4 4.4 5.3 163.3 1.5 China 1.4 1.9 1.9 2.7 1.6 2.2 121.3 0.3 USA 1.5 1.4 1.0 1.1 1.0 1.2 64.0 -0.2 Brazil 0.8 , 0.9 1.0 1.1 1.1 1.1 122.2 0.2 Table 4.4: GeographicalStructureof MerchandiseImports, 1998-2004 (YO) 1998 2000 2001 2002 2003 2004 200412000 2004-2000 % change change Total 100 100 100 100 100 100 92.5 CIS 65.0 70.8 70.0 69.2 69.3 12.2 96.3 1.4 Ukraine 8.7 4.0 3.3 3.2 3.1 3.3 60.0 -0.7 Russia 54.6 65.3 65.6 65.1 65.4 68.2 100.8 2.8 Others o f CIS 1.7 1.5 1.o 0.9 0.7 0.7 -5.2 -0.7 ROW 35.0 29.2 30.0 30.8 30.7 27.8 83.3 -1.4 EU- 15 17.5 15.2 15.3 16.3 15.4 13.7 73.8 -1.5 Germany 8.9 6.9 7.3 7.6 7.1 6.6 84.0 -0.3 Great Britain 1.4 1.3 0.7 0.7 0.7 0.8 20.7 -0.5 Italy 2.1 1.9 2.0 2.4 2.5 1.8 84.8 -0.1 New member counhies 10- 8.8 6.3 5.7 5.5 6.4 6.1 86.5 -0.2 Latvia 0.7 0.3 0.4 0.4 0.4 0.5 186.2 0.2 Lithuania 2.4 0.8 1.3 1.2 1.3 1.1 154.5 0.3 Poland 3.3 2.5 2.4 2.4 3.0 2.9 120.1 0.4 China 0.5 0.6 0.5 0.5 0.6 1.0 233.5 0.4 USA 1.5 1.6 1.6 1.1 1.3 1.2 41.0 -0.4 Brazil 0.6 0.5 0.7 1.1 0.8 0.6 129.2 0.1 Source: World Bank staff calculations basedon MSA andWITS/COMTRADE data. 4.14 Overall, given its location, the importance o f the EU as Belarus' trade partner remains very moderate and trade with the EU i s significantly lower, not only compared to new EU members, but also compared to other European CIS countries. In 2001, the ratios o f actual to projected volumes of trade with the EU("realization ratios") were 1.4 for Moldova, 1.1for the Russian Federation, 1.O for Ukraine, but only 0.6 for Belarus.59 Although trade restrictions from both sides contributed to this outcome, the major cause i s related to the slow pace o f the restructuringo f the Belarusianeconomy. 4.15 Since 2000, the impactof movementsinrealexchangerateson Belarusiantrade is the opposite of what might be expected. A sharp BYRdepreciation v i s - h i s the currencies o f major tradingpartnersin 1997- 98, as anticipated, ledto animprovement inthe trade balance. However, since end-2000, bilateralrealBYRRUR 59Freinkman, Polyakov, andRevenco(2004). 104 and BYR/US$ exchange rates have been moving inopposite directions and their impact has become diffaent &om what mightbe expected.Bythe endo f 2004, as compared to 2000, the BYRappreciated inrealtermsvis-a- vis the U S dollar by 23.4 p.p. Duringthis period, the balance o f trade withnon-CIS countries not only remained positive, but the surplus increased dramatically (eom US$133 million to US$2,375 million). At the same time, the BYRdepreciated (mostly in2003-04) by 10.3 p.p.vis-a-vis the RUR.However, the balance o ftrade withthe CIS didnot improvebut deteriorated substantially (&om US$1,017 million to US$4,441 million), which also led to the overall worsening o fthe trade balance (Figure 4.4a). Figure 4.4a: Trade Balanceby Export Markets (US$ million)and BilateralReal ExchangeRates Indices (1996=100), 1996-2004 Dec-96 Dec-97 Dee-98 DSE-99 Dee-00 Da-01 Dcc-02 D e c a l Des44 t 120 !:: 1400 1 loo 200 i -1000 -2200 -3400 - 20 -4600 l o 1996 1997 1998 1999 2000 2001 2002 2003 2004 Source: World Bank staff calculations based on IMF,NBB, and WITSKOMTRADE da 4.16 However, the above discrepancy between trade and real exchange movements could be partially explained if one looks at trade aggregates that exclude trade in energy resources.6oBelarusian trade in energy i s somewhat less sensitive to real exchange rate movements. Figure 4.4b reveals that, as expected, real BYR appreciation vis-&vis the U S dollar in2000-04 has been associated with the deterioration inthe balance o f non-energy trade with non-CIS countries: the deficit widened from US$523 million in 2000 to US$1,297 million in 2004. However, the impact o f real BYR depreciation v i s - h i s the RUR on trade with Russia was less straightforward: the 2002 surplus o f U S 1 6 5 million increased only marginally in 2003, but it suddenly turned into a deficit o f US$488 million in 2004. There are three possible explanations for such an unexpected outcome. First, it might be an indication o f the lower sensitivity o f Belarus' trade with the CIS to market signals, as well as a higher importance o f other factors. Second, this could be a one-off effect related to the changes in the principle o f VAT taxation in trade with Russia (from origin to destination) from January 1, 2005. In anticipation o f this change, imports from Russia in the fourth quarter of 2004 rocketedby two-thirds, as compared to the corresponding period in2003, while exports increased by less than 30 percent. This resulted in a trade deficit that was almost 2.5 times higher than in the fourth quarter o f 2003.61Third, it i s still possible that the growth in the deficit o f non-energy trade with Russia despite the depreciation o f the Belarusian currency may signal deterioration in the competitiveness of Belarusian exporters. Stronger evidence that this indeed may be occurring is presented inChapter 2 onthe basis o fa comparative analysis ofunitlabor costs inindustry.Futuredevelopments in this area will have to be monitored closely. 6o Energy resources are H S 2709, 2710,271 1. 6'Here we are talking about total imports from and exports to Russia due to the inability to deduct energy trade from total trade on a quarterly basis. 105 Figure 4.4b: Trade BalanceNet of EnergyResourcesby Export Markets (US$ million)and BilateralRealExchangeRatesIndices (1996=100), 1996-2004 ZMO I20 7 / 100 1400 .... ................... ...................... \... 80 200 w 40 .I000 20 -2200 a Source: WorldBank staffcalculationsbased on IMF, NBB, andWITS/COMTW DE data. 4.17 BelarushasbenefitedfromtheimprovementsinitsTermsofTrade (TOT)since 2000. Fluctuations inTOThavebeendrivenlargelybythepricedynamics for gas, oilandoilrefineryproducts. As is shownlater in this chapter, Belarus' imports are dominated by energy resources, so that average import unit values are largely affected by the dynamics o f energy (first o f all, oil and gas) prices. At the same time, Belarus is able to compensate for an increase inthe prices o f importedoil by increasing the export values o frefinery products. Net changes in TOT then depend on movements in relative prices for crude oil and refinery products. Figure 4.5 shows that export and import unit values in Belarus have been strongly correlated and also illustrates a fairly significant average improvement inTOT in2001-04 relative to the earlier period. As compared to 1997, in2004 TOT were more favorable for Belarus by 7 p.p.TOT improvements were even more significant, by 10 p.p., relative to a bottom point o f 2000, when a hike in crude oil prices was well in excess o f the respective adjustmentsinthe prices o frefineryproducts. Figure 4.5: Terms of Trade Index, 1997-2004 4 .................................................................................................. ~ I( ............................................................................ ,I \. 44 <2 /* A *\ &* ............. -----I ........................... export unit value index 0.1 .............................................. -.I-impow ......................... -fnms.af-tr.ade index 0.5 4 1997 1998 1999 2000 2001 2002 2003 2004 Source: WorldBankstaff estimatesbasedonMSA andNBB data. 106 4.18 ImprovementsinTOT, while not explainingthe overall growth dynamicsinBelarus,clearly provided essential income and growth support to the economy in the recent past. That is, the combined export and import price dynamics has been favorable for growth in Belarus. This i s an important finding, because the traditional analysis o f developments in Belarusian trade tends to be too closely focused on the negative trends associated with growth inthe importprices o f gas and other energy sources, while the positive effect o f export price dynamics remains unappreciated. 4.19 The impact of the price factor on overall export growth has been significant, especially in 2000 and 2003-04. Figure 4.6 presents a decomposition o f growth inexport and import volumes into the contribution o f price and non-price factors. It i s interesting to note that the largest contribution o f the non- price factor (an increase inphysical volumes) to both export and import growth was observed in 1997 - the year o f the highest economic growth inBelarus. This was due to a sharp increase in export volumes to Russia, driven by an increase indemand due to the initial recovery o f the economy, the acceleration o f the Belarus-Russia integration process, and relative price changes. In general, all growth o f exports during 1997-99 was due to the increase in the physical volumes o f trade, which was highenough to compensate emerged -- a contribution o f the non-price factor has been positive in each year and growing, while the for the adverse effects o f the price factor. Figure 4.6 also suggests that since 2001 a different pattern has contribution o f the price factor has been growing at an even higher rate (although from the negative value in2001). As aresult, for the entire period2001-04the contributions o fbothprice andnon-pricefactors to export growth were positive and significant, with the non-price factor being responsible for almost two- thirds (63 percent) o ftotal export growth andthe rest being attributedto price effects. Figure 4.6: Price and Non-price Factors of Growth inExports and Imports, 1997-2004 (YO) Factorsof imports growth Factorsof exports growth 45 Non-pricefactor 35 40 Price factor 25 15 5 -5 U -25 20 ' 1997 1998 1999 2000 2001 2002 2003 2004 1997 1998 1999 2000 2001 2002 2003 2004 Source: World Bankstaff estimatesbasedonMSA andNBB data. 4.20 The commodity structure of trade was relatively stable and was mostly affected by the increaseinthe share of mineral products. Onthe exports side, other notable changes inthe commodity structure included the decline in the share o f vehicles, textiles and apparel (Table 4.5). On the imports side, the share o f oil and oil products, and machinery and equipment increased and the share o f agriculturalproducts and chemicals fell (Table 4.6). 107 Table4.5: Commodity Structure ofMerchandiseExportsin 1998-2004 (YO) - H S 1998 2000 2001 2002 2003 2004 !004 / 2000 2004-2000 code % change change Total 100 100 100 100 100 100 87.6 Agricultural produce 01-15 4.8 3.7 4.7 3.8 4.5 4.7 -97.6 1.o Food 16-24 3.9 3.2 3.4 4.0 3.8 3.8 121.1 0.6 Mineral products 25-27 8.4 20.2 18.2 20.8 22.6 27.4 154.7 7.2 Chemicals 28-38 12.4 11.0 11.4 10.1 9.9 9.2 57.2 -1.8 Wood and pulpikpaper 44-49 3.9 4.3 4.2 4.2 4.4 4.1 81.5 -0.1 Textile and apparel 50-63 11.6 10.6 10.4 9.1 8.4 6.9 22.3 -3.7 Ferrous matls and ferroproducts 72-73 8.1 6.1 6.3 6.4 6.9 7.6 133.4 1.5 Non-ferrous metals 74-83 1.0 1.1 1.3 1.7 1.4 1.1 90.8 0.0 Machinery and equipment 84-85 12.7 10.9 12.0 11.5 11.4 10.3 77.3 -0.6 Vehicles 86-89 15.6 13.1 13.0 11.7 10.8 10.7 53.4 -2.4 other - 1.7.4 15.9 , 15.1 16.6 16.0 14.1 67.0, -1.7 Source: World Bank staffCi xlations basedon WITS/COMTRADEdata. Table 4.6: Commodity Structureof MerchandiseImportsin 1998-2004 (YO) - HS 1998 2000 2001 2002 2003 2004 004 / 2000 2004-2000 code % change change 100 100 100 100 100 100 92.5 Agricultural produce 01-15 5.6 7.5 5.8 4.5 4.3 4.4 12.5 -3.1 Food 16-24 5.8 5.0 7.4 6.5 5.9 5.0 90.8 0.0 Mineralproducts 25-27 24.7 31.2 27.5 26.3 26.9 28.2 74.1 -3.0 Gas 2711 9.6 6.7 7.0 6.2 6.2 6.0 72.2 -0.7 Oil andoil products 709,2710 10.7 21.7 17.8 17.6 18.6 20.9 85.2 -0.8 Chemicals 28-38 9.9 9.5 8.6 7.9 7.5 7.0 41.5 -2.5 Wood andpulp&paper 44-49 2.7 3.2 3.2 3.4 3.1 2.1 60.8 -0.5 Textile and apparel 50-63 4.6 4.3 4.5 4.1 3.9 3.4 49.2 -1.0 Ferrousmatls and ferroproducts 72-73 9.9 8.4 8.3 7.8 9.0 10.3 134.4 1.8 Non-ferrous metals 74-83 2.6 2.9 3.2 3.3 2.9 3.4 121.0 0.4 Machinery and equipment 84-85 16.3 13.3 14.3 14.9 16.1 16.9 145.1 3.6 Vehicles 86-89 6.0 3.4 6.4 4.2 3.1 3.2 79.4 -0.2 lother 11.8 11.3 10.8 17.1 17,3 15.7 168.8 4.5 4.21 In2004, mineralproductsaccountedfor 27.4 percent ofBelarus total exports (and 52.1 percent of exports to non-CIS countries). Other major exports were transport vehicles and machinery (mostly for CIS countries) and chemical products (mostly for non-CIS countries). Together these four sectors accounted for almost 60 percent of total exports. Imports were dominated by mineral products (40.6 percent of imports from Russia and 28.2 percent of total imports), machinery (30.6 percent of non-CIS imports and 12.6 percent of CIS imports), non-ferrous metals (mostly imports from the CIS), and food products. Together these four sectors accounted for 70 percent of Belarus' imports. 4.22 Exportsremain essentially concentrated in products that were traditionally produced and exportedby Belarus prior to independence.At a more disaggregated level, exports are concentrated in 10 commodities, which made up over 50 percent of the total exports in 2004. The major item was oil products which account for almost a quarter of total exports. Oil products were exported mainly to non- CIS markets. Exports o f oil products to the UnitedKingdom alone comprised about 8 percent of total 108 Belarus exports. Other important exports were potassium fertilizers (5.5 percent), ferrous metals (4.6 percent), trucks (3.9 percent), tractors (2.5 percent), and refrigerators (2.3 percent). 4.23 Belarus was able to respond to an increasing market demand for refinery products and to benefit from their growing prices by not just preserving the capacity inherited from the USSR in the refinery sector (two large oil-processing plants, the Mozyr Refinery Plant inthe south and "Naftan" in the north- west) but also by heavily investing intheir upgrade and modernization. Naftan was corporatized in 2002, but the state continues to be its major shareholder (a meager portion of shares was sold to the employees and managers o f the company). The Mozyr Refinery Plant was corporatized in the early years o f independence and became part o f the large vertically integrated oil company "Slavneft"62 in 1994. Slavneft took an active part in the reconsb-uction o f the Mozyr Refinery by directly investing in it, providing credit guarantees, and ensuring the guaranteed delivery of crude oil to the refinery (not less than 3.5 million tons a year). At the same time, modernization of the sector in general (and especially o f "Naftan") has been undertaken primarily with domestic investments. 4.24 The imports structurewas also relatively stable after 2000 (Table 4.6). Increasesinthe shares o f imports o f ferrous products and machinery and equipment and declines inthe shares o f chemicals and mineral products represent the major recent changes inthe import structure. Mineral products continue to represent the major category, accounting for 28 percent o f total imports in 2004, out o f which 21 percent i s the share o f oil and oil products. Machinery and equipment i s the second largest category o f imports (17 percent). The agro-food sector imports made up almost 10 percent, slightly below the share o f ferrous metals. At a more disaggregated level, in2004 imports o f 10 commodity groups accounted for 37 percent of total imports. Oil and condensed and natural gas alone comprised 20 percent. Other important items were iron and steel (7.1 percent) and passenger cars (2 percent). 4.25 An analysis by Broad Economic Categories (BEC) provides additional insights into the structure and trends of Belarus' merchandise trade. First, both exports and imports are extremely concentrated and have recently exhibited a clear tendency toward even greater concentration. Thus, according to BEC, Belarus' major export categories are industrial suppliers, processed (22); motor spirit, processed (321); and capital goods, except for transport equipment (41). Together these three categories accounted for 63.5 percent o f total exports in 2004 as compared to 50.8 percent in 1998. Major import categories are industrial suppliers, processed (22); fuels and lubricants, primary (3 1); and capital goods, except for transport equipment (41). Together these three categories accounted for 70.4 percent o f total imports in2004 as compared to 60.3 percent in 1998. 4.26 Second, further consolidation o f the BEC data into the three basic SNA classes63and comparison with neighboring countries (Figures 4.7 and 4.8) reveals a strong bias toward trade inintermediategoods inBelarus. Thisbias is especially pronouncedon the import side. Belarus has a much smaller share (than Poland, Lithuania and Russia) o f capital goods and especially o f consumer goods. Although, consumer goods imports in 2004 almost doubled compared to 2000, their relative importance in total imports increased only marginally (by 0.4 p.p.). Consumer goods imports remained much lower than expected given the per capita income level o f Belarus. Two reasons for this may be: non-tariff restrictions on 62 The joint stock company "Slavneft" was created in 1994 by the joint decision o f the governments o f Russia and Belarus. Slavneft embraces several operating units in both countries that are involved in oil extraction, processing, sale, and geological exploration. In2002, the governments o f Russia and Belarus sold their shares in Slavneft and Slavneft became an entirely private company. 63 See Annex 4.2 for an explanation o f the classes. Since 2002, the M S A has produced its own estimates for both merchandise exports and imports by the end-use categories, which approximate the same three SNA expenditure classes, Since the MSA series were too short, our analysis here i s based on the WITS/COMTRADE data, which are available from 1998. 109 consumer imports and non-accounted consumer imports. An additional discussion o f both these factors i s provided inthe trade regime section below. Figure 4.7: MerchandiseExportsand Imports by End-Use Categories, 1998-2004 (percent) Exports Imports 100% 0Goodsnes 0Goodsnes 80% 0Capitalgoods 0Capitalgoods 60% Intennediat Intennediat 40% goods goods b l Consumption 20% IConsumption goods goods 0% 1998 1999 2000 2001 2002 2003 2004 1998 1999 2000 2001 2002 2003 2004 Source: World Banks staff calculations based on WITS/COMTRADE data. 4.27 The shares of bothcapital-intensive and skilled labor-intensive productsinBelarus exportswere higher on average than in neighboring countries.64However, as compared to 1998, the share o f these two categoriesdeclined while the relative importance o fnaturalresourcesandunskilled labor exports increased. This indicates deterioration inthe export structure. At the same time, new EUmembers (EU-8)exhibited an opposite trend namely, an increaseinthe relative importance of labor-intensive and capital-intensive exports, which are generatedby the sectorswith greater growth potential andhigher wages. Reliance on relatively low value-added exports constrains the possibilities for the economy to generate new jobs, thus holding up both productivity growth andanincreaseinthe standardo fliving. Exports lmpons IM'O 100 , 90% 90' B O D O 8009 '0'" 70' 60'0 0 Goo& nes 60' c CGoodsncjI 50% 0 CapitalGoods 0Capital Goods 4000 8 lnurmediaugoods 8 Intermedlaragoods 3000 E4 Consumpdongoods 3o09 17Consumpwngoods 20. 3 1 0 0 0 lo:$ 100, 1I 1 3 1 no. Belarus Ukraine Lithuania Poland Russia Y , " , Belarus'Ukraine Lithuania'Poland'Russia 1 I / ~ Note: *The latest year available: 2004 for Belarus; 2003 for Lithuania, Poland and Russia; 2002 for Ukraine. Source: World Bank staff calculations based on WITS/COMTRADE data. 64World Bank (2005a). 110 4.28 At the same time, owing to the growing role of oil processing, the factor content o f Belarus' imports has been shifting toward more natural resource-intensive goods. This differs substantially from the factor intensity o f Polish and Lithuanianimports (Figures 4.9 and 4.10). Figure4.9: FactorIntensityof Exports:DynamicsandComparisonwithNeighboringCountries, 1998-201 *cent) Belarus: Factor Intencity ofexports in 1998 and 2003 Factor Intencity ofexports ofselected countries, 2003 I,< 1 7" 100% 33.9 S a d Labor 80% 0 Sk&d Labor 60% 40% 20% I . 1995 2003 0% Belarus Russia Ukraine Lithuania Poland Source: World Bank(200%). Figure4.10: FactorIntensityofImports:Dynamicsand ComparisonwithNeighboringCountries, mrcent) Belarus: Factor Intencity of imports in 1998 and2003 Factor Intencity of imports of selectedcountries,2003 50 100% 45 90% 40 NaturalResource 50% UnslonedLabor 35 70% S a dLabor 30 01 CapitalIntensive 60% 25 50% CapitalIntensive 20 B I Skined Labor 40% 15 30% Natural 10 F3 UnskilledLabor 20% Resource 5 IC% 0% I 0 B e h s Russia Ukraine Lahuania P o h d I 1 QQR .__" 2003 -... 1I1 Source: World Bank (2005a). B. EXPORT CONCENTRATIONAND SPECIALIZATION, TRADE COMPLEMENTARITY AND INTRA-INDUSTRY TRADE 4.29 Dependenceon one or only few exports HighExport Concentration-renders an economy - vulnerable to external shocks, including those caused by drastic movements inTOT. At the same time, specialization i s often associated with economies o f scale and hence with higher productivity. Lederman and Maloney (2003) examined empirical relationships between trade structure and economic growth and found, in particular, that export concentration hampers growth (even after one controls for physical and human capital accumulation) while specialization associated with expansion in intra-industry trade has a positive effect on growth. 4.30 Belarus' exports remain highly concentrated, but different markets present somewhat different concentration trends. Table 4.7 and Tables A4.9 and A4.10 in Annex 4.1 present different indicators o f 111 export con~entration~~for Belarus with a breakdown by export markets. The data suggest several trends. Exports are becoming more concentrated from the point o f view o f the number o f companies involved. In 2003, the 20 largest exporters contributed to 46 and 80 percent o f CIS and non-CIS exports, respectively. This undermines Belarus' potential for future export expansion. Country studies o f earlier successful export expansions indeveloping countries show that expcjrt booms have usually involved many new firms breaking into foreign markets. It was fairly common for more than half o f total export growth during periods o f export booms to come from new exporters. If a country i s supporting an export boom, then either a higher share o f existing firms must become exporters or new firms must be created or both (Roberts and Tybout, 1997). 4.3 1 At the same time, other conventional measures o fexport concentration exhibit different dynamics in different export markets. Thus, during 2001-03 exports to the CIS became less concentrated, while exports to non-CIS countries were more concentrated. The non-CIS market i s more sophisticated and has higher certification and standardization requirements. The data suggest that the penetration o f this market with new products is becoming increasingly difficult for Belarusian producers who in many ways are detached from new technologies and marketing techniques because the transfer o f technologies and skills i s normally associated with FDI. Table 4.7: Indices 'Export Concentrationfor 1 darus, 2001-03 1 2001 2002 2003 2001 2002 2003 Indicesof export concentration Belarus-CIS Belarus-non-CIS Export diversification index 0.496 0.465 0.459 0.714 0.718 0.737 Hirschman index 0.142 0.140 0.140 0.387 0.418 0.447 Share of 5 largest exporters intotal exports, 9'0 15.2 16.0 19.6 40.7 41.6 42.7 Share of 10largestexportersintotal exports, 9'0 24.1 25.1 26.6 57.7 55.4 57.6 Share of20 largestexportersintotal exports, % 45.1 44.6 46.1 79.3 78.4 80.7 Numberofcommoditypositions for wich export exceeds $US 5 m* 122 121 128 59 61 64 Numberofcommoditypositions for wich export exceeds $US 10m* 91 93 105 37 39 45 * According to the 3-digit SITC classifical n. Source: MSA and World Bank staff calculations based on WITS/COMTRADE data. 4.32 Table 4.8 compares Belarus' export concentration with that o f Lithuania, Poland and Ukraine.66 As all three indicators suggest, Belarus' exports are more concentrated than those o f Poland and Ukraine. Such a result could be expected: smaller countries tend to have more concentrated exports than larger ones. 65 The exports diversification index (DX) is defined as DX=sum ([hJ-hJw])/2,where hi is the share of commodity i in total Belarus exports and hi, is the share ofthe same commodity inworld exports (DXvalues are normalized to be in product i andxj i s country j's total exports (4values are normalized to be ina range from zero to unity, with higher range from zero to unity).The hirschman index i s defined as H,=sqrt [sum (~,/xj)~] xi i s countryj's exports of where numbers corresponding to greater concentration). The number of commodity positions, for whch annual exports exceed a certain amount (we took US$5 million and US$lO million) is defined using the 3-digit SITC breakdown. 66 I t should be noted that in Table 4.8 we computed the concentration indices for Belarus' total exports without a breakdown by export markets. 112 4.33 A comparison with Lithuania, which is smaller than Belarus in terms o f both population and economic size, provides an additional insight.While in 1998 Lithuania's exports were more concentrated than those o f Belarus, much o f the difference had eroded by 2003. In short, even allowing for the differences inthe sizes o f the economies, Belarusian exports are overly concentrated and the recent trends toward additional concentration appear to be rather disturbing. Export Specialization. 4.34 To access the country's export potential, various indices o f revealed comparative advantages (RCA) are used (see Table 4.11 in Annex 4.1). One commonly employed RCA index is the so-called "Balassa measure," which compares a product's share in the country's exports to its share in world e~ports.~'When the index i s calculated for specific markets or partners, it i s often called the Export Specialization Index (ESI). We estimated the ESIs for Belarus in relation to different markets (world, CIS, non-CIS, Russian Federation, EU-15, and EU-1068) and at different levels o f aggregation (2-digit and 3-digit Standard International Trade Classification (SITC)). The results o f the calculations are presented inAnnex 4.1 (Tables A4.12-A4.15). Table 4.8: Export Concentration Indicators: Belarus,Lithuania, Ukraine and Poland, 1998-2003 1998 2000 2002 2003 Belarus Number of commoditypositions* for which export exceeds $ 5 million 149 142 139 147 Number of commoditypositions* for which export exceeds $ 10million 115 108 116 125 HirschmannIndex ** 0.218 0.262 0.260 0.268 Diversification Index DX* 0.504 0.551 0.549 0.544 Lithuania Number of commoditypositions* for which export exceeds $ 10 million 70 69 84 97 HirschmannIndex ** 0.243 0.270 0.252 0.255 Diversification Index DX* 0.532 0.560 0.549 0.551 Ukraine Number of commoditypositions* for which export exceeds $ 10million 150 142 152 HirschmannIndex ** 0.142 0.144 0.114 Diversification Index DX* 0.257 0.257 0.257 Poland Numberof commoditypositions* for which export exceeds $ I O million 177 175 175 HirschmannIndex ** 0.046 0.047 0.048 Diversification Index DX* 0.185 0.187 0.186 ** For *According to the 3-digit SITC classification. 65 items exported, according to the 2-digit SITC classification. Source: World Bank staff calculations based on WITSKOMTRADE data. 4.35 Inboth markets, Belarus exhibits strong exports specialization (ESP2) in petroleum products, manufactured fertilizers, wood and wood products, textile fiber, irodsteel wires and bars, and optical instruments (SITC Code 871). At the same time, export specialization patterns differ from market to market. Thus, in the CIS market, Belarus exhibits strong export specialization (ESP2) in a number o f 67 The index for country i goodj is RCA, = (Xi,/X,,)/(& lX,,), where w-world and etotal for all goods. RCA does not determine the true comparative advantages, but simply compares the composition o f the exports o f one count~y to a certain market with the composition o f total exports that are absorbed by this market. New EUmembers from May 1,2004. 113 agricultural and food products (meat, dairy products, eggs, cereal flour, sugar confectionery), as well as in tractors, transport vehicles (782 and 786), which i s not the case with the EUmarket. 4.36 Table 4.9 shows the number o f product groups (at the 2-digit SITC) inwhich B e l m s demonstrates a strong export specialization. Globally, the number o f such groups with ESP2 i s modest, andit declined &om 12 to 9 inthe same period. The numberinthe CIS market increasedsomewhat during 1998-2003. As for the EU-15 market, after an increase in2000-01, the number o f such groups has been falling. This i s another indication o f growing export concentration inthe non-CIS market. Itis interestingto note, that Ukraine hasrecently beenmore successfulindiversifyingitstrade withthe EUthanwiththe CIS.69 Table 4.9: Export Specializationby Export Market: Number of Product Groupswith a Strong RCA ()2)* 1998 2000 2001 2002 2003 World 12 10 10 10 9 CIS 9 9 10 9 11 EU-15 12 13 13 9 7 Note: *According to the 2-digit SITC classification out o f 64 positions. Source: World Bank staff estimates. Complementarityof Trade 4.37 The Trade ComplementarityIndex'' measuresthe degreeto which the import structure o f atrade partner matches the export structure o f the country in question and thus provides usefbl information on country trade prospects. We computed trade complementarity indices for Belarus' trade with the EU-15, with the CIS and separatelywithRussia. Figure4.11shows the dynamics o fthese trade complementarity indices computed at a 3- digitSITC level (denoted as TC-EU-15, TC-CIS andTC-Russia, respectively). In1998Belarushadthe hghest degree o f trade complementarity with the EU-15, followed by the CIS and Russia. Trade complementarity indices for both the CIS and Russia fell during 1998-2000 but beganto pick up fiom 2001. By end-2003 they exceeded the 1998 levels by 2.9 p.p. (CIS) and 5.8 p.p.(Russia). At the same time, the trade complementarity index for the EU-15 declined in 1998-2003. These developments led to a considerable convergence in trade complementarity indices for all three markets byend-2003. Figure4.11:Trade ComplementarityIndicesfor Belarus, 1998-2003 lal1.....e ISJ .................................................................... l - - - - L ...................................................... 4s ........................................ ........._.......... A m..... ............................................ 4-TC-EUI5 1- ...... - C T C - C I S 25 ..................................................................... -4-TC Russia 1998 1999 2000 2001 2002 2w3 Source: World Bank staff calculations based on WITS/COMTRADE data. 69 World Bank (2004~). 70 The index of Trade Complementarity between countries k andj is defined as TCu=lOO-sum ([mik-xy]/2), where xu i s the share o f good i of countryj global exports, and mik i s the share of good i in all imports o f countryj. The index i s zero when no goods are exported by one country or imported by the other and 100 when the export and import shares exactly match. 114 4.38 The high value o f TC-EU15 for Belarus, on the one hand, could be interpreted as an indication o f the export potential o f the EU-15 market that i s yet to be utilized by Belarusianc~mpanies.'~ Onthe other hand, this estimate i s somehow biased upward owing to an exceptionally highshare o f exports o f refinery products to the EU.Inmarket conditions for oil and oil products were to change, Belarus' perspectives in the EUmarket would deteriorate considerably, unless substantial product diversification was undertaken. Intra-industryTrade 4.39 Itis generally believedthat intra-industry trade (IIT) has a positive effect on growth, although less unanimity exists in the interpretation o f this effect.'* The most widely used indicator o f IIT i s the Grubel- Lloyd (G-L) index.73 Annex 4.1 displays the results o f calculations o f G-L indices for Belarus (for total trade, and trade with the CIS, ROW and EU) at the 3-digit SITC data for the period 1998-2003. 4.40 A comparison o fthe dynamics o f G-Lindices for Belarus with those for Ukraine and Poland(Table 4.10) reveals that the G-L index for total trade in Belarus i s rather highbut has declined somewhat since 1998. In2003 the IIT intensity inPolandexceeded that inBelarus, while the opposite was the case in 1998. T h i s indicates that Belarus underutilizes potential benefits from international trade. Moreover, the high value o f the index i s due to the highintensity o f IITwith the CIS countries (and their dominance inBelarus' external trade). This is a reflection o f the fact that Belams preservedits economic and production links from the Soviet era. The level of IIT with the countries outside o f the CIS, while growing, still remains rather low. Table 4.10: Grubel-LloydIndicesfor Belarus,UkraineandPoland, 1998-2004 1998 1999 2000 2001 2002 2003 2004 2002-1998 Belarus ** Total trade 54.3 48.1 48.2 50.3 51.4 48.9 47.4 -2.9 CIS 53.3 49.1 48.3 48.8 50.1 51.2 50.1 -3.3 ROW 23.0 22.8 24.3 24.7 27.1 25.0 24.3 4.1 o/w: EU15 14.5 17.0 19.0 18.2 18.1 17.6 16.6 3.7 Ukraine* Total trade 34.5 35.6 37.9 40.1 38.4 3.9 CIS 52.9 54.5 52.4 55.7 53.9 1.o ROW 30.5 31.8 34.9 36.7 35.6 5.1 O/W: EU15 20 19.9 21.8 23.6 22.5 ---- 2.5 Poland* Total trade 48.4 50.5 55.5 55.8 57.5 9.1 CIS 17.7 21.8 19.7 17 16.7 -1.0 ROW 49.4 50.8 56.4 56.4 58.2 8.8 O/W: EU15 44.1 47.7 52.5 52.7 54.6 ---- 10.5 Note: * **The index i s calculated for merchandise trade only (groups 5-8 excluding 68), using the SITC revision 2. The index is calculated for merchandisetrade only (groups 5-8 excluding 68), usingthe SITC revision 3. Source: World Bank staff calculations based on WITS/COMTRADE data. "Itisworthnotingthat as of2002Belarus' trade complementarity withboththe EC-15andthe CIS was higher than inUkraine, which indicates a considerable potential for future export expansion inBelarus. 72 There i s no clarity as to whether the positive impact i s via increased productivity (as the conventional literature suggests) or whether it is because the countries with greater IIT also tend to be more diversified (see Krugman, 1979, Lederman and Maloney, 2003. 73The G-L index, I = [(Z, (X,+MJ- C, Ix,- M, I) /C, (X,+M,)]*lOO, where X, and M, are, respectively, exports and imports insector i (Grubel and Lloyd, 1975). The higher the index, the larger the portion o f intra-industry trade. The index ranges from 0, meaning complete lack o f intra-industry trade, to 100, indicating a fully integrated manufacturing trade. 115 4.41 International experience suggests that growth in IIT i s strongly linked to FDIinflows, so that the underdevelopment o f such trade with the EUin Belarus i s largely a consequence o f the failure to attract sizable FDI from that region. Most empirical studies o f foreign investments and trade uncover a complementary relationship between them, which suggests that the effects o f FDIon trade are dominated by production linkages and spillover. This is because FDI supports information dissemination between countries, provides a new conduit for managerial and personal informational flows, and thus helps reduce transaction costs for the countries inquestion (Swenson, 1999). Ireland. 0.7 omanBelarus Slomk Republic 0.5 I Kuwait 4 AThailand .. .- + ~ .I..I. 0.4 .*** .Sweden 0.3 0.2 FDilGDP ratio av.1995-2002 Source:WDI. 4.43 InBelarus' trade with the CIS, the following commodity groups made the largest contributionto the G-L index (calculated at %-digitSITC data): textile yardfabric (65), metal manufactures (69), industry special machines (72), industrial equipment (74), electrical equipment (77), and road vehicles (78). Together these 6 (out of 65) commodity groups accounted for 51.4percent of the G-L value for trade with the CIS in2003. 4.44 The IIT with the EU-15 i s more concentrated than that with the CIS. In 2003 the largest contributors to the G-L for this market were textile yardfabric (65), iron and steel (67), metal 74The data cover average levels o fboth exports and FDIfor 1995-2002 for 60 middle income and high income countries. The sample includes all the countries from the WBI database, with population above 2 million and average nominal GDP per capita above US$1,500 during this period. 116 manufactures (69), and footwear (85). These four commodity groups accounted for almost 60 percent o f the G-L value intrade with the EU-15 in2003. c. TRADEWITHRUSSIA:TRENDS, ROLEOFPOLITICAL FACTORS,KS R I S 75 4.45 The integration process with Russia has been important for Belarus in two fundamental ways. First, Russia provided direct demand support for traditional Belarusian exports, including labor-intensive items in the machinery and equipment sector (trucks, tractors, television sets, etc.). Second, the integration process was a primary driver for recent policy adjustments, including several major reform steps, such as the unification o f the exchange rate and the phasing out o f direct NBB financing of the budget deficit. At the same time, a geographically concentrated export strategy that targets only one country poses significant risks. Trade Makeup 4.46 As shown above, Russia is by far the largest trade partner for Belarus, and accounts for half of Belarus' total exports and two-thirds o f its imports. The share o f Belarus' exports to Russia decreased from 54.5 percent in 1999 to 47.0 percent in 2004, which gives the impression that Belarus has been diversifying its exports to the rest o f the world. However, if we take out energy products (HS 27) from Belarus exports, the share o f exports to Russia has actually increased from 59.0 to 60.9 percent. Therefore, this apparent diversification was actually no more than the effect o f higher energy prices and some growth in the export volumes o f oil products. Imports from Russia to Belarus inUS. dollar terms have increased by 62 percent, reflecting price increases for the oil and raw commodities that form the base o f Russian exports. 4.47 The trade with Russia has important features that distinguished it from Belarus' trade with rest o f the world. First o f all, it has completely different commodity structures. On the export side, Belarus' comparative advantage in the Russian market i s different from that in other markets, as i s ascertained by the respective export specialization indices (see Annex 4.1 for export specialization indices for Belarus in different markets). Therefore, Belarus' export position appears dichotomous -- goods exported to Russia have difficulty in finding their niche elsewhere else. 4.48 The fhctioning o f the entire Belarus economy is highly dependent on trade with Russia. On the export side, Russia offers the market for a large share o f many Belarus products (see Table 2.3 inChapter 2). However, there have been signs inrecent years o f increasing competitive pressures major Belarus exports are facing in the Russian market, as can be seen in their declining market shares in total Russian consumption (Table 4.11). For example, the shares o f Belarus-made TV sets in Russian visual consumption declined from 39.4 percent to 9.4 percent between 1999 and 2002. Inthe same period trucks declined from 6.2 percent to 4.9 percent, and tractors from 51.0 percent to 46.1 percent. The ratio of exports o f shoes to Russian domestic production went down from 31.8 percent in 1998 to 11.3 percent in 2003. 75This section draws on the background paper byTomashevich andElsukov (2004). 117 Table 4.11: SharesofBelarusExportsto RussiainRussianVisual Consumption andProduction, 1998-2003(percent) 1998 1999 2000 2001 2002 2003 Belarus exports 10,296 10,981 8,852 10,988 8,43 1 8,681 Russianproduction 141,000 176,000 184,000 173,000 173,000 194,000 Russian visual consumption d a 178,400 190,300 182,300 172,600 d a Ratio o f exports (%): over production 7.3 6.2 4.8 6.3 4.9 4.5 over consumption d a 6.2 4.6 6.0 4.9 d a (w/ tractor trailers) (units) Belarus exports 9,693 13,762 12,657 15,349 15,155 16,204 Russianproduction 9,800 15,400 19,200 14,200 9,200 8,000 Russianvisual consumption d a 27,000 32,300 33,700 32,900 d a Ratio of exports (%): over production 98.9 89.4 65.9 108.1 164.7 202.6 over consumption 1 n/a I 51.0 39.2 45.5 46.1 d a TV sets, video displays, video projectors (000) Belarus exports 194.5 303.3 365.3 477.4 451.9 534.0 Russian production 329 281 1,116 1,022 1,980 2,336 Russian retail sales d a Russian visual consumption 2,812 2,205 2,679 3,162 3,810, d a 7,689 1,695.9 2,649.2 4,801.2 d a Ratio of exports (%): over production 59.1 107.9 32.7 46.7 22.8 22.9 over sales 6.9 13.8 14.7 15.1 11.9 d a over consumption d a 39.4 21.5 18.0 9.4 d a Shoes (mil.pairs) Belarus exports 7.563 7.140 6.237 5.707 5.190 5.062 Russian production 23.8 29.9 32.9 36.7 42.2 44.7 Ratio o f exports over production (%) 31.8 23.9 19.0 15.5 12.3 11.3 Clothing;. textiles (mil.units) Belarus exports 0.588 0.374 0.695 0.643 0.703 0.879 Russianproduction 19.3 21.5 26.3 28.3 27.6 d a Ratio of exports over production (%) 3.05 1.74 2.64 2.27 2.55 d a Source: Rosstat, MSA. Trade-Related ResourceTransfer 4.49 Russia i s the source o f the greater part o f the energy and raw materials consumed by Belarus, which sustain the entire Belarus economy and underpin Belarus' resource-intensive exports to the rest o f the world. In addition, trade with Russia played a vital role in supporting Belarus' economy through an imputed resource transfer associated with this trade. The main channels o f this transfer were the following: 118 0 Discountedprices for imported Russian energy 0 Re-export o f Russian commodities by Belarus at higher prices 0 Non-market arrangements in bilateral trade (such as barter and inter-government agreements on mutual direct deliveries) 0 Unilateral violations by Belarus o f the provisions o f the Russian-Belarus Customs Union. 4.50 A substantial price differential between Russia exports to Belarus and its exports to countries outside o f the CIS point to a massive resource transfer from Russia to Belarus (and, to a lesser extent, to a number o f other CIS countries). Table 4.12 presents (partial) estimates o f resource transfers through the price channel from Russia to Belarus for selected commodities in 1997-2003. These amounts were estimated as the product o f the price differential between Russian exports to Belarus and Russian exports outside o f the CIS (corrected for the transport cost differential) and the export quantity. For oil, the transfer was estimated conservatively, since the differential o fthe transport costs between Belarus and the EUis not entirely clear andvaries according to the mode o ftransport. Table 4.12: ResourceTransfersfrom Russia,by SelectedChannels, 1997-2003 (US$ million) 1997 1998 1999 2000 2001 2002 2003 Import o f Russian crude oil -97.3 -200.9 212.8 285.8 181.1 430.5 398.9 Import o f Russiannatural gas 635.0 564.8 868.2 836.2 787.2 758.5 740.8 Resource transfer to Belarus through barter arrangements in energy trade, mil.USD 30.7 231.6 64.5 80.0 -- -- -- Total 568.5 595.5 1,145.5 1,202.0 968.2 1,217.7 1,139.7 Total, as percent of GDP 4.1 4.1 10.3 9.2 7.9 8.4 6.4 Total, as percent o f GDP at factor cost 4.6 4.5 10.9 11.0 9.0 9.7 7.7 Memo: shares o f barter (%) in Belarus exports to Russia, goods and services 34.3 nia 52.4 44.4 30.2 15.9 7.6 Russian exports to Belarus, goods only 45.7 36.7 38.9 26.7 17.8 8.9 4.1 Source: Tomashevich and Elsukov (2004). 4.5 1 These estimates should be treated as the upper bound, since Russia supplied other CIS countries (Ukraine included) with energy at discounted prices as well, and the low capacity o f Russian transport infrastructure (pipelines, seaports, railways) does not allow transporting all exported oil outside o f the CIS where international oil prices prevail. However, oil prices offered by Russia to other CIS countries were still higher than those offered to Belarus, which basically enjoyed Russian domestic prices. Ifwe take the prices offered by Russia to other CIS countries as the benchmark, the estimates o f resource transfers will be lower (see also Chapter 7). The price o f oil exported from Russia to other CIS countries in some years exceeded the price for Belarus by 25 percent, but it converged by 2003 (Figure 4.13). At the same time, the prices o f natural gas still differed at least twofold betweenBelarus and the CIS average in2003. 119 Figure 4.13: Russian Export Prices o f Oil to Selected Destinations, 1998-2003 (US$ per ton) - 200 - 180 - F\ I \- -o-- 160 ,' I. ...... ............ - - m - . - ... 140 /,;,A ...... ............. 120 / T I' / 100 - 0 .............. 80 60 - 40 III 20 4 4 0 1998 1999 2000 2001 2002 2003 [ -Belarus -*-. CIS wlo Belarus -- Non-CIS Source: Rosstat. 4.52 Nevertheless, Russian export transport capacities have been improving and there i s a clear trend of energy price convergence between the CIS and the rest o f the world. Therefore, the estimates in Table 4.12, as opposed to those in Chapter 7, should be considered as an indication o f the future adjustment costs that Belarus will ultimately face under the assumption that Russia i s able to export all o f its energy at international prices. These costs, while much lower than in 1999, will still be considerable - in excess o f 6 percent o f GDP based on 2003 prices and volumes o f exports.76 4.53 Barterarrangements inRussia-Belarus trade, while substantial inearlieryears, amountto a small share o f trade today. In the earlier years o f transition, however, barter arrangements were critical for maintaining bilateral trade at a highlevel, since the market mechanisms neededtime to hlly develop. Barter arrangements were centered on Russia's deliveries o f gas and electric power, which are highly liquid products. Belarus supplied Russia withmanufactured goods, which were not easily exportable to other markets. 4.54 Inaddition to providing a timely demand outlet, barter arrangements facilitated a resource transfer to Belarus via the multiple exchange rate arrangement inplace inBelarus until2000. The market exchange rate o f the Belarus rube1to the U.S. dollar until2000 was muchhigher thanthe officialrate set bythe NBB(see Chapter 1). At the same time, the official rate was used for determining the values o f barter transactions. The difference between the market and official exchange rates multiplied by the volume o f barter yields the estimates for the value o fthe resourcetransfers obtainedbyBelarus throughthis channel. 4.55 Another channel o fresource transfer fkom Russiawas openedthrough unilateralviolations byBelarus o f the Customs Union provisions. For example, inthe middle and late 1990s Belarusian importers obtained (on a case-by-case basis) the waivers o f import andexcise duties andthenre-exported to Russia without paying duties at the Russian border. Such schemes were especially profitable for excisable goods (e.g., alcohol, vehicles). W l e it is not possible to quantify the overall scale o f such arrangements, it is believed that they were quite widespread for sometime. Suchschemes were abolished, however, following the Russiangovernment's protests. 76A caveat i s inorder: the negative resourcetransfers fromoil imports in 1997-98were virtual rather than real, since oil was paid for inbarter and not in real dollars. 120 4.56 The existing Customs Union appears non-symmetric in terms o f market access. Belarus has been pursuingan aggressive strategy for penetrating the Russian market using its government capacity and exploiting the benefits o f the Customs Union. At the same time, Belarus has the second largest number o f contingency measures on Russian exports to Belarus among all trade partners (after the EU), while the Russian measures against imports from Belarus are limited to sugar (see also Box 4.2). This can be partially explained by a modest share o f imports from Belarus intotal Russian imports. 4.57 Overall, the timingo f these resource transfers from Russia was very beneficialfor Belarus, allowing the country to adjust to the drastically changing terms o f trade and external trade arrangements. The volume o fthis support was unprecedented for the CIS and reflects special political relations that prevailedduringthe time o f President Yeltsyn. Since this support was mostly trade-related (as opposed to direct financial aid), it helped to preserve the level o f Russia-Belarus integration at a higher level then elsewhere in the CIS (see Box 4.1). An important feature i s that this support was not by and large squandered away by corrupt business/political interests, as was the case in many CIS countries; rather it helped to preserve Belarus' production capacities. As a result, at the height o f the output crisis inthe CIS, Belarus was muchbetter able than Russia and any other CIS country to preserve its production capacity in manufacturing and also to significantly expand its share o f the Russian market. For example, Belarus' production o f tractors was 20 percent higher than Russia's in2000 and more than 100 percent higher in2002, while it was slightly over 50 percent of Russia's level in 1990.77After the initial transition shock was over, and especially after the 1998 crisis, Russia generated a substantial demand for traditional manufactured goods familiar to Russian consumers andproducers since the Soviet era, and Belarus was uniquely positioned to meet such a demand. 4.58 Inaddition to trade-related support, whichhas playeda leadingrole, Russia alsoprovidedBelaruswith more conventional forms o f assistance, including preferential loans, debt relief, andFDIfrom the Russianstate- controlledmonopoly Gasprom. The debt reliefcompleted by Russia in 1996 amounted to about US$900 million or 6.3 percent o f the mual GDP. Currently, about 20 percent o f Belarus' overall long-term and medium-term public extemal debt is owed to Russia. Gasprom investments inthe new pipeline capacity, undertakenmostly in 1997-99, exceededUS$ 1.1billion, which was about 45 percent o ftotal FDIinBelarus inthe period 1996-2003. InthepastGaspromalso showedafairly hightolerancefor gaspaymentarrearsbyBelarus. 4.59 One can consider these resource transfers to Belarus, as well as privileged access to Russia's market as the rent derived from special trade and economic relations between the two countries. Another specific feature o f the Belarusianmodel i s reflected inthe fact that a relatively large share o f this rent was redistributed from traders and exporters to the state budget and to public infrastructure investments. Inthe past, two primary channels o f rent redistribution were surrender requirements at the (overvalued) official exchange rate and much higher domestic prices o f gas and other energy than import prices. The annual estimates o f redistribution through the former channel in 1996-2000 varied from US$90 million in 1997 to US$681 million in 1998, or from 0.7 to 5.1 percent o f GDP. The domestic gas price exceeded the import price by 40-130 percent in 1996-2004 (see also Chapter 7). Russia-BelarusEconomicandTrade Arrangements 4.60 In 2000 Russia and Belarus formed a common Union State which envisioned a common economic space that would include a free trade area and a Customs Union, monetary union (not yet achieved yet), and eventually a political union (elements o f which are inplace: the Higher State Council, the Council o f Ministers, and Parliament). The bodies o f the Union State conduct joint economic programs-the most important o f which are infrastructure, energy, and regulatory programs-and 77 This i s not to say that productioninBelarus remained at Soviet levels. In fact, Belarus' production o f tractors went down by two-thirds f i o m 1990 to 2003 while Russia's went down by 96 percent. Nevertheless, the contraction of production inBelarus was much smaller than inother CIS countries. 121 promote interstate cooperation. However, these programs are o f limited magnitude and do not affect mutual trade to a great extent. 4.61 Special political relations with Russia and inter-state economic agreements helped many firms in Belarus to obtain Russian orders and to keep operating even in the most difficult periods o f low demand inthe early andmid-1990s. The agreements on mutual cross-deliveries have been inplace since 1993. In recent years the role o f these agreements has diminishedand the vast majority o f energy deliveries from Russia have been paid in cash. Thus, non-cash payments accounted for 80.1 percent o f total payments for imported Russian gas in2001 but accounted for only 12.5 percent in2004. 4.62 Along with the interstate agreements there have been agreements between subnational governments (regions), and these have gained more prominence in recent years. Belarus' regions have concluded agreements with 70 Russian regions, which indicate that Belarus' Ministry o f Foreign Affairs has a good commercial diplomatic capacity for effective export promotion.78Four Russian regions stand out in bilateral trade volumes -- the City o f Moscow, Tyumen, St. Petersburg, and the Moscow region. Although direct targets for trade volumes are no longer a part o f these agreements, they play an important role in bringing government involvement to facilitate trade and overcome the current acrimonious business environment inboth countries. 4.63 The integrationprocess within the Union State has been far from smooth and i s still in the early stages." Infact, the implementation o f a number o f core agreements signed within the framework o f the Uniontreaty has been on hold for some time. Inparticular, it was initially agreed to achieve the following integrationbenchmarks inthe course o f 2000-02, but they have still not beenreached: 0 The establishment o fjoint consortia for gas transit The harmonizationo fregulatory policies inenergy, communications, and transport, which would effectively result inthe equalization o f tariffs inthese sectors 0 The harmonizationo f taxation. 4.64 Moreover, the earlier agreement on the introduction o f the single currency on January 1, 2005, has not been implemented. These delays have slowed down the pace o fbilateral integration considerably. 4.65 Nevertheless, the Union Treaty has already yielded important arrangements fostering mutual trade-most as well - Kazakhstan, the Kyrgyz Republic, and Tajikistan -- but the customs border does not exist only important, a functioning Customs Union. The Customs Union includes three other members between Russia and Belarus. Although the full harmonization o f tariffs has not been achieved (about 5 percent o f the tariff lines in Russia's and Belarus' tariff schedules still differ), the two countries have customs formalities.80 However, as mentioned above, the Customs Union i s asymmetric -- Belarus abolished the mutual customs border, which allows trade to flow between Belarus and Russia without restricts a significant number o f Russian exports while Russia generally does not respondinkind. 4.66 The absence of a full-fledged customs border erodes the border effect, which i s probably the most important factor that distinguishes international and domestic trade and dampens trade flows. As a result, Russian-Belarus trade bears features o fboth inter-regional trade (no customsborder, with some exceptions listed "ThiscapacityislargelylackinginotherCIScountries. 79 There are views, however, to the effect that this process lost its steam and does not have any serious prospects. 80Although the customs border has been formally abolished, there are still some remaining administrative barriers in place. Thus, a mandatory statistical declaration with supporting documentation shouldbe filed inBelarus inadvance o f each trade transaction, which adds time and expense for traders. Inaddition, a few years ago temporary customs posts were establishedby Russia on an ad hoc basis in order to combat the re-exportation o f some sensitive goods, which violated the articles of the Customs Union. This practice has been discontinued, however. 122 below) andinternationaltrade (different national currencies, andremainingnon-tariffbaniers listed below). The erosion o f the border effect i s a powerfbl factor inboosting bilateral trade. Box 4.1 compares trade dynamics between Russia and Belarus with trade dynamics between Russia and Ukraine to illustrate the scale o f trade benefits for Belarus that derive ftom its special traderelations withRussia. Box 4.1: ComparativeDynamicsofExports to Russiafrom UkraineandBelarus The table below presents the evolution o f exports flows from Belarus and Ukraine to the Russian Federationinthe post-Soviet period. Inthe Soviet era, bothcountries hadrelied on machinery and equipment exports to Russia to the same degree - about one-fifth o f total exports. However, while Belarus' share o f machinery and equipment exports to Russia in total exports declined by only one-fourth to 15 percent, Ukraine's exports dropped by almost 4 times to 5.6 percent. In the Soviet era, Ukraine's machinery exports to Russia were 2.7 times larger than those o f Belarus. In 1999 Belarusian exports were double those of Ukraine. The gap has been closing gradually since 2000, however. The share of machinery and equipment inBelarusian exports to Russia remained quite stable over 1998-2002and accounted for some 30 percent. At the same time, this has also meant that Belarus' exports have remained sensitive to economic developments in Russia, while Ukraine has significantly diversified its trade and i s less vulnerable to changes indemand inRussia. In1990the share ofRussiainBelarus' exports accounted for 41.5 percent o fthe total. After the collapse o fthe Soviet Union, Belarus' exports share to Russia actually increased, while inUkraine it declined muchbelow 20 percent. ComparativeDynamics of Machineryand MetalworkingandEquipmentExports to RussiafromUkraine and Belarus, 1990-2002 Change, US$ million 1990 1996 1999 2000 2001 2002 1990-2002,Yo Ukraine Total exports 78,335.9 14,400.8 10,332.7 14,572.6 16,264.7 17,957.1 -77.1 Exports to Russia 42,794.6 5,577.4 2,113.0 3,515.6 3,679.5 3,189.1 -92.5 Share intotal exports, `YO 54.6 38.7 20.4 24.1 22.6 17.8 -36.9 Exports of machines, transport equipment to Russia (SITC 7) 16,766.9* 1,091.3 467.1 696.9 889.3 998.3 Share inexports to Russia, % 39.2* 19.6 22.1 19.8 24.2 31.3 -20.1 Share intotal exports, % 21.4* 7.6 4.5 4.8 5.5 5.6 -15.8 Belarus Total exports 32,631.0 5,652.0 5,908.9 7,331.1 7,450.6 8,020.9 -75.4 Exports to Russia 13,557.9 3,024.4 3,222.0 3,715.7 3,962.7 3,977.1 -70.7 Share intotal exports, % 41.5 53.5 54.5 50.7 53.2 49.6 8.0 Exports o f machines, transport equipment to Russia (SITC 7) 6,303.1* 1,033.3 972.2 1,183.9 1,240.4 1,186.7 Share inexports to Russia, % 46.5* 34.2 30.2 31.9 31.3 29.8 -35.8 Share intotal exports, % 19.3* 18.3 16.5 16.1 16.6 14.8 -4.5 * Estimates, based on inter-republican trade in 1988. Note: The data for 1990 should be treated with caution, as they depend a lot on the prevailing prices and the exchange rates used for the conversion o f inter-republican trade. Source; World Bank (2004~). 4.67 However, actual trade regulations and practices still suffer from some non-tariff barriers and xreaucratic hassles, which often contradict the signed agreements. Listed below are some measures 123 regulating Russian imports to Belarus which are out o f line with the bilateral agreements and constitute market protection measures.81 0 Quotes on tobacco and seafood imports 0 Restrictions on beer imports such as expensive licensing and the minimal consignment requirement, importationthrough customs warehouses only; the additional payment inthe amount o f 30 percent o fthe cost o f the glass bottles or other containers 0 Licensing o f the importationo f specific commodities, such as soap, margarine, flour, tires, grouts, and bread and confectionary 0 Importation o f white sugar through customs warehouses only; white sugar imports producedfrom sugarcane are let in only if accompanied by special (compensated) permits, with the certificate o f origin and certificate o f compliance (Box 4.2) 0 Special duty stamps required for imports o f car fuel. 4.68 The above contingency measures were applied in an ad hoc manner that does not meet WTO rules on antidumping and safeguards. In addition, Belarus initiated several anti-dumping investigations (including exports o f metal pipes, confectionery, and asphalt) aimed mainly at Russian exporters. The Russian Ministry o f Economic Development and Trade estimated that the 2004 annual loss o f Russian exports to Belarus because o f the contingency measures exceeded US$250 million. Inparticular, exports o f beer declinedby 60 percent relative to 2002, exports o f seafood declined by 20 percent, and exports o f sugar almost disappeared (Box 4.2). Box 4.2: Russia-Belarus Sugar Dispute In 2004, Russia introduced safeguard measures on the importation o f white sugar made from sugarcane from Belarus. Belarus responded in kind by introducing restrictions on the importation o f white sugar from both sugarcane and sugar beets from all four o f the other members o f the Customs Union (Russia, Kazakhstan, the Kyrgyz Republic, and Tajikistan). Thus, both Russia and Belarus violated the Customs Unionprovisions. The resulting adjustments in the trade flows insugar, however, unilaterally benefited Belarus. On the Russian side all sugar exports were restricted, while on the Belarus side only exports of sugar from sugarcane were restricted. As a result, Belarus' sugar exports to Russia in 2004 increased by 44 percent while Russian sugar exports to Belarus declined by 62 percent relative to the 2003 levels. Apparently Belarus increased its domestic consumption o f less expensive sugar made from sugarcane, and increased exports to Russia o f domestically produced sugar from sugar beets. Overall, Russian sugar export declined from more than US$11 million in2001 to US$325,000 in2004. Source: Ministry o f Economic Development and Trade o f the Russian Federation. D. TRADEREGIME 4.69 This section analyzes Belarus' trade regime and its implications. It concludes that the Belarus tariff regime is fairly liberal while the overall trade regime remains quite restrictive because o f its non-tariff and regulatory barriers.The section also reviewsmajor recent developments inBelarus' WTO accessionprocess. ImportTariffs 4.70 Belarus, like many to other countries, applies both MFN and full tariffs (which are twice the MFNtariffs) on its imports. About 90 percent of non-CIS imports enjoy MFNtreatment. However, 70 percent o f imports come from CIS countries with which Belarus has free trade agreements, with a few exemptions. Moreover, two-thirds o f all imports come from Russia, with which Belarus has formed a Union State with no customs procedures between the two countries. *'As reported by the Russian Ministryo f Economic Development and Trade; effective as o f April 21,2005. 124 4.71 Table 4.13 presents simple average and import weighted average tariffs (averaged over all tariff lines with non-zero imports) applied to different partner g o ~ p sFor ~all tariffs, their maximum and minimum ad . ~ valorem rates were assessed for eachtariff line.83There are about 1,600 lineswith specific or mixedtariffs inthe Belarus import tariff schedule. Such a high reliance on specific and mixed tariffs leads to (economically inefficient) highly differentiated import taxation and adds an extra administrative burden for both traders and customs officers. Moreover, the Belarusgovernmentrelies heavily on temporary and seasonal changes inbasic tariffstructure excessivelysegmentedanduser-unfriendly. import tariffs that are valid for aperiod of 6 to 12months, as well as on tariff exemptions.This makes the entire Table 4.13. Import-WeightedAverage Tariff RatesinBelarus, 1998-2003(inpercent) 1998 1999 2000 2001 2002 2003 All goods All partners(w/o CIS countries) simple average min 13.2 12.9 13.0 11.6 10.6 10.5 max 13.7 13.5 13.5 11.9 11.1 10.9 weighted average min 11.1 10.4 10.4 12.0 8.4 9.9 max 12.6 12.4 11.4 12.6 10.3 11.2 MFNpartners simpleaverage min 12.7 12.6 12.8 11.3 10.6 10.4 max 13.3 13.2 13.3 11.6 11.0 10.9 weighted average min 10.1 9.9 10.3 9.8 8.4 9.8 max 12.0 12.0 11.2 10.5 10.3 11.2 Non-agricultural goods All partners(w/o CIS countries) simple average min 13.3 12.9 13.2 11.6 10.5 10.4 max 13.8 13.5 13.7 11.8 10.9 10.8 weighted average min 11.2 10.3 10.9 12.1 7.9 9.3 max 12.3 12.3 11.8 12.7 9.9 10.4 MFNpartners simpleaverage min 12.8 12.6 13.0 11.3 10.4 10.4 max 13.4 13.2 13.5 11.6 10.8 10.7 weighted average min 10.1 9.8 10.7 9.6 7.9 9.2 max 11.6 11.9 11.6 10.1 9.9 10.3 Agricultural goods All partners(w/o CIS countries) simple average min 12.2 12.4 11.7 11.8 11.6 10.9 max 13.0 13.4 12.6 12.6 12.5 11.7 weighted average min 10.7 10.6 8.7 11.2 10.9 13.2 max 14.0 12.5 9.9 12.2 12.1 15.7 MFN partners simple average - min i i . 8 i i . 1 ii.5 ii.5 i i . 5 16.9 max 12.7 13.2 12.4 12.3 12.6 11.9 weighted average min 10.2 10.2 8.7 11.0 10.8 13.3 max 13.8 12.4 9.9 12.0 12.3 16.1 Imdicit tariff rates For all imports(w/o CIS) Hln H/A 5.7 7.0 8.0 8.8 For MFNimports H/A H/A 6.0 7.6 8.9 9.8 Budget losses As percent of imports H/A H/JI 4.8 5.0 0.4 1.0 As percent of GDP Hln H/A 0.9 1.0 0.1 0.2 Source: World Bank staff estimates. 4.72 As is seenfromthe table, the simpleaveragetariffwas quitelow anddeclining duringtheperiod 1998- 2003, with its maximumreduced from 13.7 to 10.9 percent. The weighted average tariff (maximum) also fell from 12.6 to 11.2 percent during the same period. The table does not include rates for CIS imports, which are close to zero. The MFNtariff is somewhat lower andalso decreasedin 1998-2003.The 1998-2001tariffschedule was based on the 1997 Resolution of the Council of Ministers "On Customs Tariff of the Republic of Belarus" ~ 82While compiling the table, specific tariffs were converted into their ad valorem equivalents. Inthe case o f mixed tariffs, their ad valorem rates were used. 83All o f the tariffs were estimated at the 6-digit H S level. When any product group had several tariff values at the broader H S level, the minimumand maximumrates were chosen. 125 with annual amendments. In 2002 the Council of Ministers issued a new resolution on import tariffs that completely revised the 1997 schedule. Import tariff rates were lowered for the majority o f products, which i s reflectedina significant reductiono faveragetariffs inthat year. 4.73 Table 4.14 compares the basic characteristics of the Belarus tariff schedule with a wide range o f transition economies, as well as with the EU. The general characteristics o f the Belarus tariff schedules resemble those o f Russia and Poland. This i s not surprising, since Belarus harmonized 95 percent o f its tariff lines with Russia. Belarus' tariff levels and variations appear to be quite low by international standards-at least, they are not higher than those o f the eight new EUmembers before their accession. Table 4.14: Basic Characteristicsof Tariff SchedulesinBelarus and SelectedCountries (for non-agricultural,commodities) Domestic No. o f tariff Simple Coefficient o f Max lines International peaks Year lines average variation (percent o f peaks (percent (percentof o f tariff lines) tariff lines Belarus 2003 8746 10.6-11.0 0.58 30.0 0.3" 16.7** 0.0 Ukraine 2003 8258 6.9 1.o 50.0 19.6 8.5 5.4 EU-15 2002 8305 4.2 0.9 26.0 17.1 0.9 1.5 Armenia 2001 4450 2.3 1.8 10.0 76.8 0.0 23.2 Czechoslovak Customs Union 2001 8201 4.2 0.8 30.1 16.2 0.8 1.8 Hungary 2001 10368 7.0 0.6 78.0 10.3 2.3 1.6 Latvia 1999 8608 2.9 1.8 30.0 21.5 0.0 16.4 Lithuania 2001 8488 2.5 2.2 33.8 79.8 1.4 15.8 Poland 2001 8394 10.1 0.6 119.2 5.0 13.4 1.2 Russia 2001 8716 10.1 0.5 20.0 0.6 10.4 0.0 * Does not account for temporary exemptions from customs duties granted under the Belarus' government decisions for less than one year. **Accounting for the ad valorem equivalent o f specific and mixed tariffs. Notes: 1. Coefficient o f variation is a measure o f relative variation and i s calculated as the ratio o f the standard deviation over the mean. 2. Domestic tariff peaks are defined as exceeding three times the overall simple average applied rate. 3. International tariff peaks are defined as exceeding 15 percent. Sources:World Bank staff estimates; World Bank (2004~). 4.74 The average weighted agricultural tariff exhibited a sharp hike in2003. However, this hike can be explained by the increase in the tariff equivalent o f just a few commodities, such as raw sugar (sub- heading 170111) and meat and edible offal frozen (sub-headings 020714, 020727). The ad valorem import tariff for raw cane sugar o fjust 1percent ineffect in2002 was replaced in2003 by the tariff quota, with the specific tariff with the ad valorem equivalent exceeding 100 percent. However, the specific tariff was applied for imports exceeding the quota o f 420,000 tons. The ad valorem import tariff for meat and edible preparations increased from 25 percent in2002 to 70 percent in 2003. Had the 2003 tariffs for the above-mentioned groups remained at the 2002 level, the average weighted agricultural tariff would have been between 10.7 and 13.3 percent, (i.e., close to the 2002 level). The same i s true for the average tariff rates for all goods, which would have remained constant had the import tariff rates for sugar, meat and edible offal remainedconstant. 4.75 Table 4.15 presents import-weighted tariffs for agriculture and food (Chapters 1-24 less fish and fish products [Chapter 31 of the Harmonized System [HS]). Some agricultural tariffs were considerably higher than the average tariffs, especially for edible preparations; beverages and spirits; edible fruit and 126 nuts; and meat and meat offal (Chapters 21, 22, 08, and 02, respectively). Nevertheless, these levels of agricultural tariffs, except for a few lines, do not seem excessively high in comparison with international practices. Table4.15: Import-WeightedAverageTariff RatesAppliedto AgriculturalImportsfromAll MFN Partnersin2003, by H S Chapter (percent) Min Mor 4.8 4.9 MEAT AND EDIBLE MEAT OFFAL 21.9 22.3 DAIRY PRODUCE; BIRDS'EGGS; NATURAL HONEY: EDIBLE PRODUCTSOF ANIMAL ORIGIN, NOT ELSEWHERESPECIFIEDOR INCLUDED 15.0 15.0 PRODUCTS OF ANIMAL ORIGINNOT ELSEWHERESPECIFIED OR INCLUDED 6.7 7.3 LlvE TREESAND OTHERPLANTS BULBS, ROOTSAND THE LIKE,CUT FLOWERSAND ORNAMENTAL FOLIAGE 11.5 14.4 EDIBLEVEGETABLESAND CERTAIN ROOTSAND TUBERS 14.7 14.7 EDIBLE FRUITAND NUTS;PEELOF CITRUS FRUITSOR MELONS 16.5 28.7 COFFEE, TEA, MATE AND SPICES 12.7 12.7 CEREALS 6.1 6.1 PRODUCTS OF THE MILLINGINDUSTRY, MALT: STARCHES: INULIN,WHEAT GLUTEN 10.0 10.0 OIL SEEDSAND OLEAGINOUSFRUITS; MISCELLANEOUSGRAINS, SEEDSAND FRUIT; INDUSTRIALOR MEDICINAL PLANTS STRAW AND FODDER 5.0 5.0 LACS; GUMS, RESINS AND OTHER VEGETABLESAPS AND EXTRACTS 5.O 5.0 VEGETABLEPLAITING MATERIALS; VEGETABLEPRODUCTSNOT ELSEWHERE SPECIFIEDOR INCLUDED 15.0 15.0 ANIMAL ORVEGETABLEFATSAND ons AND THEIRCLEAVAGEPRODUCTS; PREPAREDEDIBLEFATS ANIMAL OR VEGETABLEWAXES 12.0 12.5 PREPARATIONSOF MEAT, OF FISHOR OF CRUSTACEANS,MOLLUSCSOR OTHER AQUATIC INVERTEBRATES 16.4 16.9 SUGARS AND SUGAR CONFECTIONERY 85.4 98.2 COCOAAND COCOA PREPARATIONS 5.8 5.8 PREPARATIONSOF CEREALS,FLOUR STARCHOR MILK, PASTRYCOOKS' PRODUCTS 10.1 10.1 PREPARATIONSOF VEGETABLES,FRUIT, NUTSOR OTHERPARTSOF PLANTS 11.6 15.0 MISCELLANEOUSEDIBLEPREPARATIONS 10.8 32.5 BEVERAGES, SPIRITS AND VINEGAR 26.1 29.7 RESIDUES AND WASTEFROMTHE FOOD INDUSTRIES;PREPAREDANIMAL FODDER 6.0 6.0 TOBACCOAND MANUPACTURED TOBACCOSUBSTITUTES 19.4 19.4 Source: World Bank staff estimates. 4.76 Owing to the privileges granted to certain importers, and to smuggling, the implicit tariff reflecting the actual collection rate was lower than the average statutory tariff. The collection rate was in the range o f 5.7 to 8.8 percent for all non-CIS partners during the period under review. The minimum estimates o f budgetary losses from incomplete import tariff collection fluctuated between 0.1 and 1.3 127 percent o f GDP, with a declining trend. This collection gap i s not highcompared to other CIS countries. Itreflects both a lower incidence o f smugglinginBelarus and the recent phasingout o f individual import duty exemption^.'^ 4.77 Insum, import tariff rates inBelarus have not been too highby international standards. Hence, the Belarus import tariffregime may be deemed quite liberal. Non-Tariff Barriers (NTBs) and Contingency Measures 4.78 Incontrast to tariff barriers, Belarus NTBsappear quite high.The mainNTBsinclude: (i) licenses and quotas; (ii) foreign exchange restrictions; (iii) contingency measures; and (iv) ad hoc administrative restrictions on trade. 4.79 Like many other countries, Belarus applies import licensing for two classes o f products: (i) potentially dangerous and environmentally unfiiendly products; and (ii) excisable goods, such as some alcohol. Like many other CIS countries, Belarus imposes foreign exchange restrictions and the 30 percent export surrender requirement. Although not extraordinary, these requirements represent restrictions on exporters' activities. 4.80 Belarus applies safeguard measures, such as quotas and anti-dumping duties, on the basis o f its safeguard legislation ineffect since 2000. The law i s in general in conformity with WTO agreements, but its application raises questions. The case presented above o f the recent imposition o f safeguard measures on raw sugar, had a questionable legitimacy and led to a collapse inRussian sugar exports to Belarus. To exacerbate matters, there are no clear procedures for the application o f the contingency measures in the CIS free-trade area. And, in general, external curbs on domestic protectionist pressures in Belarus are quite weak. 4.81 Belarus would be best served if it restrains its application o f contingency measures. These should be viewed as extraordinary measures, should be preceded by bilateral negotiations, and should be subject to strict adherence to WTO rules, notwithstanding the fact that Belarus i s not a WTO member and, hence, i s not formally bound by WTO disciplines. 4.82 It is believed that a large number of ad hoc administrative restrictions on trade exist in Belarus at both the national and local levels. These restrictions are primarily aimed at limiting the importation o f consumer goods and, as shown above in this chapter, they seem to succeed inkeeping the share o f consumer imports relatively low. It i s beyond the scope o f this report to attempt to identify and catalogue all o f them, but based on communications with the private sector, several examples are worth highlighting: 0 There are recurrent confiscations o f imports and transit goods on the basis o f small technical errors or ambiguities in the Customs documentation. As a result, several EU freight companies have decided to ship their goods to Russia and Central Asia through the Baltics or Ukraine. 0 The Belarus Customs operates in two quite different modes with respect to import clearance. It places much stricter controls on the imports o f consumer goods than on industrial inputs. For consumer imports, the minimumindicative prices are the norm, and they are highenough to make a considerable portion o f potential import unprofitable. 0 For a specific group o f consumer imports which are considered products o f comparative advantage for the country (television sets, refrigerators), importers must receive special permits from the Ministry o fForeign Affairs. 84 However, as shown inTable 4.16, the efficiency o f the excise taxation o f imports remains low. 128 There are region-specific requirements on a mandatory share o f domestically produced goods to be stocked inretail outlets (from 20 to 70 percent o f the available a~sortment).~~ e Regional administrations apply differentiated rates o f sales taxes depending on the origin o f the goods. Three different rates are commonly applied for local, Russian, and other imported goods. As an example, the rate difference can be as highas 5-15 percent for specific daily products.86 Preferences are established in state procurement infavor o f local firms.87 4.83 Although not all o f these regulations target imports directly, they are in effect trade-restrictive. The government i s advised to undertake a review and to cleanse the large regulative array in order to liberalize trade. The existing customs procedures for the control o f the customs value o f imports, which de facto act as minimal prices on imports, contradict the WTO Customs Valuation Agreement. This issue mustbe addressed on apriority basis. 4.84 Inaddition to the formal non-tariffbarriers listedabove, the most damagingbarriers to trade are o f an informal nature. They are associated with implementation modalities and practices o f existing regulations. Available surveys o f the business environment point to implementation problems o f NTBs that raise effective trade barriers and sour the business climate. For example, the implementation o f customs controls i s viewed by businesses as a barrier to trade (see Chapter 5). A high level o f informal non-tariff restrictions undermines the benefits o f a statutory liberal trade tariff. 4.85 Belarus i s in compliance with the WTO Agreements on Technical Barriers to Trade and on Sanitary and Phytosanitary Measures, which stipulate non-discrimination by importers. Belarus has been gradually modifying its standards system to conform to international standards systems and practices. For example, two new laws (the L a w on Technical Regulations and Standards and the L a w on Conformity Assessments), both passed in 2004, lay the groundwork for the introduction o f the modem two-tiered standards system consisting o f internationally compatible mandatory technical regulations and voluntary standards. However, movement toward implementing this system has been slow, partly because o f financial constraints on the development o f technical regulations. At present, Belarus producers and importers have to satisfy more than 18,000 compulsory state standards. The current system i s derived from the former Soviet GOST Standards System with its excessive regulation. 4.86 Reforming the standard compliance system i s an important element o f an export diversification strategy. Standards serve as a catalyst for technical and administrative change, enabling industries to reach their comparative advantage in new markets. Whilst the implementation o f EU and international standards will be a key issue inimproving access to the EUand other markets, it will also play a key role inimproving quality standards for Belarus consumers. M a r k e t Access Issues 4.87 The most important non-tariff barriers that transition economies are facing in the world market are anti-dumping measures.@ Box 4.3 presents a list o f anti-dumping measures (in force) faced by Belarusian exports. The longest list i s presented by the EU, which maintains definitive anti-dumping measures against five Belarusian exports. Although they have a stifling effect, these measures cover less 85 See Resolutionof the Ministry of Commerce#34 (07/07/2003). 86 Starting from 2003, annualBudget Laws (Article 10) provide regional administrations with a right to differentiate local sale taxes depending on the origin of goods. See also Minsk City Council Resolution #141 (11/15/2004), Vitebsk Oblast Council Resolution #lo0 (12/01/2004), Brest Oblast Council Resolution #lo4 (11/25/2004), and Grodno OblastCouncil Resolution #91 (11/25/2004). '*According 87 See, for example, GovernmentResolutions#652 (05/19/2003), #1629 (03/20/2003), and #1586 (12/14/2004). to Finger, Ng andWangchuk (2001) anti-dumping initiations against transition economies during 1995-99accountedfor 43 percento fthe total anti-dumping initiations worldwide. 129 than 4 percent o f Belarus' non-energy exports to the EU. At the same time, existing estimates o f Belarusian losses from applied anti-dumping measures fall inthe range o f US$250-300 million annually, out o f which about US$70-100 milliong9relates to the anti-dumping measures applied to potassium fertilizers. The loss may increase with the latest EU enlargement.g0 In addition, although the quotas on textiles were phased out from January 1, 2005,'l the EU continues to apply quotas (albeit increased) for textile imports fi-omsome countries which are not the WTO members, including Belarus. Box4.3: Anti-DumpingMeasuresRecentlyFacedby Belarus 0 EU:polyester filament tow; polyester staple fibers; potassiumchloride; urea; urea and ammonium nitrate solutions India: acrylic fiber 0 Turkey: polyester synthetic staple fibers (not processed) 0 USA: steel concrete reinforcing bars 0 Ukraine: matches; ruberoid; wood fiber stabs; spiral compressor units. Sources:WTO, MFA o f Ukraine. 4.88 To conclude, the Belarus trade regime i s characterized by modest tariff rates but rather extensive non-tariff barrier^.'^ At the same time, although Belarus does not enjoy the same preferential access to Western markets as many developing countries, the primary constraints to export expansion and diversification are explained by domestic factors, such as the weak capabilities o f the existing enterprise sector and the deficiencies o f the business environment, which hamper bothrestructuringand new private entry, both domestic and foreign. ExportandInvestmentRegimes 4.89 Belarus' export regime i s generally liberal, although export taxes are collected on some commodities and there i s licensing outside o f safety and security measures. The investment regime and the export promotion measures have yielded mixedresults. 4.90 Commodity coverage by quota and/or licensing i s determined by ecological, health and cultural measures (for example, industrial waste, precious metals, antiques) and by obligations according to international regulations (for example, textiles, which are subject to EU quotas, or mineral fertilizers, which are subject to EU anti-dumping duties). Also, for some products licensing i s imposed to ensure their supply to domestic markets (for example, wastes and scraps o f ferrous and non-ferrous metals). Export duties were abolished by the end o f 1996 but were reintroduced at the end o f 1999 under pressure from Russia, with which Belarus has a common customs territory. Export duties are now applied to some products that are important categories o f Russian exports, especially processed oil products, which constitute over 95 percent o f all goods subject to export duties inBelarus. 89As reflected invarious publications andpresentations bythe Belarus MFA officials. 90The transition period granted for some products (potassium chloride, in particular) ended in M a y 2005 but has been extended recently to April 13, 2006 (EC Regulation No.858/2005 o f 6 June 2005). However, even the transition arrangements left little scope for an increase in exports to new EU member countries (since it has been conditional on following agreed minimumprices and quotas, reflecting a three-year average export volume in the periodpreceding the enlargement). 91According to the Agreement on Textiles and Clothing o f the Uruguay Round. 92 This conclusion i s in agreement with the IMF's overall trade restrictiveness rating for Belarus. Belarus i s assigned rate "8" (on a 1 - 10 scale; the higher the number is the higher i s the trade restrictiveness), consisting o f a low tariff restrictiveness rate ("2" o n a 1-5 scale) and the most restrictive non-tariff barrier rate ("3" on a 1-3 scale). 130 4.91 Export duties per se are not prohibited by WTO agreements and, from the economic standpoint, are equivalent to import tariffs. However, they may be deemed trade-restrictive measures, albeit subject to interpretations. Hence, it isworthreassessingthe potentialbenefits o fthese taxes for the Belarusian economy. 4.92 Belarus applies the destination principle o f value added taxation. VAT paid on both domestic and imported inputs i s subject to reimbursement upon the exportation o f finished goods. The available evidence indicates that the VAT refund mechanismcauses fewer problems for exporters than in other CIS countries. However, the current tax legislation provides only for a restricted rate o f VAT reimbursement by introducing an additional 4 percent turnover tax on exports. Thus, contrary to the tax regimes inother countries, Belarus preserves some value added taxation o f its exporters. 4.93 The government conducts export promotion activities in accordance with the National Programo f Export Development for 2000-05. In December 2004, the government adopted a resolution on export promotion measures in 2005. This resolution contains a long list o f planned activities (see Box 4.4). In addition to being insufficiently specific, the plan envisions such measures as the elaboration o f multiple "strategies," "concepts," conferences o f line ministries' bodies," etc., which bear a heavily bureaucratic flavor and may or may not yield results. Other measures, much as raising import tariffs for synthetic optimizing commercial diplomacy efforts -- will be quite helpful if properly implemented. Nevertheless, fibers, are rather questionable. However, still other measures - such as regulatory harmonization or the overall results o f this programremain to be seen. Box 4.4: Selected Directionsfor Export Promotion for 2005 1, Export market diversification: Creation o f country and regional export strategies Standards harmonization Control o f harmful substances inlive animals andplants inaccordance with E C Directives Strategy o f CIS market penetration 2. Promotion o f exports o f products with h g hR&D input 3. Reduction inenergy- and material-intensity o fBelarus economy 4. Higher efficiency o f Belarus diplomatic efforts 5. Elaboration o f Export Development Program for 2006-2010 6. Raising import tariff on synthetic fibers 7. Attracting IF1loans for SME development 8. Program for the development o f the service sector 9. Bilateralagreements (with a number o f countries) on international roadtransport 10. Introduction o f I S 0 9000 in580 firms and I S 0 14000in87 firms 11, Internet promotionactivities Source; Government Program o f Export Promotion for 2005. Adopted by Government ResolutionNo. 1690 01 December30,2004. 4.94 Future export promotion strategies in Belarus should be more streamlined. D e Wulf (2001) reviewed the international experience in export promotion and concluded that a good export promotion trade representation, and trade fairs) and onshore objectives (issues o f competitiveness -- quality strategy should strike a balance between offshore objectives (information gathering, market research, standards, pricing, supportive services, domestic input supply, development o f new business models and practices). The current government strategy i s weak on the latter issues. In addition, Belarus does not have an export promotion agency, which could on the one hand act as a coordinator o f export promotion efforts and on the other hand foster close relationships and provide services to exporters. Although not every export promotion agency has proved to be an efficient organization, Belarus could benefit from best internationalpractices inthe development o f export promotion organizations. 131 4.95 To date, export promotion efforts and commercial diplomacy have yielded positive results mostly in the Russian market (discussed earlier in this Chapter). Trade relations with the EU (outside of the booming exports o f oil products) remain constrained, although Belarus enjoys Generalized System o f Preferences (GSP).93 In addition, the PCA Agreement with the EU was never ratified and there i s no bilateral trade regulation harmonization program in effect today. Nevertheless, a few European firms established partnerships with Belarusian companies, especially on an outward processing basis, which provides easier access to the European market. However, Belarus' export performance in the EUmarket remains quite modest, considering the country's favorable geographic location and export potential. 4.96 The legislation on foreign investment in Belarus i s reasonably good. The Investment Code adopted in 2001 and amended in 2004 is, in general, in conformity with WTO trade-related investment measures. However, as Chapter 5 suggests, the business environment i s acrimonious as the legislation i s not properly enforced. 4.97 At the same time, Belarus has established six free economic zones (FEZs) with a better investment and business climate and a more lenient taxation regime. As o f January 1, 2005, the taxation regime inthe FEZs was unified across all zones, and streamlined, and simplified, which was a step inthe right direction. The residents o f the FEZs enjoy considerable tax benefits, including a 50 percent reductioninthe statutory rates o fthe VAT, and the profit tax i s halved. 4.98 Based on limited evidence, we can conclude that the business environment in the FEZs appears somewhat better than in the rest o f the country. However, this i s not sufficient to make the FEZs very attractive to foreign investors, given the problems with Belarus' investment image abroad. Fiscal Aspects of the Trade Regime 4.99 Table 4.16 presents aggregated data on trade taxation in Belarus. The table shows that the share o f revenue from foreign trade in total tax receipts stood within a modest range. This provides additional justification for the simplification o f the import tariff schedule. While the tariff yields fairly small revenues, it i s disproportionately segmented, and the existence o f 1,600 tariff lines with specific and mixed tariffs greatly complicates customs administration while increasing the risks o f corruption. The ratio between revenues from import tariffs and export taxes fell from 52:l in 2000 to 6.5: 1 in 2001 and further to 2.6:l in 2004, indicating a very high and increasing, relative importance o f export taxation, which i s usually found only incommodity-exporting countries. 2000 2001 2002 2003 , 2004, Total tax revenue (BYR mill.) 2,433,567.6 4,389,113.3 6,263,380.9 9,373,720.4 12,660,483.7 Total foreign trade revenues (BYR mill.) 141,797.3 299,982.8 523,590.8 957,158.8 1,094,784.9 As percent oftotal tax revenues 5.8 6.8 8.4 10.2 8.6 Composition o f taxes on trade (as percent o f total trade revenues): Import tariff 90.0 80.7 76.1 66.3 68.4 Export tax 1.7 12.4 18.0 27.1 26.6 Other taxes on trade 8.2 6.9 5.9 6.6 5.O Share of indirect taxes collected on imports intotal collection: Excise tax 4.4 3.7 3.9 3.5 3.0 VAT 21.9 25.1 26.5 33.3 32.2 93However, currently the possible withdrawal o f GSP rights because o f alleged non-respect for labor rights i s being consideredby the European Commission. 132 4.100 Ifthe VAT andexcises are considered, imports account for one-thirdofthe total VAT collection, which i s natural for a small open economy. The low collection o f excises on imports (3.5 percent o f the total excise collection) raises questions about the efficiency and integrity o f customs administration. Excises are levied on alcohol, tobacco, cars, gasoline, and other goods. The import shares o f these goods intotal consumption are quite high,except for gasoline. The WTO Accession Process 4.10 1 Belarus has been involved inthe process o f WTO accession for more than decade but this process i s far from completion. Belarus submitted its application for WTO accession in September 1993 and the Working Party was established a month later. The Memorandum on Trade Regime was submitted in January 1996. The meetings o f the Working Party were held in 1997, 1998, 2001, 2003, and 2004. The goods offer has been under negotiation since 1997 and the services offer since 2000. The Factual Summary was drafted in2004. 4.102 The preliminary analytical assessment o f the impact o f Belarus' accession to the WTO reveals that Belarus will, on aggregate, benefit from the accession, with GDP rising by 3.4 percent and welfare rising by 1.6 percent (Pave1 and Tochitskaya, 2005). The largest gains will come fiom changes in the domestic tax rates, including a reduction inexport tariffs, which will be an export-creating measure. 4.103 Untilrecently there were significant obstacles to WTO accession for Belarus owing to the many Working Party members' complaints about the non-compliance o f Belarus' regulations and trade practices with WTO agreements. However, Belarus made considerable progress in its WTO membership bid last year by introducing a large number o f new WTO-compliant legislative measures. This is commendable considering that the Belarus government has acted on its own, with little international support. Progress was also made on several sectoral fronts such as agriculture, standards, and intellectual property rights. Nevertheless, much remains to be done. New laws should be complemented by an adequate regulatory framework, while hundreds o f existing regulations should be reviewed and, if necessary, modified. In addition, much more progress i s needed in liberalizing and de-monopolizing a number o f sectors, including insurance and banking services, and telecommunications. It i s also worth noting that the WTO negotiations on market access are still at an early stage. Thus, the full scope o f Working Party member demands i s not yet clear. A summary o f issues related to the WTO-related legislation i s provided inTable 4.17. 4.104 Reportedly, agriculture i s not likely to be a contentious issue in WTO accession. Belarus and the Working Party have reached a preliminary agreement on historical estimates for the Aggregate Measure o f Support (with 1997-99 as a base) and the allowed level o f support (US$500 million for the Amber Box support measures, equivalent to 4.2 percent o f the average GDP for that period). The current agricultural import tariffs inBelarus are not too high,with the exception o f few commodities. 4.105 Intellectual property rights legislation i s reportedly largely TRIPS-compliant. According to the country rating by the International Intellectual Property Rights Organization, enforcement i s not ideal but i s quite respectable inrelation to the comparator countries. 4.106 The banking sector will need to introduce regulations allowing for the establishment o f foreign branches inthe territory o f Belarus. The state-dominated insurance sector will have to be liberalized. 4.107 In the telecommunications sector, the government expressed its commitment to create an adequate legislative and regulatory framework and to fully liberalize the sector by January 1, 2007. The Law on Electric Communications, which i s in line with the prevailing international practices, has been submitted for approval. At the current negotiations, Belarus upholds two basic conditions for the market 133 entry: the 49 percent share o f foreign capital in the authorized fund (equity capital) o f the registered legal person, providing facilities-based services, in line with the common national practice; and the exclusive rights o f the national telecommunications operator for the construction and operation o f the network infrastructure for long distance and international telecommunications until January 1, 2007. Since entry into the WTO before that date i s unlikely, this position should not be a stumbling block in the negotiations. A more important task i s the creation o f a regulative framework based on the newly proposedlegislation, in accordance with the dynamic time frame envisioned by the government. 11necessary legislationby Note: The list o f amended legislation and further actions i s indicative of WTO accession problems but i s by no means exhaustive. A complete WTO actionplan would require substantial further work by national and international experts. 4.108 Belarus is still at an early stage in its WTO accession process, which could be comparedto the stages o f Russia and Ukraine three to five years ago. Uhaine's and Russia's experience with WTO accession should serve as a warning to the Belarus' government regarding excessive optimism about the 134 speed and ease o f accession. Ukraine and Russia have been in the process o f concluding bilateral market access agreements for several years and the process i s still not completed. Belarus has not signed a single bilateral agreement to date, and from this perspective the government does not have sufficient information to properly plan its potential progress inthe WTO negotiations. 4.109 Moreover, when compared to Russia and Ukraine, Belarus may face some additional bottlenecks inits future accession negotiations which are likelyto be associated withproblemsconcerningthe general business environment in the country, such as the high level o f subsidies (including export subsidies) and non-tariff barriers (including import restrictions). 4.110 To speed up the harmonization o f the legal and regulatory framework in accordance with WTO rules, the Belarus government may benefit fkom international technical assistance. The Belarus Ministry o f Foreign Affairs, which acts as the coordinating ministry on WTO accession, indicated its interest in this issue. One immediate task for such assistance is the external legal examination o f the large array o f recently introduced laws. Other tasks may include regulatory harmonization with WTO rules in various areas, including standards, financial services, and telecommunications. E. CONCLUSIONSANDRECOMMENDATIONS 4.111 The main conclusion o f this chapter relates to the slow restructuring o f Belarus' export patterns. Since Belarus i s a small open economy, its growth prospects depend heavily on its export capabilities. The low dynamism o f the country's exports points to serious limitations in the existing growth model. The struggle to improve in the export structure and to bring about effective integration into the world economy represents the core o fthe competitive challenges that Belarus faces. 4.1 12 The other findings in this chapter with respect to trade performance could be summarized as follows: 0 A strong export performance has been a distinctive feature of the recent growth episode. In 2000-04 exports more than doubled, backed by an improved demand in Russia and higher oil prices. The contribution o f the price factor to overall export growth has been significant recently: in 2001-04 about one-third o f total export growth was due to price movements. However, imports grew at a highrate as well so that the trade deficit as a percent o f GDP was relatively stable during 2000- 03. The hike inimports in2004 ledto a sharp deterioration inthe trade deficit to 9 percent o f GDP. 0 Belarus' exports remain highly concentrated in terms of export markets, exported products, and the role of leading exporters. The share o f Russia, while it has declined somewhat, still accounts for about half o f total exports and about 90 percent o f CIS exports. The 20 largest exporters are a source o f more than 55 percent o f all exports and more than 80 percent o f non-CIS exports. 10 main export commodities accounted for over 50 percent o f total exports in 2004. These were the products traditionally produced and exported by Belarus prior to independence. Excessive concentration renders the country's trade vulnerable to external shocks. 0 Trade restructuring and diversificationare taking place at a much slower pace than inthe neighboring countries. While the EU's share in Belarus' exports has been growing (24 percent o f total exports in 2004 as compared to 7 percent in 1998), it i s still extremely low if one accounts for the country's location. Moreover, the recent expansion in exports to the EUhas a very narrow base. It has occurred primarily at the expense o f a sharp increase inexports o f oil products. 135 0 In addition to high concentration, analysis has revealed several serious weaknesses in recent export patterns which, if not addressed, pose a serious risk for future growth. The number o fproduct groups, inwhich Belarus exhibits strong export specialization i s low, and declined between 1998 and 2003. The factor intensity structure o f exports shows the increasing importance o f exports o f resource-intensive and unskilled labor-intensive exports. Reliance on such commodity groups generally limits the possibility o f job-generation and productivity improvements in the economy. The underdeveloped intra-industry trade with the EUreflects the failure to attract European FDI.This further limitsopportunities for trade-relatedproductivity gains. 0 There have already beensigns of increasingcompetitivepressuresthat the country's exports face inthe Russianmarket as expressed intheir declining market shares intotal Russian consumption. 4.113 The integration process with Russia has been important for Belarus in two fundamental ways. First, Russia provided direct demand support for traditional Belarusian exports, including labor- intensive items in the machinery and equipment sector. Second, the integration process was a primary driver for recent policy adjustments, including several major reform steps such as the unification o f the exchange rate and the phasingout o f direct NBB financing o f the budget deficit. 4.114 Economic and trade relationswith Russia were critical for the early growth in Belarus in the secondpart of the 1990s.Thanks to its specialrelations with Russia, at the height ofthe output crisis inthe CIS, Belarus managed to preserve its production capacity inmanufacturingto a muchbetter extent than any other CIS country (Russia included). The Union Treaty has already yielded important arrangements for fostering mutual trade by setting up a functioning Customs Union that led to a practical abolishment o f the mutual customs border. At the same time, excessive export concentration inRussia i s a reflection o f the dichotomous nature o f Belarus' export capabilities. 4.115 Trade with Russia played a vital role in supporting the Belarus economy through a significant resource transfer. The main channels o f this transfer were discounted prices for Russian energy, non-market trade arrangements (such as barter and inter-government agreements on mutual direct deliveries), and the use o f unilateral violations by Belarus o f the provisions o f the Customs Union. The resource transfer from Russia has been significant throughout the post-Soviet period. Belarus (as well as other CIS members) continues to benefit from energy import prices that are much lower than their world market equivalent, but this effect has been steadily declining. Moreover, until recently Belarus received even better energy arrangements than the rest o f the CIS. (Compared to the prices o f gas imports to Ulu-aine, in 2000-03 the average annual transfer receivedby Belarus through lower gas prices amounted to about 2 percent o f GDP.) 4.116 Belarus used rents associated with special relations with Russia quite strategically. A large portion o f these rents was centralized by the government and used for various public programs, including infrastructure investments, enterprise support, and social assistance throughout the economy. In the medium term, however, Belarus will face the unavoidable costs o f adjustments that relate to future higher prices for Russian gas and oil. The latter costs, as measured against actual 2003 energy prices and import volumes, exceeded 6 percent o f GDP a year. 4.117 Overall, the Belarus trade regime is characterizedby modest import tariff rates but fairly extensive non-tariff barriers. Average import tariff rates were stable and quite modest during 1998- 2003, staying between 10 and 14 percent. Agricultural import tariffs do not seem excessively high, with the exception o f sugar. Although sugar i s a sensitive commodity inmany countries, Belarus' current sugar import tariff seems unreasonably high. The government could be advised to reconsider its rationale. The fiscal importance o f import taxation i s quite modest which providesjustification for simplification o f the import tariff schedule, which i s currently too segmented. 136 4.1 18 However, informaland regulatory non-tariffbarriersunderminethe benefits of a statutory liberal tariff regime. There are a variety o f ad hoc administrative regulations on both the national and local levels which are trade-restrictive. The government i s advised to undertake a review o f the large regulatory array in order to free up international trade. It should also improve its customs valuation practices to get rid o f the remnant o f import minimum pricing under the disguise o f indicative import values. 4.119 Standards reformshould be expedited.Although the legislative framework is mainly inplace, slow reform implementation has not allowed switching from the excessive compulsory regulation inherent in the ex-Soviet GOST system to the modem two-tiered system o f internationally compatible mandatory technical regulations and voluntary standards. 4.120 Belarus' legislation on foreign investment and FEZ arrangements is reasonably good. However, it has not resulted in sizable foreign investment owing to an acrimonious economy-wide business environment. 4.12 1 Belarus' regional integration efforts have been quite successful in the direction of Russia and rather modest in the direction of the EU. By virtue o f its geographic position, Belarus should intensify its trade integration strategy with the EU, the political situation permitting. 4.122 Belarus has made considerable progress in its WTO membership bid recently by introducing a large amount of new WTO-compliantlegislation. Nevertheless,much remains to be done. Since no single bilateral market access agreement has been signed as yet, Belarus should be considered as being at the early stage o f accession. New laws should be complemented by an adequate regulatory framework, while the existing regulations should be reviewed and, if necessary, modified. In addition, much more progress i s needed in liberalizing and de-monopolizing a number o f sectors, including financial services and telecommunications. In order to expedite the harmonization o f the legal and regulatory framework in accordance with WTO rules, the government may benefit from international technical assistance. 4.123 Key bottlenecks that are likely to present themselves in Belarus' future WTO accession negotiations would be associated with the general problems in the country's business environment and would include such issues as subsidies and import restrictions. 137 ANNEX 4.1. TRADESTATISTICS Table A4.1: Balanceof Payments,1996-2004 (Inmillions ofU.S. dollars) Items 1996 1997 1998 1999 2000 2001 2002 2003 2004 debit -17.9I -61.6I -41.1I -57.3 -101.91 -183.8 -171.2I -265.6I -166.7 2.1. Assets -17.7I -61.6I 28.0I -15.4II -5.7 1 25.5II -2.4I 0.8I 3.2 138 Table A4.1 Continued credit 30.9 4.1 19.7 34.8 13.4 2.1 17.7 Items II 0 1 0 1 1996 I 1997 I 1998 II 1999 II 2000 II 2001 II 2002 1I 2003 I1 2004 3.1.1. Trade credits 3.1.2. Loans 3.1.3. Currency and deposits 3.1.4. Other assets 3.2.1. Trade credits 3.2.3.Currency and deposits Source: NBB. 139 Table A 4.2: Directions of Merchandise Exports, 1997-2004 (Inmillions ofUS.dollars) I 1997 1998 1999 2000 2001 2002 2003 2004 Total 1 7,301.2 7,069.7 5,908.9 7,331.0 7,450.6 8,020.9 9,945.6 13,751.7 CIS 5,378.9 5,160.2 3,621.6 4,404.7 4,493.7 4,384.4 5,453.4 7,295.8 Ukraine 425.4 386.9 280.6 559.7 421.8 271.6 343.5 539.8 Russia 4,7 80.O 4,608.1 3,222.0 3,7 15.7 3,962.7 3,977.1 4,898.7 6,463.0 Others of CIS 173.5 165.1 119.0 129.3 109.2 135.7 211.2 293.0 ROW 1,922.3 1,909.5 2,287.3 2,926.3 2,956.9 3,636.5 4,492.2 6,455.9 EU 15 - 492.6 481.9 526.4 689.4 821.4 1,440.3 2,279.1 3,298.1 Germany 217.3 199.6 215.5 231.7 241.0 347.9 421.2 502.8 Great Britain 30.2 38.2 51.6 95.9 222.9 493.7 938.3 1,147.6 Italy 64.2 73.0 64.8 76.1 85.4 130.1 135.2 143.0 New member countries 10 - 571.6 639.4 797.7 1,361.4 1,286.9 1,245.1 1,287.8 1,744.9 Latvia 72.5 171.4 260.4 467.3 492.3 520.1 344.2 326.0 Lithuania 137.8 157.6 174.7 348.8 275.8 256.7 265.0 356.3 Poland 245.8 184.9 208.3 276.8 248.0 273.3 434.2 728.8 China 115.8 99.7 169.5 136.2 143.1 217.4 162.3 301.5 USA 93.2 103.4 80.1 99.3 77.4 91.3 102.5 162.8 Brazil 60.6 58.9 67.5 65.9 76.7 89.4 113.4 146.4 Table A 4.3: Directions of Merchandise Imports, 1997-2004 (InmillionsUSdollars) Total 8,688.8 8,549.3 6,673.7 8,492.4 8,286.4 9,092.3 11,558.0 16,345.5 CIS 5,817.0 5,554.4 4,288.8 6,015.4 5,796.8 6,295.3 8,006.2 11,806.1 Ukraine 967.5 739.9 415.7 340.6 277.4 290.7 362.1 544.9 Russia 4,673.1 4,670.4 3,766.7 5,549.7 5,437.9 5,922.3 7,559.3 11,142.6 Others of CIS 176.4 144.1 106.3 125.2 81.5 82.4 84.9 118.6 ROW 2,871.8 2,994.8 2,384.9 2,477.0 2,489.6 2,797.0 3,551.8 4,539.4 EU 15 - 1,431.6 1,492.5 1,321.5 1,290.0 1,271.1 1,482.9 1,776.7 2,242.0 Germany 691.1 757.7 693.0 587.6 604.1 693.1 820.3 1,081.0 Great Britain 99.1 116.9 80.1 106.4 61.4 67.7 79.3 128.4 Italy 157.9 179.0 167.9 162.6 164.1 215.2 283.9 300.5 New member countries 10 - 729.2 752.2 487.0 534.6 475.5 495.8 734.8 997.2 Latvia 67.1 56.5 32.2 29.7 36.1 36.1 44.3 85.0 Lithuania 191.9 208.0 102.6 69.0 107.3 109.4 154.2 175.6 Poland 250.0 282.9 212.5 215.8 202.0 221.8 348.5 475.0 China 36.2 41.5 37.8 47.4 41.3 46.5 71.8 158.0 USA 138.1 124.6 129.6 138.7 131.6 103.2 150.2 195.6 Brazil I 50.6 52.1 35.9 42.3 60.8 104.5 89.2 97.0 Source: WITS/COMTRADE,MSA. 140 Table A 4.4: Commodity Structure ofMerchandiseExports (YO) S I T C code 1998 1999 2000 2001 2002 2003 2004 Total, US$million 7,069.7 5,908.9 7,331.1 7,450.6 8,020.9 9,945.6 13,751.7 Total 100.0 100.0 100.0 100.0 100.0 100.0 100.0 Foodproducts (0+1+22+4) 8.5 7.5 6.8 8.0 7.7 8.4 8.3 Agricultural Materials (2-22-26-27-28) 1.4 1.8 1.6 1.5 2.0 2.1 1.9 Textiles fibers (26) 1.6 1.7 2.0 2.0 1.7 1.4 1.2 Ores, minerals &metals (27+28+68) 1.o 0.8 0.8 0.9 1.3 1.o 0.7 Energy (3) 7.8 9.1 19.8 17.8 20.3 22.0 26.9 Manufacturing (5 to 8-67-68) 72.5 70.7 62.8 65.3 59.7 57.4 52.9 Iron & steel (67) 5.4 4.2 3.7 3.7 3.9 4.1 5.0 Other 1.7 4.3 2.5 0.9 3.4 3.4 3.1 Source; World Bank staffcalculations ased on WITSKOMTRADE data. Table A 4.5: Commodity Structure ofMerchandiseImports(YO) S I T C code 1998 1999 2000 2001 2002 2003 2004 Total, US$ million 8,549.3 6,673.7 8,492.4 8,286.4 9,092.3 11,504.9 16,345.5 Total 100.0 100.0 100.0 100.0 100.0 100.0 100.0 Foodproducts (0+1+22+4) 11.1 12.3 12.1 13.0 10.8 9.9 9.1 Agricultural Materials (2-22-26-27-28) 1.6 1.6 1.5 1.6 1.6 1.4 1.2 Textiles fibers (26) 0.8 1.o 0.8 0.7 0.6 0.7 0.7 Ores, minerals &metals (27+28+68) 3.1 3.5 3.6 3.4 3.6 3.6 3.6 Energy (3) 23.8 22.9 30.4 26.8 25.7 26.4 27.7 Manufacturing (5 to 8-67-68) 49.5 47.9 43.2 47.1 44.7 45.0 44.7 Iron & steel (67) 8.4 8.6 6.8 6.7 6.0 6.7 7.6 Other 1.6 2.1 1.5 0.6 7.0 6.3 5.5 Source: World Bank iffcalculations isedon WITS/COMTFUDEdata. ~ 141 TableA 4.6: CommodityStructureofMerchandiseExportsbyBEC(YO) BECode 1998 1999 2000 2001 2002 2003 2004 Total, US$million 7,069.7 5,908.9 7,326.4 7,450.6 8,020.9 9,945.6 13,329.4 Total 100.0 100.0 100.0 100.0 100.0 100.0 100.0 Foodand beverages 1 8.2 7.2 6.5 7.1 7.4 8.o 8.3 Primary:Mainly for industry 111 0.1 0.0 0.1 0.1 0.1 0.2 0.0 Primary:Mainly for householdconsumption 112 1.1 1.5 0.9 0.7 0.5 0.7 0.6 Processed:Mainly for industry 121 0.8 0.4 0.8 1.o 0.8 0.8 0.9 Processed:Mainly for household consumption 122 6.3 5.3 4.8 5.9 6.0 6.3 6.8 Industrial supplies, nes 2 36.4 36.5 34.1 34.9 33.5 33.0 32.4 Primary 21 1.8 1.5 1.5 1.5 2.1 1.7 1.4 Processed 22 34.7 35.0 32.6 33.4 31.3 31.4 31.0 Fuelsand lubricants 3 7.6 8.9 19.6 17.3 19.9 21.6 27.3 PrilMry 31 0.4 0.5 0.9 1.o 1.2 1.5 1.9 Processed: Motor spirit 321 7.1 8.4 18.5 16.2 18.4 19.7 24.7 Processed:Other 322 0.1 0.1 0.2 0.1 0.2 0.4 0.7 Capitalgoods (except for transport equipment), and parts and accessories thereof 4 12.3 12.4 10.4 11.7 11.3 10.6 9.8 Capital goods (except for transportequipment) 41 9.0 9.9 8.0 9.0 9.0 8.4 7.8 Parts and accessories 42 3.3 2.5 2.4 2.7 2.3 2.2 2.0 Transport equipment and parts and accessoriesthereof 5 18.0 15.1 13.3 12.9 11.0 10.4 10.4 Passengermotor cars 51 0.6 0.1 0.1 0.0 0.0 0.0 0.0 Other: Industrial 521 8.7 8.3 7.8 7.7 7.1 6.4 6.5 Other:Non-industrial 522 0.4 0.5 0.4 0.4 0.4 0.3 0.2 Parts and accessories 53 8.4 6.2 5.0 4.8 3.6 3.8 3.6 Consumer goods nes 6 15.7 15.6 13.5 14.6 13.5 13.0 11.8 Durable 61 6.1 6.4 5.9 6.6 6.7 6.6 6.1 Semi-durable 62 6.4 6.1 5.0 5.2 4.1 3.8 3.3 Non-durable 63 3.2 3.0 2.7 2.8 2.7 2.7 2.3 Goods nes II 1.7 4.3 2.5 0.9 3.4 -.. 3.3 0.0 Source: World Bank staffestimates based on WITS/COMTRADE data. 142 TableA 4.7: Commodity Structure ofMerchandiseImportsbyBEC (YO) BECode 1998 1999 2000 2001 2002 2003 2004 Total, US%million 8,549.3 6,673.7 8,646.2 8,286.4 9,092.3 11,558.0 15,443.8 Total 100.0 100.0 100.0 100.0 100.0 100.0 100.0 Food and beverages 1 7.7 8.8 9.3 9.9 8.1 7.5 7.3 Primary: Mainly for industry 111 1.3 2.5 3.3 1.1 0.9 0.7 0.9 Primary:Mainly for householdconsumption 112 1.1 1.1 0.9 1.1 0.8 0.9 0.8 Processed:Mainly for industry 121 2.1 2.5 2.2 2.4 2.1 1.5 1.3 Processed:Mainly for householdconsumption 122 3.2 2.8 2.9 5.3 4.3 4.3 4.3 Industrial supplies,nes 2 35.0 38.0 34.4 34.4 33.3 33.7 35.4 Primary 21 3.4 3.9 4.1 3.2 3.5 3.3 3.3 Processed 22 31.6 34.1 30.3 31.2 29.7 30.4 32.1 Fuelsand lubricants 3 23.8 22.9 30.4 26.9 25.7 26.3 29.3 Primary 31 19.2 18.3 25.7 23.3 22.6 23.0 27.1 Processed:Motor spirit 321 1.4 1.8 2.5 1.1 1.1 1.4 1.1 Processed:Other 322 3.3 2.9 2.2 2.5 2.1 1.9 1.o Capital goods (except for transport equipment), and parts and accessories thereof 4 14.9 14.4 12.6 13.6 13.7 14.8 16.7 Capital goods (except for transport equipment) 41 9.5 9.5 8.5 8.9 9.5 10.5 11.2 Partsand accessories 42 5.4 4.9 4.1 4.7 4.2 4.3 5.5 Transport equipmentand parts and accessories thereof 5 9.6 7.2 5.5 8.6 6.3 5.3 6.1 Passengermotor cars 51 1.o 0.4 0.3 1.8 0.2 0.2 0.2 Other: Industrial 521 2.7 2.3 1.5 3.0 3.0 2.1 1.9 Other: Non-industrial 522 0.0 0.0 0.0 0.0 0.0 0.0 0.0 Partsand accessories 53 6.0 4.5 3.7 3.8 3.O 3.1 3.9 Consumer goods nes 6 7.2 6.7 6.2 6.1 5.9 5.8 5.3 Durable 61 1.o 0.7 0.6 0.5 0.6 0.6 0.7 Semi-durable 62 1.4 1.3 1.4 1.5 1.5 1.3 1.4 Non-durable 63 4.9 4.7 4.3 4.0 3.8 3.8 3.2 Goods nes 7 1.6 2.1 1.6 0.6 7.0 6.5 0.0 Source: World Bank staff estimatesbasedon WITS/COMTRADE data. 143 Table A 4.8: TotalExports, without Oil Products, 1998-2004 1998 1999 2000 2001 2002 2003 2004~ Total, US$ thousand 7,069,724.8 5,908,935.1 7,331,030.1 7,450,625.7 8,020,911.8 9,945,588.4 13,751,699.6 Exportswithout oil products 6,524,908.3 5,380,342.9 5,895,298.7 6,136,581.2 6,415,886.2 7,795,091.7 10,154,978.3 CIS Total exports 5,160,188.6 3,621,620.9 4,404,729.7 4,493,730.0 4,384,404.2 5,434,605.1 7,295,817.6 Exportswithout oil products 4,819,081.8 3,468,992.2 3,945,226.1 4,252,960.8 4,282,909.1 5,337,581.3 6,936,893.7 Russia Total exports 4,608,147.1 3,222,030.6 3,715,696.8 3,962,717.2 3,977,107.1 4,879,857.8 6,462,97 6.6 Exportswithout oil products 4,317,793.2 3,173,261.5 3,649,765.5 3,916,999.8 3,956,617.0 4,845,884.7 6,222,220.6 Ukraine Total exports 386,903.8 280,609.9 559,727.9 421,818.7 271,581.6 343,520.0 539,809.6 Exportswithout oil products 346,705.3 185,243.9 187,676.7 252,388.9 209,665.6 302,747.1 451,232.7 Others of CIS Total exports 165,137.7 118,980.4 129,305.0 109,194.1 135,7 15.5 211,227.3 293,031.4 Exportswithout oil products 154,583.3 110,486.8 107,783.9 83,572.1 116,626.5 188,949.5 263,440.4 ROW Total exports 1,909,536.2 2,287,314.2 2,926,300.4 2,956,895.7 3,636,507.6 4,5 10,983.3 6,455,882.0 Exportswithout oil products 1,705,8263 1,911,350.7 1,950,072.6 1,883,620.4 2,132,977.1 2,457,510.4 3,2 18,084.6 EU- 15 Total exports 481,923.9 526,371.8 689,449.0 821,448.5 1,440,298.1 2,279,044.2 3,298,117.4 Exports without oil products 461,234.8 498,626.8 560,480.5 543,282.2 645,564.4 800,573.5 907,736.0 Germany Total exports 199,585.1 215,496.2 231,726.1 241,044.9 347,941.1 421,183.8 502,848.3 Exportswithout oil products 195,186.2 214,740.4 231,698.5 233,509.8 265,856.0 315,450.7 364,142.9 GreatBritain Total exports 38,162.1 51,641.I 95,895.2 222,930.5 493,725.9 938,265.4 1,147,562.7 Exportswithout oil products 33,275.6 32,834.9 31,266.4 26,328.1 35,667.5 36,075.0 64,196.2 Italy Total exports 73,032.8 64,775.8 76,050.5 85,410.8 130,059.4 135,252.0 142,956.7 Exportswithout oil products 72,083.4 64,282.0 74,859.7 82,826.8 130,059.4 133,982.2 140,952.4 New member countries - 10 Total exports 639,359.8 797,739.1 1,361,440.6 1,286,872.9 1,245,086.1 1,288,018.2 1,744,902.1 Exportswithout oil products 457,462.5 463,400.7 518,599.4 506,334.1 555,958.4 732,551.6 938,357.2 Latvia Total exports 171,405.1 260,431.1 467,311.3 492,265.9 520,108.8 344,349.7 325,999.9 Exports without oil products 82,686.4 86,177.0 91,285.9 79,370.2 86,744.9 110,526.0 153,700.4 Lithuania Total exports 157,566.8 174,653.7 348,777.0 275,803.8 256,736.1 264,98 1.6 356,277.0 Exports without oil products 138,380.2 123,965.5 139,670.2 158,530.7 177,795.3 240,422.3 283,412.8 Poland Total exports 184,918.3 208,326.0 276,753.1 248,001.4 273,280.0 434,171.6 728,753.7 Exports without oil products 136,833.5 162,877.9 207,120.0 165,860.3 193,020.4 243,819.5 357,001.1 China Total exports 99,65 1.4 169,459.3 136,218.0 143,054.2 217,428.6 162,252.2 301,490.8 Exportswithout oil products 99,65 1.4 169,459.3 136,218.0 143,054.2 217,428.0 162,250.8 301,490.8 UnitedStates Total exports 103,351.2 80,107.7 99,286.4 77,429.5 91,315.8 102,468.7 162,830.9 Exports without oil products 103,346.7 80,018.4 99,068.4 76,431.3 86,012.6 102,468.7 153,141.2 Source: WITS/COMTRADEdata. 144 Table A 4.9: Export DiversificationIndex at 3-digit SITC level 1998 1999 2000 2001 2002 2003 Total 0.504 0.530 0.551 0.557 0.546 0.536 CIS 0.477 0.502 0.498 0.496 0.465 0.459 Russia 0.458 0.479 0.481 0.481 0.481 0.476 ROW 0.668 0.669 0.697 0.705 0.718 0.715 EU-15 0.769 0.742 0.751 0.773 0.779 0.795 Source: World Bank staff calculations basedon WITS/COMTRADE data. Table A 4.10: HirschmanIndex (at 3-digit SITC level), 1998-2003 1998 1999 2000 2001 2002 2003 Total 0.153 0.170 0.221 0.204 0.219 0.228 CIS 0.151 0.149 0.165 0.142 0.140 0.140 Russia 0.153 0.146 0.142 0.141 0.141 0.140 ROW 0.256 0.289 0.361 0.387 0.418 0.447 EU-15 0.216 0.213 0.252 0.364 0.519 0.615 Source: World Bank staff calculations based on WITS/COMTRADE data. 145 Table A 4.11:RevealedComparativeAdvantage Indices, 1998-2003 (Totalexport, 3-digitSITC level)* SITC code Product Description 1998 1999 2000 2001 2002 2003 011 Beef, freshichilldlfrom 0.78 0.55 0.52 1.77 2.03 2.21 017 Meavoffalpresvdn.e.s 1.33 1.72 1.68 2.03 2.44 3.36 022 Milkpr excbuttricheese 1.72 1.43 2.97 3.85 3.02 4.73 023 Butter and cheese 8.30 7.86 7.06 10.29 11.06 12.75 024 Cheeseand curd 3.23 2.19 2.54 2.93 2.82 3.43 025 Eggs, albumin 18.33 26.80 18.18 15.10 10.42 10.14 037 Fishishellfish,prep/pres 0.56 0.58 0.71 0.83 1.74 2.10 045 Cerealgrains nes 0.41 0.02 0.00 0.94 2.89 5.06 046 Flourimealwheavmeslin 1.08 0.54 2.94 1.04 0.08 0.20 047 Cerealmealiflour n.e.s 13.22 I.75 1.03 2.42 0.20 5.81 061 Sugarimollassesihoney 5.82 6.40 6.67 5.65 8.68 8.09 062 Sugar confectionery 5.01 5.12 5.70 4.13 3.64 3.33 073 Chocolateicocoapreps 1.30 1.35 1.99 2.08 2.18 1.47 091 Margarineishortening 4.32 3.47 4.40 2.60 0.82 1.10 211 Hidehkin (ex fur) raw 1.13 0.70 0.77 0.95 4.99 2.25 212 Furskinsipieces,raw 4.26 8.70 9.35 6.31 4.12 5.78 245 Fuelwoodiwoodcharcoal 0.97 1.62 1.73 1.67 1.21 2.33 247 Wood inroughisquared 2.92 2.70 2.45 2.95 3.00 2.79 248 Wood simply worked 1.71 2.38 2.44 2.13 2.47 2.73 265 Veg text fibre ex covju 4.26 5.01 3.94 8.68 10.32 7.70 266 Synthetic spinningfibre 17.30 20.43 24.57 25.81 20.00 27.35 273 Stoneisandgravel 2.15 1.34 1.49 2.14 2.36 1.69 278 Other crudeminerals 2.86 1.72 1.43 1.14 1.58 1.73 288 Nfbasemetalwastenes 0.88 1.24 1.10 1.51 3.30 1.40 322 Briquetteslligniteipeat 1.47 1.56 0.80 0.84 2.43 4.01 334 Heavypetrolhitum oils 4.64 4.53 6.97 6.75 8.30 9.80 335 Residualpetrol.prods 1.48 1.02 1.52 3.17 2.81 3.11 533 Pigmentsipaintslvarnish 2.42 1.66 1.55 2.55 0.79 0.60 562 Manufactured fertilizers 23.80 31.81 27.45 29.17 32.31 29.83 571 Primaryethylenepolymer 2.41 2.73 3.01 3.44 2.72 2.55 592 Starchesigluesietc. 2.32 1.83 2.57 2.76 2.16 1.96 611 Leather 1.09 1.23 1.09 1.51 1.34 2.30 613 Furskins tannedidressed 2.58 3.78 2.24 1.38 3.72 3.31 625 Rubbertyresitreads 5.97 4.28 3.77 3.50 1.93 2.04 634 Veneeriplywoodletc 2.54 2.46 2.53 2.58 2.34 2.08 651 Textile yam 3.43 4.60 4.13 3.99 3.62 3.71 654 Woven textile fabric nes 5.38 6.92 6.16 5.36 5.72 5.95 657 Specialyamsifabrics 2.94 1.95 2.26 2.69 2.23 2.38 659 Floor coverings etc. 2.38 2.38 3.03 2.84 2.32 1.84 662 Clayirefractorymaterial 2.65 3.20 4.49 5.09 4.79 4.33 672 Primaryiprodsirodsteel 7.79 9.26 9.49 4.96 4.60 3.70 676 Ironisteelbarshodsietc 4.70 3.52 3.10 5.02 5.07 5.62 677 Ironisteelrailway mat1 3.86 2.70 0.02 0.10 0.19 0.81 146 678 Ironisteel wire 4.81 4.92 5.30 5.46 6.42 6.96 693 Wire prod exc ins electr 13.45 15.26 14.12 12.52 11.90 13.21 697 Base metal h"hold equipms 2.70 3.97 3.91 4.18 4.02 3.81 721 Agric machine ex tractr 2.22 4.33 3.91 3.57 2.40 1.58 722 Tractors 14.71 27.11 21.19 21.79 17.74 14.82 746 Ballholler bearings 3.95 3.17 2.75 2.43 2.05 1.20 775 Domestic equipment 2.73 3.86 3.90 4.15 4.24 3.92 782 Goodsiservice vehicles 6.26 6.37 5.50 5.42 4.39 3.84 783 Roadmotor vehicles nes 3.76 3.38 7.02 6.54 7.17 5.74 786 Trailers/caravans/etc 4.45 4.59 4.14 4.39 3.80 2.53. 811 Prefabricated buildings 4.46 3.40 3.53 3.35 2.06 1.28 812 Sanitarylplumbiheat fixt 2.66 1.47 1.63 2.17 1.98 2.17 821 Fumiture/stuff fumishg 2.55 2.03 1.81 1.94 1.97 1.82 842 Womenigirl clothing w e n 1.97 2.08 2.01 2.10 1.71 1.57 844 Womenigirl wear knit/cro 2.15 1.28 0.94 1.10 0.72 0.61 851 Footwear 2.44 2.31 1.89 1.68 0.86 0.73 871 Optical instruments nes 1.11 1.18 1.43 3.10 3.53 2.58 891 Arms and ammunition 2.46 0.00 0.01 0.00 0.00 0.00 ... *Commodities with RCA>2 in any year. Source: World Bank staffcalculations basedon WITS/COMTRADE data. 147 Table A 4.12: Export SpecializationIndices, 1998-2003 (Exports to CIS, 3-digit SITC level)* SITC code Product Description 1998 1999 2000 2001 2002 2003 011 Beef, freshichilldifrom 0.35 0.21 0.33 0.92 1.20 3.10 017 Meauoffal presvd n.e.s 0.23 0.88 0.90 1.76 2.86 5.40 022 Milkpr exc buttricheese 1.19 1.44 2.45 4.89 6.07 8.16 023 Butter and cheese 2.14 2.42 2.47 3.79 4.77 3.78 024 Cheese and curd 1.85 2.81 2.26 2.61 2.67 3.33 025 Eggs, albumin 7.53 9.48 8.43 9.01 8.95 7.72 035 Fish,dried/salted/smoked 1.01 1.28 1.49 1.25 1.47 4.52 037 Fish/shellfish,prep/pres 0.63 1.01 1.70 1.23 2.19 2.96 047 Cereal mealiflour n.e.s 3.80 0.89 0.71 2.06 0.27 5.85 061 Sugarimollasseslhoney 1.40 0.87 1.20 0.99 2.80 2.18 062 Sugar confectionery 1.56 2.23 2.06 2.08 3.14 3.80 212 Furskinsipieces, raw 4.04 6.77 5.08 1.62 1.97 3.03 245 Fuel woodiwood charcoal 2.81 8.97 11.43 10.98 4.97 14.95 246 Wood chipsiwaste 3.61 0.91 0.18 0.62 0.00 0.45 247 Wood inroughisquared 5.52 7.62 6.20 6.91 8.21 7.89 248 Wood simply worked 2.23 2.02 1.35 1.02 0.90 0.53 264 Jutehast fibre raw/retd 0.46 1.59 2.07 0.03 0.73 0.00 265 Veg text fibre ex cot/ju 3.05 1.86 1.so 5.73 5.21 4.64 266 Synthetic spinningfibre 15.41 15.98 15.63 18.15 17.98 16.05 268 WooVanimal hair 1.90 3.60 1.62 2.53 6.04 2.90 277 Natural abrasivesn.e.s. 0.10 0.00 3.95 1.11 0.00 0.00 288 Nfbasemetalwastenes 1.88 1.52 0.96 0.02 1.46 3.77 322 Briquettesiligniteipeat 2.40 0.45 0.20 0.38 0.70 0.73 334 Heavy petrolhitum oils 3.34 2.32 4.17 3.10 1.64 1.04 335 Residualpetrol.prods 1.15 0.44 1.09 2.56 3.28 3.92 344 Petrol./hydrocarbon gas 0.00 0.01 5.54 8.91 8.98 17.56 515 Organo-inorganic compnds 4.05 2.57 1.69 1.54 2.38 3.29 562 Manufactured fertilizers 12.52 8.22 6.05 5.66 4.48 4.19 571 Primaryethylene polymer 6.48 6.97 7.11 7.92 6.45 4.69 574 Polyacetalsipolyesters.. 1.98 1.60 1.10 1.33 1.36 2.48 579 Plastic wasteiscrap 0.89 0.62 0.76 2.85 4.35 7.25 592 Starchesigluesietc. 1.62 1.69 2.17 2.33 1.70 0.74 611 Leather 1.84 2.47 2.04 2.27 3.06 2.90 621 Materials o frubber 1.41 1.09 1.07 1.82 2.14 1.97 625 Rubber tyresitreads 4.66 4.32 3.28 3.43 2.39 2.55 634 Veneeriplywoodietc 2.53 2.36 2.11 2.15 2.04 1.72 651 Textile yam 6.73 6.71 6.38 8.01 8.35 7.10 652 Cotton fabrics, woven 2.26 1.48 1.71 1.83 1.51 1.41 654 Woven textile fabric nes 1.82 1.87 1.98 2.16 2.54 2.52 657 Special yamsifabrics 3.50 2.57 2.48 3.17 2.96 2.79 659 Floor coverings etc. 1.90 2.64 2.45 2.66 2.21 1.79 661 Limeicementkonstr mt"l 2.50 1.99 1.96 1.66 0.89 0.83 662 Clayirefractory material 1.65 2.12 2.51 3.08 3.14 2.92 663 Mineral manufactures nes 1.71 1.49 1.71 1.82 2.40 2.72 664 Glass 2.58 2.33 1.97 3.27 3.09 3.09 672 Primaryiprods irodsteel 7.12 8.03 9.49 10.37 1.19 0.28 676 Ironisteel barsirodsietc 3.52 2.23 1.10 1.69 3.08 5.67 678 Ironisteel wire 4.04 2.93 1.86 3.20 3.20 3.17 682 Copper 0.97 0.68 0.98 0.95 3.21 1.71 683 Nickel 0.36 0.38 0.65 2.46 0.21 1.oo 693 Wire prod exc ins electr 8.18 8.97 6.72 7.74 9.39 8.77 694 Nailslscrewsinutsibolts 4.23 0.79 1.06 1.32 1.32 1.69 148 Table A4.12 Continued 697 Base metal h"ho1d equipms 2.64 5.12 4.24 4.30 4.49 3.90 713 Internal combust engines 3.18 2.96 2.59 2.26 2.13 2.68 721 Agric machineex tractr 0.96 2.51 1.83 1.60 1.24 0.99 722 Tractors 5.63 11.27 10.44 10.95 12.52 10.60 735 Metal machine tool parts 2.15 1.30 2.46 3.86 3.08 3.18 746 BalVroller bearings 6.46 5.79 4.55 4.14 4.49 3.46 761 Television receivers 1.56 3.22 2.74 3.68 3.33 2.43 771 Electpower transmequip 2.81 2.10 1.55 2.03 2.53 2.84 775 Domesticequipment 1.99 3.67 3.09 3.33 3.70 3.39 782 Goodsiservicevehicles 8.34 9.09' 8.12 7.03 6.15 4.74 783 Roadmotor vehiclesnes 2.23 3.93 5.48 4.19 4.79 4.93 784 Motor veh parts/access 3.41 2.81 2.71 2.90 1.88 2.50 785 Motorcycles/cycles/etc 6.38 9.95 7.80 8.52 6.46 4.23 786 Trailersicaravansletc 4.31 7.31 5.54 4.96 4.71 4.19 811 Prefabricatedbuildings 2.08 1.52 2.23 1.64 1.13 0.55 821 Fumiturehfffumishg 1.77 1.91 1.81 2.10 2.47 2.54 871 Optical instrumentsnes 3.32 6.17 2.42 4.31 6.81 3.99 873 Meters and countersnes 0.81 2.14 2.12 2.29 1.88 1.68 885 Watches and clocks 1.75 2.69 1.93 1.30 1.28 n.74 - *Commodities with ESP2 in any year. Source: World Bank staff calculations basedonWITS/COMTRADE data. 149 Table A 4.13: Export Specialization Indices, 1998-2003 (Exportsto Russia, 3-digit SITC level)* SITC code Product,Description 1998 1999 2000 2001 2002 2003 017 Meatfoffal presvd n.e.s 0.18 0.68 0.80 1.61 2.51 4.88 022 Milkpr exc buttricheese 1.03 1.15 2.35 4.67 6.65 7.89 023 Butter and cheese 1.71 1.81 1.92 2.84 3.47 2.66 024 Cheese and curd 1.29 1.92 1.58 1.80 1.79 2.21 025 Eggs, albumin 8.67 9.73 9.69 10.10 9.27 7.78 035 Fish,dried/salted/smoked 0.99 1.34 2.02 1.88 1.68 3.53 037 Fish/shellfish,prep/pres 0.55 0.89 1.51 1.12 1.73 2.32 046 Flourimealwheatlmeslin 0.60 0.49 2.48 2.00 0.86 1.06 047 Cereal mealiflourn.e.s 3.79 0.84 0.99 0.78 0.39 3.10 061 Sugarimollassesihoney 1.27 0.61 0.82 0.43 2.17 1.66 062 Sugar confectionery 1.35 2.02 1.83 1.97 3.63 4.16 073 Chocolateicocoa preps 0.47 1.21 1.39 1.47 1.65 2.33 075 Spices 1.05 1.07 2.57 0.13 0.05 0.02 111 Beverage non-alcohol nes 0.54 1.46 1.04 1.47 2.28 1.36 212 Furskinsipieces, raw 3.76 5.53 3.98 1.43 1.48 2.28 245 Fuelwoodiwood charcoal 6.97 9.08 9.38 9.51 7.32 11.25 247 Wood inroughisquared 6.06 7.19 6.32 8.78 8.99 8.81 248 Wood simply worked 2.79 2.01 1.95 1.94 1.91 1.87 264 Jutehast fibre rawiretd 0.38 5.61 7.65 0.02 5.67 0.00 265 Veg text fibre ex cotlju 4.24 1.71 1.27 5.68 5.19 3.68 266 Synthetic spinning fibre 10.83 10.32 10.85 12.46 12.13 10.62 268 Wool/animal hair 2.01 2.76 1.77 2.74 5.23 2.52 277 Natural abrasivesn.e.s. 0.21 0.01 6.48 2.86 0.00 0.00 278 Other crude minerals 1.64 0.48 0.46 0.46 1.07 2.04 282 Ferrous wasteiscrap 3.78 0.70 0.68 0.78 0.89 7.20 288 Nfbasemetalwaste nes 3.07 2.16 2.01 1.41 6.49 7.61 321 Coal non-agglomerated 0.00 0.04 0.01 0.00 3.42 0.20 322 Briquetteslligniteipeat 3.70 3.08 0.28 0.32 0.87 0.20 333 Petrol.hitum. oi1,crude 0.00 0.00 0.00 0.00 13.50 11.55 334 Heavypetrolhiturn oils 4.58 2.07 2.67 2.01 0.73 1.29 342 Liquidpropanehutane 0.68 1.99 5.76 0.00 3.55 0.00 344 Petrolhydrocarbon gas 0.00 0.02 7.46 11.30 13.00 11.13 515 Organo-inorganic compnds 3.58 1.79 0.93 0.99 0.15 0.31 562 Manufactured fertilizers 10.21 9.67 10.19 8.07 10.41 9.72 571 Primary ethylene polymer 6.57 7.21 8.13 7.97 6.11 3.92 574 Polyacetalsipolyesters.. 1.85 1.34 1.01 1.16 1.15 2.24 579 Plastic wasteiscrap 0.97 3.16 2.34 3.56 3.98 5.51 592 Starchesigluesietc. 1.32 1.35 1.87 2.01 1.56 0.63 611 Leather 2.04 3.04 2.24 2.33 3.12 3.00 621 Materials of rubber 1.42 0.97 1.20 1.81 2.04 1.70 625 Rubber tyredtreads 4.25 3.56 3.30 3.51 2.68 2.77 634 Veneeriplywoodietc 1.95 2.14 2.34 2.32 2.24 1.so 651 Textile yam 5.57 5.15 5.36 7.22 7.53 6.35 652 Cotton fabrics, woven 2.69 2.04 2.52 2.76 2.09 1.94 654 Woven textile fabric nes 2.35 2.10 2.57 2.45 2.85 2.64 657 Special yamsifabrics 2.79 2.27 2.53 3.06 2.69 2.60 659 Floor coverings etc. 2.10 3.24 3.32 3.27 2.74 2.16 661 Lime/cementlconstr mat"l 2.70 1.86 1.86 1.70 1.20 1.23 662 Clayirefractory material 1.78 2.38 2.78 3.10 2.98 2.70 663 Mineral manufactures nes 1.85 1.56 1.78 1.84 2.27 2.70 664 Glass 2.43 2.02 2.07 3.12 2.45 2.58 667 Pearls/precious stones 0.00 0.00 3.78 7.05 0.00 0.00 150 Table A4.13 Continued 672 Primaryiprodsironisteel 7.56 6.92 9.84 9.37 5.42 2.21 676 Ironisteelbars/rods/etc 3.41 2.07 1.06 1.92 3.66 7.96 677 Ironisteelrailway mat1 1.97 2.03 0.01 0.29 0.94 3.20 678 Ironisteelwire 5.32 4.07 3.44 4.36 4.75 5.62 682 Copper 1.60 0.94 1.38 1.46 4.08 2.33 683 Nickel 0.98 1.26 2.35 4.73 0.38 2.08 685 Lead 1.65 0.00 0.02 0.06 0.43 2.72 686 Zinc 0.48 0.59 0.14 2.62 0.10 0.13 693 Wire prod exc ins electr 7.22 7.58 6.28 7.34 8.53 8.69 694 Nails/screws/nuts/bolts 4.43 0.81 1.16 1.32 1.18 1.65 697 Base metalh"hold equipms 2.00 4.07 3.41 3.41 3.59 3.28 713 Internalcombust engines 3.92 3.49 3.36 2.95 2.37 2.44 718 Powergeneratingequ nes 3.59 2.25 2.66 2.89 2.24 3.51 721 Agric machine ex tractr 1.01 2.72 2.40 2.12 1.59 1.16 722 Tractors 6.52 8.54 7.93 8.85 8.99 7.23 735 Metal machinetool parts 1.74 1.01 2.27 3.60 2.59 2.60 746 Ballirollerbearings 5.70 5.46 4.21 3.76 4.56 3.75 761 Televisionreceivers 1.38 2.77 3.02 3.86 3.50 2.56 771 Elect power transmequip 2.61 2.19 1.96 2.11 2.29 2.75 773 Electricaldistrib equip 1.02 2.14 2.31 1.56 1.70 2.17 775 Domestic equipment 1.43 2.60 2.29 2.51 2.85 2.56 782 Goodsiservicevehicles 6.99 7.34 7.00 6.73 6.22 4.54 783 Road motor vehiclesnes 2.54 3.73 5.15 4.10 4.58 4.59 784 Motor veh padaccess 3.96 3.31 3.28 3.14 1.74 2.19 785 Motorcycledcyclesietc 5.37 7.72 6.35 6.98 5.26 3.20 786 Trailersicaravansietc 4.83 6.11 5.40 5.10 4.43 3.63 811 Prefabricatedbuildings 2.04 1.40 2.63 1.57 0.94 0.78 821 Fumitureistuff fumishg 1.57 1.70 1.69 1.95 2.23 2.24 871 Optical instrumentsnes 3.61 5.60 1.91 3.77 5.48 3.03 873 Meters and countersnes 1.01 2.45 3.37 2.64 2.56 2.43 885 Watches and clocks 1.44 2.26 1.66 1.10 1.04 0.64 931 UNSpecialCode 0.96 1.21 2.57 0.74 4.91 3.13 971 Goldnon-monetaryex ore 0.00 0.00 1.80 2.26 0.00 0.00 *Commodities with ESP2 inany year. Source: World Bank staff calculationsbasedonWITS/COMTRADEdata. 151 Table A 4.14: Export SpecializationIndices,1998-2003 (Exportsto the EU-15,3-digitSITC level)* SITC code Product Description 1998 1999 2000 2001 2002 2003 045 Cerealgrains nes 0.00 0.00 0.00 0.00 9.78 0.00 054 Vegetables,frsh/chld/frz 3.47 1.50 2.28 1.84 0.52 1.18 058 Fruit presvdifiuitpreps 6.40 2.10 3.31 2.02 0.97 0.67 211 Hideiskin (ex fur) raw 11.87 4.91 4.45 6.53 23.57 8.80 212 Furskinsipieces,raw 0.36 0.01 0.00 13.87 1.18 3.99 247 Wood inroughisquared 5.75 3.20 3.23 3.82 1.45 2.74 248 Wood simply worked 10.37 22.27 19.96 14.63 10.48 7.17 265 Veg text fibre ex cotiju 0.06 0.00 0.51 3.52 13.21 3.47 266 Synthetic spinningfibre 18.90 17.61 13.55 8.80 5.87 10.28 267 Man-made fibres nesiwast 4.10 1.50 0.51 0.60 0.65 0.35 269 Worn clothingetc 3.52 0.23 0.03 3.14 17.85 8.90 282 Ferrouswastelscrap 5.04 2.61 2.79 2.73 1.93 0.99 288 Nfbasemetalwastenes 2.29 8.71 7.77 9.82 14.43 4.66 322 Briquettes/lignite/peat 6.68 8.17 3.60 2.83 4.06 9.35 334 Heavypetrolhitum oils 4.02 3.62 8.78 17.70 28.11 38.95 515 Organo-inorganic compnds 6.22 4.05 5.74 1.44 0.55 0.47 522 Elementsloxidesihal salt 3.10 1.05 0.92 0.75 0.48 0.29 562 Manufacturedfertilizers 12.99 15.29 11.29 13.47 5.13 5.26 574 Polyacetals/polyesters.. 0.01 2.28 1.03 0.26 0.11 0.15 592 Starchesigluesietc. 4.42 0.23 2.17 2.32 0.96 2.35 611 Leather 4.24 1.54 0.87 2.84 1.34 5.64 634 Veneeriplywoodietc 7.18 7.42 6.79 6.87 3.53 2.07 635 Wood manufacturesn.e.s. 5.75 6.90 7.53 5.93 4.43 3.06 651 Textile yam 6.10 6.62 5.74 4.43 2.82 2.95 652 Cottonfabrics, woven 2.76 3.17 4.12 3.44 1.95 1.59 654 Woven textile fabric nes 10.17 15.84 15.04 13.81 7.32 6.58 658 Made-up textile articles 2.75 2.53 1.80 2.53 1.12 0.45 665 Glassware 2.44 2.24 1.91 1.47 0.69 0.64 672 Primaryiprodsirodsteel 7.52 6.79 3.28 2.54 2.27 2.82 676 Ironisteelbarsirodsletc 3.18 2.80 6.05 7.02 7.42 6.19 678 Ironisteelwire 23.79 28.47 30.45 20.58 16.21 15.60 693 Wire prodexc inselectr 47.37 46.85 32.40 20.44 11.16 13.59 694 Nails/screws/nutsboIts 4.57 3.36 3.57 3.44 2.09 1.51 722 Tractors 9.11 5.12 5.73 3.80 2.88 0.92 733 Mtlm-tools w/o mtl-rmvl 1.34 3.42 1.78 0.44 0.3 1 0.15 775 Domesticequipment 0.02 2.92 3.18 1.73 0.33 0.15 813 Lightingfixtures etc 0.15 0.05 0.24 1.43 3.16 1.84" 821 Fumitureistuff fumishg 2.27 3.23 3.00 2.81 1.65 1.06 841 Menshoys wear, woven 5.87 5.19 4.39 3.09 1.44 1.19 842 Womenigirl clothing wen 12.87 11.06 8.57 6.85 3.69 2.94 843 Menboy wear kniticroch 4.15 4.81 4.25 2.65 1.70 1.69 844 Women/girlwear kniticro 6.30 3.90 3.95 3.53 2.08 1.11 845 Articles of apparelnes 10.70 9.64 7.45 5.92 3.77 2.40 871 Optical instrumentsnes 6.45 6.37 5.55 7.91 5.39 2.94 872 Medicalietcinstruments 6.24 7.01 5.75 4.79 3.34 2.48 884 Optical fibers 2.47 3.00 2.35 1.52 1.27 0.93 * Commoditieswith ESP2 inany year. Source: World Bank staff calculationsbasedon WITS/COMTRADEdata. 152 Table A 4.15: Export SpecializationIndices, 1998-2003 (Exports to the EU-10,3-digit SITC level)* SITC code Product Description 1998 1999 2000 2001 2002 2003 022 Milkpr exc buttricheese 3.66 2.21 11.71 10.39 4.50 0.72 036 Crustaceansmolluscs etc 4.26 17.29 6.27 5.77 1.60 0.03 037 Fishishellfish,prepipres 0.08 0.02 0.04 0.05 1.66 2.69 045 Cereal grains nes 0.79 0.07 0.01 0.31 22.53 63.08 047 Cereal mealiflour n.e.s 4.31 0.70 0.00 0.00 0.00 0.71 058 Fruit presvdifruit preps 1.52 0.60 1.20 1.11 2.40 1.38 211 Hideiskin (ex fur) raw 0.58 1.24 1.06 1.35 4.52 6.76 212 Furskindpieces,raw 0.66 0.00 1.79 7.92 4.85 7.49 222 Oil seeds etc - softoil 2.43 0.02 1.23 6.56 2.39 0.00 223 Oil seeds-notsoft oil 2.07 0.45 0.26 0.06 1.43 0.41 245 Fuelwoodiwood charcoal 17.44 18.75 7.54 4.21 3.28 6.06 247 Wood inroughisquared 19.64 8.79 7.79 8.14 12.23 10.98 248 Wood simply worked 7.74 4.30 3.12 3.25 4.14 10.15 265 Veg text fibre ex coVju , 1.51 0.17 0.25 2.09 4.46 2.97 266 Synthetic spinningfibre 86.21 41.21 30.40 29.54 25.93 40.93 273 Stoneisandigravel 8.07 3.55 2.66 3.60 4.86 4.10 278 Other crude minerals 6.51 5.78 3.10 2.88 3.73 4.55 282 Ferrous wasteiscrap 0.77 2.61 3.25 3.60 1.38 1.83 288 Nfbasemetalwastenes 4.25 0.17 0.62 1.18 0.93 0.72 291 Crudeanimalmterialnes 2.17 1.69 1.oo 1.02 0.63 0.33 322 Briquettes/lignite/peat 1.47 0.93 0.71 1.10 4.66 4.15 333 Petrol.ibitum. oil,crude 2.01 1.oo 0.84 1.18 0.64 0.83 334 Heavypetrolibihlmoils 10.91 15.28 13.46 16.13 16.54 12.31 335 Residualpetrol.prods 3.01 3.78 2.34 4.23 3.40 5.40 342 Liquid propaneibutane 0.20 4.12 4.70 2.11 4.47 7.70 344 Petro1,ihydrocarbongas 16.56 6.30 2.03 0.00 1.12 2.37 351 Electric current 0.01 0.00 0.00 0.31 1.20 3.31 512 Alcoholsiphenolsiderivs 0.49 0.35 0.32 4.77 0.00 5.30 513 Carboxylic acid compound 6.41 2.84 1.67 0.38 0.16 1.31 514 Nitrogen function compds 8.25 3.33 1.55 0.58 0.11 0.01 515 Organo-inorganic compnds 10.61 20.06 14.99 15.41 17.31 15.34 522 Elementsloxidesihal salt 4.31 5.47 2.62 1.64 2.80 4.41 524 Other inorganic chemical 0.53 4.29 0.54 0.04 0.00 0.00 562 Manufacturedfertilizers 47.62 48.84 27.85 29.64 34.17 34.76 571 Primaryethylene polymer 3.37 2.12 1.51 2.19 3.18 2.90 574 Polyacetalsipolyesters.. 2.03 0.77 0.97 0.94 0.72 0.83 592 Starcheslgluesietc. 6.52 2.06 2.07 3.16 3.08 4.58 625 Rubber tyresitreads 1.97 2.41 0.86 0.89 0.42 0.60 634 Veneeriplywoodietc 4.43 4.87 3.45 2.23 2.20 2.05 651 Textile yam 4.65 2.18 1.82 1.81 1.72 2.55 654 Woven textile fabric nes 5.90 4.78 2.70 1.62 1.65 3.74 661 Lime/cement/constrmat"l 3.73 3.62 3.07 2.36 6.31 7.20 672 Primaryiprodsironlsteel 5.50 4.62 8.97 10.89 12.72 18.25 677 Ironisteelrailway mat1 0.79 2.13 0.02 0.18 0.49 4.05 678 Ironisteelwire 0.90 1.31 0.66 1.89 2.56 2.37 693 Wire prod exc ins electr 7.28 9.50 7.10 6.81 8.55 12.69 722 Tractors 41.74 31.13 11.23 14.22 13.51 16.41 746 Ball/roller bearings 3.52 1.78 0.85 0.60 0.47 0.38 841 Mensiboys wear, woven 2.50 1.73 0.36 0.46 0.27 0.31 883 Cine fild developed 0.12 0.18 0.00 0.00 0.02 3.89 898 Musical instrumsirecords 0.04 0.01 0.00 1.01 1.28 2.01 *Commodities with ESP2 inany year. Source: World Bank staff calculationsbasedon WITS/COMTRADE data. 153 ANNEX4.2. CLASSIFICATION OF BELARUS EXPORTSAND IMPORTS INTO THE BASIC SNA CLASSES W e have partially rearranged Belarus' trade data by BEC to approximate the three basic SNA classes usingthe following approach: I. Capitalgoods.Sumofthecategories: 41 Capital goods (except transport equipment) 521 Transport equipment, industrial 11. Intermediate goods. Sum of the categories: 111 Foodandbeverages, primary: mainly for industry 121 Food andbeverages, processed: mainly for industry 2 Industrial suppliers 3 Fuels and lubricants 42 Parts and accessories o f capital goods (except transport equipment) 53 Parts and accessories o f transport equipment 111. Consumption goods. Sumo f categories: 112 Food and beverages, primary: mainly for household consumption 122 Food and beverages, processed: mainly for household consumption 51 Passenger motor cars 522 Transport equipment, non-industrial 6 Consumer goods IV. Goods nes (7) Note: Some goods are of dual use (for example motor spirits and passenger cars). We allocate them among categories on the basis o f the prevailing use. 154 CHAPTER5 THEBUSINESS ENVIRONMENT ENTERPRISESECTORDEVELOPMENT FOR 5.1 This chapter looks at the links between the business environment and the development o f the enterprise sector. The business environment i s analyzed in terms o f a nexus o f policies which regulate entry and exit, regulatory institutions, infrastructure and corporate governance legislation, and which together are critical in determining countries' competitiveness and growth prospects (Box 5.1). The chapter looks at both micro-level and macro-level variables such as market structure and competition. I Box 5.1: BusinessEnvironmentand Growth , I Recent developments in economic theory place strong emphasis on the importance o f the business climate -- the nexus o f policies, institutions, physical infrastructure, human resources, and geographic features which influence the efficiency with which different f i and industries operate - for a country's evolution o f its comparative advantage and growth prospects. Two particular links are worth mentioning. First, the ability to provide the business community with a stable and low-cost business climate -- security, good public services and regulation, and predictability - is critical for f m s ' productivity, market structure and contestability. Second, the quality o f the business climate i s directly linked to the intensity o f new market entry. Business environments do not have to be perfect but they have to be "good enough" in a number o f crucial dimensions to stimulate a critical mass o f new entry. Inmost cases it is new firms that are responsible for generating and securing new niches in world markets. Sustained economic growth inthe longer term i s driven by the emergence o f new economic activities rather than by the scaling-up o f traditional production. The effects o f a poor business climate are felt more heavily in economies which are less dependent o n extractive industries. Manufacturing and high-value services tend to be more demanding in terms o f the quality o f logistics, infrastructure, and regulation. While the combination o f macroeconomic instability, crime, a weak and politicized financial system, high transport costs, and predatory local officials will have relatively little influence o n the productivity o f offshore oil industries, it will be devastating for small-scale and medium-scale manufacturing. Given the structural characteristics o f the Belarusian economy, this suggests that improvements in the business I Sources: environment have to be o f special concern for the government of Belarus. World Development Report (2005); Eifert, Gelb, and Ramachandran (2005). 5.2 The chapter analyzes the links between the business environment and the structure of the enterprise sector, which is an important historical determinant o f businesspractices. This i s followed by an analysis o f the linksbetweenthebusinessenvironment andthebehavioral determinants ofthe economic policies. Inth~broader s context, the chapter looks at the regulatory costs of compliance: entry, functioning, and exit. This quantitative analysis is complemented bya qualitative analysis ofthe businessenvironment. 5.3 The government of Belarus has taken several steps to improve the business climate for entrepreneurs and to increase the role o f the private sector in the economy. Since 2001, multiple changes have been introduced in the regulatory regime in the areas o f licensing, registration and taxation. In particular, the long-awaited Presidential Decree No. 17 of 16 July 2003 provided for a reduction in the number of licensed spheresg4 o f activities, reducing them from 165 to 48. An important asset o f the Belarusian state i s a relatively good capacity for timely dispute resolution and a low level o f corruption within state institutions. 94 The decree identifieslicensed spheres withoutlisting separateactivities, which offers the possibilities of different interpretations. 155 5.4 However, recent positive changes have often been neutralized by the introduction o f measures that increase the administrative pressures on enterprises. For example, Decree No. 29 o f December 12, 2002 lifted some registration restrictions (such as registering at home addresses) and increased a number o f possible declared activities; however, it also expanded the list o f causes for declining registration, which lengthened the procedure for the verification of a company's founders and the registration process for manufacturers. Another recent Decree (No. 148 of March 24, 2005) improved the regulations regarding the rental costs o f market space and VAT payments, but at the same time envisaged the confiscation of goods and the recall o f licenses after only two recorded irregularities in a given year.95 Such regulatory ambivalence undermines trust in the regulatory environment and renders business unnecessarily more costly and less competitive. 5.5 Belarus i s in dire need o f regulatory reform. Despite recent improvements, business registration and regulation procedures remain extremely cumbersome. On average, it takes nearly twice as long to register a new business inBelarus as it does inRussia or Poland. Moreover, D e Novo (DN) firms are at a disadvantage in competing with state-controlled enterprises. The business environment's tilt toward traditional firms and the high costs o f starting a business are serious obstacles to growth. T o ensure a sustainable strengthening o f the competitiveness o f the economy, the government needs to address the existing weaknesses inthe regulatory system without delay. A. STRUCTURALDETERMINANTSOFTHE BUSINESSENVIRONMENT 5.6 The Belarusian enterprise sector i s dominated by large state and semi-state enterprises. The private sector contribution to GDP in Belarus i s much smaller than that in other countries in the region (Table 5.1). The output and employment share o f small enterprises (SEs) 96 inthe economy is estimatedto be in the range of 7-9 percent. According to the MSA, in 2004 the share o f SMEs in Belarus' GDP amounted to 8.8 percent. Inindustry, less than 3 percent o f output was producedby enterprises with less than 100 employees97and about 6 percent by enterprises with less than 200 employees, which i s far less than in comparable transition economies. Owing to slow restructuring o f enterprises, the average employment per industrial enterprise declined very little (less than 7 percent), from 485 in 1996 to 453 in 2003. This i s in contrast to other transition economies where the decline inthe number o f employees per enterprise was muchmore significant. Table5.1: PrivateSector Sharei,nGDP, 2000-03 ("0) 2000 2001 2002 2003 , , Belarus 20 20 25 25 Ukraine 60 60 65 65 Russia 70 70 70 70 Bulgaria 70 70 70 75 Croatia 60 60 60 60 Latvia 65 65 70 70 Source: Transition Report, 2004, EBRD. 5.7 The new enterprise sector the majority o f which i s inprivate hands, has emerged and i s growing slowly and unevenly. Unlike the situation in most transitional economies where the number o f non-state 95 Entrepreneurspay somewhere between4 and 6 penalties a year on average. 96 The Law "On State Support of Small Enterpreneurship inBelarus" defines small enterprises (SEs) as those with 100 employees inthe industrial sector, 60 inagriculture, 50 inconstruction and wholesale trade, 3 - inretail trade and 25 - inother - - non-manufacturing sectors. 97 Individual entrepreneurs (withno legal entity status) are not included inthe above official statistics. The share o f enterprises with less than 100 employees (including individual entrepreneurs with no legal entity status) inthe total industrial output i s estimated at about 7 percent. 156 small enterprises and their share intotal output and employment have steadily increased, inBelarus small enterprise growth has been very uneven. The number o f SEs grew steadily in the early transition years and reached a peak around 1999 (when the total number o f registered enterprises reached approximately 29,600), but it went into reversal during 2000-01. By end-2001, the number o f SEs was down to about 27,800 or 94 percent o f the 1999 level. Small enterprise growth resumed in 2002 and by end-2004 the number o f SEs reached 32,800 or 110 percent o f the 1999 level. However, overall employment inthe SE sector fell from 9.6 percent to 8.8 percent o f the total (Figure 5.1). Figure5.1: Number of SmallEnterprisesandTheir ShareinOutput andEmployment, 1999-2004 1200 - 180 SE share inGDP 14% 160 I= SE/Total 12% employment 140 120 10% Total Industry SE Industry/ 100 8% employment - DSEIndustryI 80 Total Industry 6% 60 +outputNumberof SEs 4% (left axis) 40 Enterpreneurs 20 2% (thousands) 0 0Yo 1999 2000 2001 2002 2003 2004 Source: MSA (2003,2004a, 2004d). 5.8 The insignificant size o f the SE sector in Belarus i s not a result o f the highrate o f bankruptcies. The universe of SEs seems to be very stable, with very few entries and exits. In 2002 more than 93 percent of SEs was well established businesse~,~~set up before 2000. As a result, the enterprise sector lacks flexibility and i s unable to respondquickly to changingmarket challenges. 5.9 The number o f individual entrepreneurs (not registered as legal entities) expanded fairly rapidly between 1999 and 2002, showing a growth o f about 50 percent. However, this growth was largely o f a compensatory nature: it reflected a rapid decline in the number o f entrepreneurs in the earlier period o f 1995-97. Overall, the number o f entrepreneurs in 2004 exceeded its 1995 level by only 11percent." An unincorporated individual business offers the benefits o f a lower regulatory burden, but at the same time it positions individual entrepreneurs in the grey area between the formal and the informal sectors, with its informal costs and harassment. However, the choice o f the status of an individual entrepreneur over that of a legal entity can be explained by the excessive regulatory burden faced by new legal entities and also by the tax advantages that individual entrepreneurs enjoy. 5.10 While Belarus' physical infrastructure for business development i s developed relative to the rest of the CIS, it tends to lag behind that o f the new EU members. The situation in the telecommunications 98"Belarusian Business 2003." 99"Belarusian Business2003", MSA. 157 sector could be considered as indicative."' InBelarus there are currently about 35 telephone subscribers per 100 inhabitants, while in Russia and Ukraine there are 36 and 30, respectively. At the same time, in Estonia 100percent o f households have fixed line phone access and inPoland access i s about 65 percent. 5.11 In 2002 the share of households in Belarus with internet access was double that in Russia. In Belarus there were, on average, 8 internet users per 100 inhabitants. By contrast, Poland and Estonia had, on average, 23 and 33 users per 100 inhabitants, respectively. Recent evidence, however, shows a trend toward growing use o f the internet in Belarus. From 2002 to 2003, regular internet use jumped by 30 percent. Moreover, the country's lower costs for establishing telecommunications connections bode well for the business environment. It costs nearly three times more to establish a business phone connection in Russia, Ukraine or Moldova (Figure 5.2). Figure5.2: BusinessTelephone ConnectionCharge as a Share of GDP per Capita,2002 (YO) 18 I 1 16 14 12 10 8 6 4 2 0 Kazakhstan Russia Ukraine Belarus I Source: International Telecommunications Union(2003). B. BEHAVIORAL DETERMINANTSTHEBUSINESSENVIRONMENT OF BusinessSegmentationand Government Control 5.12 Structural changes inthe Belarusian economy, as measured by the number and size o f enterprises and their ownership, reflect a socio economic context that i s broadly similar to that o f a "reformed' centrally planned model that was implemented inits original form inPoland and Hungary inthe 1970s. In this model, small non-state (private and cooperative) enterprises were allowed to provide a marginal but necessary supply that could not be provided by large SOEs. However, both historical experience and theoretical analysis suggest that such a model suffers from fundamental macro and micro weaknesses (Box 5.2). looChapter 7 presents an analysis o f the situation inenergy sector mfrastructure. 158 Box 5.2: The MainWeaknessesof the Market Socialism of the 1970s and 1980s The practice o f reformed market socialism, as illustratedby the cases o fYugoslavia, HungaryandPoland inthe 1970sand 1980s,had several important principles that differentiated it fiom the traditional Soviet-style model o f development. The fundamental guiding ideawas to combine the dominance o f state ownership withsome market coordination. The state was an owner o f the bulk o f industrial enterprises, with some private ownership allowed to compensate for the lack o f competitive production in consumer products and light manufacturing. However, in contrast to the classical centralized system, the methods o f enterprise control were decentralized, usually to the enterprise level. Relative to classical socialism, enterprises had considerable discretion in their production and sales decisions. At the same time, the government remained heavily involved inmanipulatingthe prices o fcertaingoods, as well as incredit allocation. However, historical hindsight regarding the "reformed socialist" experiences, especially o f Poland and Hungary, tells us that the model i s fundamentally economically unstable. Its main weakness relates to the fact that state-owned enterprises cannot become real profit maximizers and in reality they do not have a hard budget constraint. Without private ownership, enterprises largely remain insufficiently efficient and flexible. Inparticular, they are not capable o f expanding sufficient amounts o f non-traditional exports. As a result, the traditional mechanisms o f market regulation do not work properly. Instead, there exists a monetary overhang of excessive monetary injections into the state-supported firms. All this leads to a number o f macroeconomic vulnerabilities: - Investment decisions are not based entirely on profit motivation, which leads to excessive credit demand and over- borrowing. - Over-borrowing -- Export brings innon-market credit allocation, inflation, and shortages. growth i s lagging, which leads to a weak current account. Credit and other shortages make market socialist economies prone to excessive external borrowing and foreign debt accumulation. Source: J. Kornai (1992). 5.13 Today the relationshipbetween businesses and the state inBelarus i s dominated by the "culture" o f this model. All enterprises - state-owned or private, large or small - are heavily regulated and controlled through different methods and policy instruments. The state, as a source o f regulations, subsidies, and demand rather than as a force for establishing an enabling business environment, still seems to be a dominating economic force. 5.14 At the same time, the regulatory regime for Gaditional and DNfirms differs considerably. Table 5.2 shows the differences in the regulatory approach to state and semi-state enterprises on the one hand and new private sector firms on the other. 5.15 Such an approach to the regulation o f business activities distorts the incentive structure in the enterprise sector and places Belarus among the least favorable countries for business in the region. Domestic and foreign entrepreneurs alike complain about state domination and interference, frequently on an ad hoc basis. The frequency and scale o f such concerns i s reflected in the Index o f Economic Freedom,"' which consistently ranks Belarus' economic environment as one o f the worst among 161 countries for the last 10 years (Table 5.3). lo' The index encompasses 50 different variables, including trade policy, the government's fiscal burden, state interference, property rights, etc. 159 Table 5.2: DifferentRegulatory Regimesfor New andTraditionalEnterprises New PrivateSector Old Enterprises, bothState-owned and Privatized Only about 20 percent o fnew f i i More than 50 percent o f state and about 45 percent of ex- ts other subsidies ive measures and ,butsegmented state * A good example i s the "transfer" inM a y 2004 o f 30.9 percent of "Mobile Digital Communications" owned by two private stakeholders to the state, making it a major shareholder. Another example is the import o f seafood products where de facto there are no private operators. ** For instance, the President's Decree No. 320 o f July 2004 establishes a state monopoly o n car liability insurance, allowing it to be sold only by state-owned companies or companies that have a more than 50 percent state ownership. Sources: IPM(2004); World Bank staff analysis. Table 5.3: IndexofEconomicFreedom (Scores: 5 - the worst, 1-the best) 2005 Ranking 2005 score 2002 score 2000 score 1998 score 1995 score Estonia 4 1.65 1.73 2.19 2.43 2.4 Latvia 28 2.3 1 2.49 2.69 2.84 d a Poland 41 2.54 2.6 2.84 2.91 3.46 Bulgaria 62 2.74 3.28 3.35 3.6 3.56 Moldova 77 3.06 3.30 3.35 3.48 4.1 Ukraine 88 3.21 3.84 3.75 3.83 4.05 Russia 124 3.56 3.74 3.75 3.54 3.55 Source: 2005 Index of Economic Freedom, Heritage Foundation. 5.16 As indicatedbyFigure 5.3, the quality o f the economic incentives regime''* inBelarus i s low and has deteriorated since 1995 (graphically, Belarus i s below the 45 degree line). This represents a rare case o f the significant deterioration of ratings in a post-communistcountry. Moreover, such a decline has come from the lowest base among neighboring countries (Ukraine, Moldova, Russia and Latvia), at the same time that there neighbors improved after 1995 (positioned above the 45 degree line). lo' The regime includes such variables as gross capital formation, government budget, trade, trade barriers, I P protection, soundness o f banks, export, intensity o f local competition, interest rate spread, and domestic credit to the private sector. 160 Figure5.3: GlobalView: EconomicIncentivesRegime !! :i iLttu,r * MmxIoo / " % 4 0 1 2I 3I 4 SI 0 f 8 Q 3 1995 Source: 2005 KnowledgeAssessment Methodology (KAM),World Bank Institute,World Bank. 5.17 Another result o f the existing economic model i s weaker cooperation between small and large enterprises than in other transition economies. As demonstrated by the BEEPS 2002 survey, in Belarus, only about 17 percent o f small/private enterprises sell the majority o f their product to large enterprises in contrast to 35 percent in Ukraine, 27 percent in Latvia and 38 percent in Russia. Several reinforcing factors may be responsible for this outcome. First, the majority o f large enterprises are not restructured, in terms o f both the internal production process and the external cooperation links. As a result, they still have an "in house" capacity for auxiliary production, which was usually spun-off in other transition economies as independent small enterprises. Also, they have an established network o f suppliers from the Soviet era and no incentives to change them. Second, the environment for private sector development seems to "favor" smaller enterprises. As i s demonstrated later in the chapter, the natural growth o f enterprises from small to medium i s halted at the level o f US$1millionin annual turnover, above which it seems to be impossible for a private firm to operate without strong political backing and connections. Such a regulatory burden reinforces the economy's dependence on traditional suppliers and markets, and makes the entire industrial structure much less flexible. Consequently, the enterprise sector i s divided into two universes with only a small layer o f medium-size firms. 5.18 At the same time, it is worth noting that Belarus operates a fairly well-performing system o f contract enforcement. Once the firms enter the system, dispute resolution i s relatively simple. According to the Cost o f Doing Business (CODB) 2005 survey, an average business can expect to go through 28 procedures from the moment the plaintiff files the suit untilthe actual payment and should expect to wait, on average, 210 days untilthe court resolution. By contrast, inRussia it takes 29 procedures and 330 days to reach a resolution, and in Ukraine it takes 28 procedures and 269 days, while the regional average i s about 410 days. Belarus also outperforms Poland, where the contract enforcement mechanisms are particularly cumbersome and, on average, it takes nearly three years. The court's ability to mitigate the relationshipbetween private business and the state i s more problematic and will be addressed later inthis chapter. It i s worth mentioning, however, that firms still do not have much trust in the contract enforcement system. This can be seen, for example, from the fact that so many Belarusian firms continue to rely on pre-payments in their operations. According to the BEEPS, in 2002 the average share o f prepaid sales amounted to 46 percent in Belarus, which was substantially higher than in Russia (31 percent), Lithuania (21percent), and Moldova (27 percent), but was very similar to Ukraine (46 percent). 161 Figure5.4: ShareFirmsInvolvedinBribingGovernmentOfficials, 2002 Share of briber firms, YO Lithuania Poland Moldom Belarus Russia Ukraine 0 10 20 30 40 50 60 70 Source: BEEPS (2002). 5.19 Another potential opportunity for nurturing a supportive business environment i s related to the relatively low level o f corruption in Belarus, Belarus has a better score in the corruption perception indexes compiled by the World Bank Institute than the average CIS country (Figure 5.4).'03 Belarus also shows a slightly lower incidence o f bribery when compared to Poland. InBEEPS 2002, 25 percent of the sampled Polish firms indicated corruption as a major obstacle to business, while only 17 percent o f businesses inBelarus indicatedthat corruption was an obstacle. While Belarus has a better performance in indicators o f administrative corruption, its relative position has somewhat deteriorated since the late 1990s. Of the 24 countries surveyed in the BEEPS 2002, Belarus was one out o f only three countries (along with Bosnia-Herzegovina and Russia) that showed a statistically significant increase in the fi-equency o f administrative payments between 1999 and 2002. For Belarus i s to capitalize on its relative advantage, it needs to ensure that administrative corruptioni s kept incheck. The BusinessEnvironment and Ownership Changes 5.20 Privatization, which in leading transition economies has allowed the "re-population" o f national economies with businesses o f different sizes and ownerships, has been very slow in Belarus. This i s a primary reason for the lack o f a critical mass o f diversified owners powerful enough to pressure the government to provide a more friendly, transparent and equalizing business environment. Moreover, the existing state o f the business climate inBelarus undermines the attractiveness o f investments inprivatized and DNenterprises, depressingtheir growth and settling the economy into a low quality equilibrium. 5.21 Since the start o fprivatization in 1993, Belarus has consistently missed its targets inprivatization programs. Small-scale privatization is yet to be completed, while large scale privatization has been minimal. Most of Belarus' most attractive enterprises remain in state control. As o f January 1, 2004, the government held large blocks o f shares in 539 open joint stock companies, or 39 percent o f all such companies. The state holding in 303 o f these enterprises exceeded 50 percent. While the 2004-05 103The perception index i s based on the index o f the most widely available corruption indices. See Kaufinann, Kraay, and Mastruzzi (2003) for a description. 162 privatizationprogram listed 95 enterprises, none o f them seems to be large or otherwise attra~tive."~ a As result, most (interms o f output) industrial enterprises remain in state control either through full or partial ownership. c. REGULATORY COMPLIANCE COSTS GeneralPerception 5.22 At first glance it seems contradictory that consistently higher profit margins in the small enterprise sector for the last five years attracted a relatively small number o f new entrants. Such an inconsistency can be explained by the existing formal and informal regulatory barriers to new entry and, more generally, for doing business inBelarus. 5.23 According to the the business environment inBelarus deterioratedinthe last few years more than in other transition economies (Figure 5.5). Also, compared to other countries in the region, in Belarus entrepreneurs are more pessimistic about the unfriendliness o f the business environment and perceive it as deteriorating over time.lo6 Figure5.5: Perceptionofthe BusinessEnvironmentEvolution (10-point scale: 5 -great improvement, -5 - serious worsening) -5 -4 -3 -2 -1 0 1 2 Note: EWS surveys (polling 150 enterprisesand conducting 2 focus groups), compatible with (and extractable from) CODBs, were conductedinBelarus and other CEE/FSU countries. Source: EWS 2003,2004. Regulatory Cost ofEntry 5.24 The emerging entrepreneurs in Belarus face greater obstacles to business registration than their counterparts inneighboring countries. The latest changes inthe registration processes producedmixed results. On average, in 2003 businesses spent 40 days on compliance with statutory procedures, 6 days less than in 2002. However, while re-registration became less lengthy, the time spent on actual first-time registration increased. In addition, registration processes became more costly, reaching on average US$187 in 2004, compared to US$165 in 2002. These costs represent 25.3 percent o f 2004 gross national income (GNI) per capita. Though they are not particularly highby international standards, they are still higher than in Poland, Russia andUkraine (20.3,6.7, and 17.6 percent o fGNIper capita, respectively). lo4Annual Report ofthe Belarus State Committee on Securities Market, 2004. lo5BEEPS, ARCS, CODB, Doing Business, EWS, see Box 5.3. lo6Early Warning System(EWS) Survey, World Bank, 2002-04. 163 5.25 In2004, new entrepreneurs could expect to go through 16 procedures to start a business in Belarus. InPoland and Russia the system o f business registration i s simpler. On average, it requires 10 procedures in Poland and 9 procedures in Russia to start a new venture. The length o f time necessary for registration inBelarus i s almost twice as long as in the neighboring countries (see Figure 5.6). To start a new business, an entrepreneur should expect to spend nearly 80 days, compared to roughly a month in Poland, Russia and Ukraine. Figure5.6: Average Durationfor BusinessRegistrationinSelectedCountries(days) 80 70 60 50 40 30 20 10 0 Belarus Poland Russia Ukraine Source: EWS 2004. 5.26 While the registration process largely concerns new companies, existing companies are also affected. Duringthe last 10years, established enterprises had to re-register three times, and in addition re- registrationi s requiredevery time a change i s made inthe firm's founding documents. 5.27 In the licensing regime, despite recent improvements, entrepreneurs stress that the fact the procedures for obtaining business licenses continue to be complex and contradictory and that the amount of paperwork i s frustrating. For certain types o f business activities such as legal services, it i s almost impossible to receive a license. 5.28 While there i s little direct evidence o f the scale o f informal barriers to entry, some behavioral gaps and inefficiencies clearly point to the highincidence o f such barriers. For example, according to the BEEPS 2000 survey, 32 percent o f Belarus' small businesses indicatedhaving "no effective competition." Inthe follow-up survey, BEEPS 2002, the percentage of firms reportinglittle competition from outsiders remained at the same level. This i s a much greater percentage than in comparator countries (Figure 5.7). Only 3 percent of firms in Poland and 6 percent in Ukraine indicate that they have no effective competition. The numbers suggest the existence o f strong informal barriers to new market entry. However, as shown in Chapter 2, competitive pressures in Belarus have strengthened considerably since 2002. 164 Box5.3: BusinessClimate SurveyMethodology 1 BEEPS, CODB, Doing Business, and EWS are main country surveys conducted by the World Bank and its partners in the last 4-5 years. These surveys reflect on the quality o f the business environment, capture its ongoing changes, and provide cross-country comparisons. Business Environment and EnterprisePerformanceSurvey (BEEPS) is a joint survey conducted by the World Bank and the European Bank for Reconstruction and Development It covers over 4,000 firms in 22 transition countries o f CentrayEastern Europe, the former Soviet Union, and Turkey, and examines a wide range o f interactions between firms and the state. Based on face-to-face interviews with managers and owners, BEEPS is designed to generate comparative measurements in such areas as the quality o f the business environment, state capture, corruption and lobbying, which can then be related to specific fmcharacteristics and firmperformance. Cost of DoingBusiness(CODB) is a survey o f enterprises that has been conducted by the World Bank to identify and assess administrative barriers, as well as to estimate the costs -both formal and informal - o f doing business ina country. The enterprise samples consist o f at least 600 enterprises per country, representing all regions and industries. Based o n face-to-face interviews with managers and owners and focus groups with entrepreneurs, the survey identifies specific country issues and interprets the results. The CODB methodology has been tested inmany countries inEastern Europe and Central Asia, and i s compatible with E W S surveys and FIAS's Administrative and Regulatory Cost Surveys (ARCS). Doing Business Surveys (Doing Business 2004, Doing Business 2005) assess business regulations and their enforcement inthe areas o f enterprise entry, operations and exit. Based o n interviews with experts and practitioners, the Doing Business i s a standardized annual survey o f factual information concerning laws and regulations in force. The Doing Business indicators are comparable across 145 economies and measure government regulations and their effect o n businesses, especially on small and medium-size firms. Early Warning System Survey (EWS) is a quick and flexible instrument tracking the quality o f the changing business environment and identifying problems or difficulties that may have emerged in the recent past. Based on face-to-face interviews with managers and owners o f at least 150 companies, it covers main sectors. It is supported by focus groups of entrepreneurs. Standardizedand cross-country comparable, the EWS has been conducted for the last three years inmany countries o f the ECA region on an annual or a bi-annualbasis. Source: World Bank. a Figure5.7: FromWhichoftheFollowingDoesYour CompanyFacetheGreatestCompetitiveThreat? 100% 90% Ea Other 80% 70% Smuggled goods 60% 50% 0 Myfirmhas no effective 40% competitors 30% 0 Legalimports 20% Domestic Informalsector 10% 0% IJDomesticFormalSector Bulgaria Poland Ukraine Latvia Belarus Moldova Russia Uzbekistan Source: BEEPS 2000, World Bank. 5.29 Reported differences in the growth of SE sales among individualoblasts o f Belarus also suggest the existence o f informal market protectionismat the regional level. As an example, SE sales inMinskcity in2001 increased217 percent (year to year) comparedwith 184percent inMinsk blast.''^ Similarly, increasesinsales in lo'MSA (2004d), 165 2002 were reported by 44 percent of Minsk city SEs and only 28 percent of Minsk oblast SEs. Such local differences pointto the existenceo fadditional (probably informal) barriersto new entry which remainundetected by traditional business surveys. Shortages of tradmg places and the level of fees established by local administrations10sare example o fregionalpoliciesthat diversify conditions for market entry. 5.30 Belarus has one o f the weakest legal fkmeworks for shareholder protectioninthe region.lo9The Doing Business database (2005), which examines the degree to which investors are protected through disclosure o f ownership and financial information, points out that businessesinBelarus are not required to disclose beneficial ownership or even to have an internal audit before the release o f financial statements. The ownership and financial information is not publiclyavailable to investors. Onthe disclosure index, Belarus has a score o f 1(on a scale o f 0 to 7, with higher values indicating more disclosure), compared with the regional average o f 3.6 (4 in Polandand 3 andUkraine) and5.6 for OECD. 5.3 1 Belarus' low level o fattractivenessfor FDIpoints strongly at informalities as a prevailingbarrier to new entry. There is a sharp mismatch between the fact that Belarus has, "on paper," one o f the most favorable regulatory investment climates11ointhe FSU, a relatively large industrialpotential and a well-trained workforce, buthas avery lowlevelofFDI."' Forexample, UNCTADratedBelarus as fifty-sixth among 140countries inits investment attractivenessyet downgraded Belarus to the ranko f 104as anFDIperformer in2000-02 (Table 5.4). This indicates a major under-utilizationo fthe country's growthpotential. Table 5.4: InwardFDIPerformanceIndex (ratio of FDIglobalshare to GDP globalshare) and InwardFDIPotential(ranking among140 countries), 1997-2002 FDIPerformance Index, Rank andRatio FDIPotential, Rank and Score inthe 2000-02 1997-99 1995-97 0-1 range Estonia 21 16 24 38 2.350 3.073 3.315 0.275 Latvia 47 23 11 49 1.377 2.661 5.099 0.234 Poland 56 45 45 44 1.179 1.615 2.325 0.256 Bulgaria 25 30 60 64 2.145 2.135 1.572 0.195 Moldova 15 48 36 110 2.994 1.598 2.469 0.129 Ukraine 89 96 96 94 0.622 0.6011 0.791 0.156 China 50 43 20 39 1.331 1.806 3.768 0.273 Russia 111 107 104 33 0.317 0.483 0.593 0.291 Source: UNCTAD. FDIPerformance Index, 1997-2002. 108 The President's Decree No.148 of March 2005 on the support of entrepreneurship, while establishing maximum rental fees for places in markets, provides for the possibility o f increased tariffs at the discretion o f local and municipal authorities. log The JSC Law was passedin 1992 and does not represent an exhaustive set of guidelines on the regulation o f the control and ownership o f enterprises. The new law which i s expected to rectify some o f the problems has been drafted and i s expected to be passedsometime in2005-06. 1I O Although the latest changes to the InvestmentCode that came into force at the beginning o f 2005 abolished some foreign investors' privileges. 111 The FDIannual net inflow in 1998-2004 was consistently lower than 1.5 percent of GDP, except for 1999, owing to the constructiono f the Yamal-Western Europe pipeline by Gazprom. 166 Regulatory Costsof BusinessOperations 5.32 The high costs of overregulation, regulatory uncertainty and informalities affect companies in their daily operations in a multitude o f ways (Figure 5.8). Figure5.8: Evaluationof the Severity of Problems(10-point scale: 10is asevere problemand 1is no problem) andtheir Dynamicsbythe RegulatoryArea (10-point scale: -/+5 is the largest negative/positivechangeduringthe last year) Non-tax fiscal inspection Unplanned tax inspections Accountancy rules for taxes 2002 W 2003 Reporting requirements -6 -4 -2 0 2 4 6 8 10 Source: EWS, 2004. 5.33 Businesses identify permits and the variety o f inspections as the most severe administrative barriers in the Belarus business environment that are deteriorating over time.Il2 Obtaining land and construction permits are at the top o f the list o f administrative barriers. Comparing with the situation five years ago, participants o f the CODB surveys indicate that, overall, the regulatory environment for access to business premises has worsened and securing premises has become more costly and time-consuming. Obtaining land for construction ranks among the most burdensome locally administered processes which affects both starting and expanding businesses. 5.34 Constructionpermits are equally burdensome to acquire. The time taken to receive such a permit ranges from a half year to a year. Difficulties with receiving construction permits, as they are issued by local administrations, vary considerably depending on'the locality. Inlarge cities the process can take up to 1.5 years, whereas in suburbs, small cities or rural areas the time may be much less. Respondents emphasized that because of the lengthy process the regulations relevant to construction permits often changed while the application was being processed, which has ledto additional delays. 5.35 The situation regarding preliminary import permits and customs clearance i s also quite complicated. The procedures and conditions attached to import transactions became worse in 2003 compared to the situation five years earlier, although less deterioration i s reported compared to the situation a year previously (Table 5.5). Among the difficulties that exist in the import process, the businesses list the following (in the order o f increasing difficulties): (i) prohibitions on the import o f specific goods; (ii) pre-import permits; (iii) certification of imported goods; (iv) customs clearances; and, overall, (v) lack o fbusiness confidence. 'IzEWS Survey, World Bank,2004. 167 Table5.5: ChangesinProceduresand ConditionsAttached to ImportTransactions, 2001-03 Incomparisonwith Worse Unchanged Better , , 2003 2002 2001 2003 2002 2001 2003 2002 2001 1year ago 43% 53% 49% 54% 45% 46% 3% 2% 6% 3 years ago 51% 63% 67% 43% 34% 29% 6% 2% 4% 5 years ago 56% 66% 63% 34% ,30% , 32% 10% 5% 5yo Source: CODB 2004. 5.36 The process o f customs clearance has deteriorated over time. It takes on average 5 days (about 2 days more than three years ago). However, as a separate transaction (after other import-related issues are settled) it compares well with other countries inthe region (Figure 5.9). Figure5.9: AverageNumberofDaysin2001to ClearImportedGoodsthroughCustoms,Selected Countries 10000% 80 00% 60 00% 40 00% 20 00% I 0 00% I Ukraine Belarus Bulgaria Moldova lhbekmtan mssia Source: BEEPS, World Bankand EBRD, 2002. 5.37 Regarding export-related regulations, survey participants feel that the situation has improved in some areas but worsened in others (Table 5.6). It takes slightly less time to clear exports though customs than it didthree years ago. Also, unlike the situation inother countries inthe region, VAT refund was not seen as a problem by exporters. At the same time, exporters' list o f complaints i s even longer: in addition to all significant problems faced by importers, exporters complain about fixed state prices and highexport duties. Overall, with respect to the customs and foreign trade regulations, according to the BEEPS the situation in Belarus deteriorated considerably between 1999 and 2002: the share o f firms that consider these regulations to be either moderate or major obstacles to their businesses increased from 33 to 49 percent. Duringthe same period, the respective shares inRussia declined from 31to 28 percent, while in Ukraine they declined from 51to 42 percent. Table 5.6: ChangesinProceduresand ConditionsAttached to ExportTransactions Incomparisonwith Worse Unchanged Better 2003 2002 2001 2003 2002 2001 003 2002 2001 1year ago 33% 46% 56% 65% 51% 40% 2% 4% 5% 3 years ago 44% 60% 66% 53% 35% 29% 3% 5% 6% 5 years ago 47% 66% 68% 45% 27% 25% 8% 7% 8% Source: CODB 2004. 168 5.38 Anecdotal evidence which was not registered by quantitative surveys points to emerging signs o f deterioration in customs administration. The focus group respondents o f the last EWS survey confirmed this trend, reporting arecent sharpdeterioration incustoms, sanitary inspection, andthe police. 5.39 The tax burden (the multitude o f taxes, excessive tax inspections, the instability and complexity o f the taxation legislation and severe penalties for unintentional mistakes) has long been criticizedby the Belarusian business community. For example, eight taxes are imposed on revenues and five on salaries. Different taxes overlap and, in certain cases, the amount o f one tax payment i s dependent on the amount o f an~ther."~ 5.40 For entrepreneur^"^ the most serious problems stem from the instability and complexity o f the tax legislation and the severe penalties for unintentional mistakes. Taxes are regulated by scores of frequently changing legal acts which often contradict one another. For example, the State Taxation Committee's clarification o f the procedure for levying income tax, o f March 23, 1999, was amended six times over the next two years. 5.41 A bleak assessment o f the tax environment, although it improved slightly over time, was shared by both legal entities and individual entrepreneurs, even though the latter face much simpler taxation procedures (Table 5.7). Table 5.7: Assessmentof TaxationProblemsbythe PolledEconomicEntities (5 point scale -0 = no problemsand 5 =very severeproblems) Total population Individual entrepreneurs Legal entities 2001 2002 2003 2001 2002 2003 2001 2002 2003 ~ Hightax rates 4.2 4.0 3.7 3.8 3.8 4.0 4.3 4.0 3.7 Inability to foresee how many 4.0 4.1 3.4 3.4 4.1 3.5 4.1 4.1 3.4 taxes will be levied inthe future Overly complicated and 4.3 4.1 3.9 3.7 3.6 3.3 4.4 4.2 4.0 incomprehensible taxation and accounting procedures Harsh sanctions for 4.4 4.3 4.2 4.2 4.2 4.1 4.5 4.4 4.2 transgressions Changeable taxationprocedures 4.5 4.3 4.2 4.3 4.0 4.1 4.5 4.3 4.3 Arbitrary actions o f tax 3.5 3.4 2.9 3.4 3.3 3.4 3.5 3.5 2.8 inspectors Out-of-court transfer of finds 3.7 3.7 3.0 3.1 3.7 2.9 3.8 3.7 3.0 from bank accounts of legal entities and extra-judicial confiscation o f assets Source: CoDB Survey, 2004. 5.42 To ensure the timely payment o f all taxes, 80 percent o f the businesses maintain a staff o f three or more accountants. In addition, many o f them use outside accountants or consultants to deal solely with 'I3Onaverage, individual entrepreneurs (unincorporated) are subject to 2 taxes whereas legal entities pay 11taxes. 'I4CODBs 2004. 169 taxes. Even individual entrepreneurs are forced to have in-house accountants to ensure that all taxes are calculated and paid correctly. 5.43 Businessmen focus groups' l5 rank "Non-tax fiscal inspections" and "Unplanned tax inspections" as major problems. Unplanned tax inspections and non-tax fiscal inspections have become major tools for discretionary law enforcement. The practice o f assigning revenue targets to tax offices and tax officials for the collection o f fees and penalties creates a perverse enforcement culture. While the situation regarding planned tax inspections improved significantly in 2004 in comparison to 2003, unplanned inspections had increased in number and severity. In addition, inspections by other controlling agencies continue to create major difficulties for businesses. 5.44 InBelarus, price controlplays a muchmore important role inthe regulation ofbusiness activities of both state enterprises and private businesses than i s the case o f other transitional economies. Price control increases regulatory costs by imposing additional costs o f compliance and by affecting profitability. The CODB survey revealedthat a staggering 53 percent in2001 and 66 percent in2002 o f respondents had been affected by price and margin controls to varying degree. The government uses a variety o f tools to achieve price control objectives andfrequently changesthe mix o fprice regulation instruments(Table 5.8). Table 5.8: How Does the State Control Prices for Goods and Services? (YOof positive answers), 2001-03 2001 2002 2003 Through restrictions placed o n profitability 48 24 38 Through fixed prices o n goods or services 45 50 48 Through ceilings introduced for retailprices 46 38 39 Through the introduction o f minimal retail prices 12 13 13 Source: CoDB, 2004. 5.45 Prices are controlled to a large extent in state enterprises (74 percent o f the surveyed companies with state participation are affected by price control). In particular, a large number o f enterprises are presently included in the national and regional lists o f monopolists and the prices for the goods and services they produce are regulated in accordance with the anti-monopoly legislation. However, private firms and small enterprises are also being affected increasingly (Table 5.9). Table 5.9: D o State Agencies Exert Any Influence on Pricing? 2001-03 (YO) n They do 2001 2002 2003 Individual entrepreneur 45 29 34 Non-state unitary entreprise 49 60 62 State unitary enterprise 79 86 77 Limited liability company 56 66 63 Additional liability company 59 59 66 Closedjoint stock company 75 80 68 Openjoint stock company 85 76 76 Source: CoDB, 2004. 115Conducted during EWS Surveys, 2001-04. 170 5.46 Administrative wage increases and full employment policies are other important components o f government policy that are detrimental to businesses. The activist government labor policies create a serious challenge to the competitiveness o f Belarusian enterprises, irrespective o f their size and ownership. Using regulatory and discretionary measures and discouraging the rationalization o f employment, the government imposes serious constraints on the reduction o f employment to levelsjustified by market conditions. 5.47 Many enterprises report excessive employment. Among large state-owned and privatized companies, more than a quarter claim to have excessive staffing levels (Table 5.10). However, in some small and medium non-state enterprises, employment i s excessive as well. The factors that prevent the rationalization o f staffing levels are for the most part related to moral suasion, regulatory costs, and direct governmental pressures (Table 5.11). Table 5.10: HowManagersAssessthe CurrentEmploymentLevelofTheir Firms(by sizeoffirm) (%) Sufficient Insufficient Donot know 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 Source: CoDB, 2004. Table 5.11: ReasonsPrecludinga Reductionof Staff, 2002-03 (%of positiveanswers) 2003 2002 W e think that it i s not rightto dismiss staff 44 24 Itwill causeproblems with the state authorities 14 45 Staff dismissal i s a lengthy and expensive process 28 25 It will invite problems withtrade unions 4.5 Other 12 13.5 Source: CoDB, 2004. 5.48 Two observations can be made on the basis o f these data. First, the higher share o f large companies claiming excessive employment i s another reflection o f the fact that large, predominantly state-owned enterprises operate under fairly soft budget constraints.' l6A highly pronounced "moral justification o f excessive employment" may be merely a way for managers o f state and semi-state enterprises "to read the mind" o f the government. Second, managers do not see workers' representation as a significant obstacle to reducing staff levels, which may be explained partly by the fact that workers feel secure intheir positions. Surveys also show that enterprises that try to reduce staff despite political signals are exposed to lengthy litigation, which often ends with a decision to reinstate the laid o f f employees. `I6At the same time, 10percent o f excessive staff infirms with 10to 100 staff, which are mostly private, shows that the regulatory costs of labor rationalization are high. 171 5.49 The issue o f employment levels has gained particular importance because o f the steady administrative wage increase policy. For more than five years enterprises have been under intense pressure from the authorities to raise wages at a rate that on average has been well in excess of any improvements in productivity. This undermines the competitiveness and profitability o f enterprises and results ina deterioration inthe attractiveness o f the country's business climate. 5.50 The difficulties that employers in Belarus face in rationalizing employment levels can be quantifiedthrough comparative employment indices. The Bank's Doing Business 2005 database measures the incidence o f part-time and fixed-term contracts, working time requirements, minimumwage laws, and the rigidity o f local regulations on dismissal and hiring. The measures are compiled into three indices: difficulty o f hiring,rigidity o f working hours, and difficulty of firing. Each index has an assigned value of between 0 and 100, with higher values representing more rigid regulation. The overall rigidity of the employment index i s the average o f the three indices. 5.5 1 For Belarus, the overall rigidity o f employment index i s 54, compared with Poland at 34, Ukraine at 64, and Russia at 27 (Table 5.12). Firing costs are calculated on the basis o f the number o f weeks' worth o f salary inseverance, notification and penalties that must be paid to dismiss a worker. For Belarus, the direct firing costs are lower than the regional average at 21 as opposed to 38.3, but we should account for other non-monetary obstacles to employment termination discussed earlier inthis section. Indicator Belarus Russia Ukraine Poland OverallRigidity ofEmployment 54 27 64 34 Index Difficulty ofHiring Index 33 0 33 11 Rigidityof Hours Index 60 60 80 60 Difficulty ofFiringIndex 70 20 80 30 Firingcosts (weeksofwages) 21 17 94 25 Costs ofExit 5.52 As was mentioned above, inBelarus there has been little creation or liquidation o f companies, both large and small. The bankruptcy law was adopted in 1991- the first in the FSU republics. Untilthe end o f the 1990s, however, this law was practically unused. Until 2001, bankruptcies were filed mostly against defunct companies, for which there was no other way o f formal liquidation owing to accumulated debts. The situation began to change in 2002, when the number o f bankruptcy filings increased about fourfold (Table 5.13). Nevertheless, about 90 percent o f all bankruptcy cases were o f small private companies. According to estimates by the Supreme Economic Court, bankruptcy cases could have been initiated against about half o f all existing state enterprises (as about 60 percent o f them were consideredinsolvent); yet only 91enterprises were inthe bankruptcy process at the begnning o f 2003."' 'I7Vestnik of the Supreme EconomicCourt of Republic o fBelarus, 2003, Issue 8. 172 Table 5.13: Dynamicsof Bankruptcy Cases, 1998-2002 1998 1999 2000 (est) 2001 2002 Number of 56 200 400 265 1165 Source: Vestnik o f the Supreme Economic Court o f the Republic ofBelarus, 2003-04. 5.53 Although the financial cost o f exit fi-om business activity inBelarus i s relatively small (4 percent o f the value o f the bankruptcy estate), the completion o f bankruptcy procedures comes at a prohibitive time cost (5.8 years) and a very low recovery rate o f 11.9 percent (Table 5.14). Table 5.14: Efficiency of the Bankruptcy Proceduresin Transition, 2003-04 Time (years) Recovery rate (cents on a dollar) 2003 2004 2003 2004 Belarus 2.1 5.8 ... 11.9 Russia 1.5 1.5 ... 48.4 Bulgaria 3.8 3.3 ... ... 34.2 Latvia 1.2 1.1 85 Slovak Republic 4.7 4.7 ... 39.6 Ukraine 3.0 2.6 ... 25.5 Uzbekistan 3.3 4 ... 12.5 Poland 1.5 1.4 *.. 68.2 Source: Doing Business in 2004, Doing Business in 2005, World Bank. D. QUALITAT~VEANALYSIS OFTHEBUSINESSENVIRONMENT 5.54 As inmany other economies inthe region, the importance o f informalities and the underpinning regulatory culture inthe Belarusianeconomy means that an analysis that i s based solely on the "incidence and costs" o f the specific regulatory instruments i s insufficient. In particular, it should be noted that numerous informalities and regulatory instability create conditions in which regulatory instruments can be, and are, used for purposes other than the declaredpurposes. 5.55 InBelarus the government has been using its regulatory power to attain a set of strategic objectives that i s different from those that were declared and that are customary for market economies. In mature market economies, business regulations have three major functions: (i) creation o f a level the playing field for all participants; (ii) the encouragement o f entrepreneurship; and (iii) protection o f the consumers, To successfully perform these functions, the business environment should: (i) be based on rules that are applied equally to all participating agents; (ii) use only the minimuminterventionsnecessary to achieve its goals; and (iii) be implemented by an efficient and honest administration. In contrast, in Belarus, the administration uses the business environment (its rules, instruments and institutions) as a discretionary tool to: (i)achieve selected social objectives; (ii)maintain the market power o f well- connected companies; and (iii) maintain administrative control over business activities in general. At the same time, it i s worth noting that changes in the business environment in Belarus are less driven (than in the rest o f the CIS) by spontaneous regulatory practices that relate primarily to state capture. 5.56 In Belarus the declared and implemented social purpose of the enterprise sector is more pronounced than in other transition economies. Job security and the availability o f inexpensive basic products and services are an important part o f the implicit contract between the state and the society. Fulfilling of these social obligations requires a business environment that is conducive to low 173 unemployment,"* price stability, a supply o f broadly available cheap basic goods and services, and stable and broad-based growth inreal wages. This social objective requires a highly interventionist government policy. Moreover, changes inthe business environment have been introduced from the top down, with the mechanism o f public-private consultations being quite weak. The institutional capacity to monitor the quality o f the business environment and support business promotion (including attracting FDIattraction), based on the identified deficiencies, remains insufficient. 5.57 Another source o f dissatisfaction with the prevailing business environment relates to the fact that it does not support fair competition. Businesses perceive regulatory enforcement as highly uneven and generally unfair. The business regulators (as permitted by ad hoc regulatory practices and their discretionary power o f regulatory interpretation) are in a position to offer to selected businesses an arrangement "deal" o f reduced competition or even no competition, in their niche markets through customized regulatory applications, tailored interpretations, and "formalized" informalities. In other words, selective use o f the regulatory environment appears to create monopolistic rents for individual entrepreneurs that may be shared with the regulator. In this context, the perception that the business environment has deteriorated in recent year^,"^ despite several positive specific developments, could be interpreted as a growing number o f entrepreneurs becoming dissatisfied with the balance between the costs o f administrative protection from competition and their gains from this regulatory protection. 5.58 The established practice o f the selective use o f business regulations initiated in 2004 poses a risk for the government's effort to adjust its strategy toward a broader involvement o f the private sector inthe economy, including a more liberal policy toward SMEs. At the same time, the substantial licensing reforms introduced in 2004 may have contributed to a less negative perception o f the changes in the quality o f the business environment which were reflectedinthe 2004 survey. 5.59 A new and worrying trend inthe business environment relates to increased protectionism and the segmentation o f the economic space. Regional governments, facing difficulties in meeting output targets by local enterprises, have been trying to protect these enterprises from external competition. This has resulted in imposing informal trade barriers for goods from other regions o f Belarus. Such a policy i s highlydistortivebecause itprevents the most competitiveenterprises from realizing economies o f scale. 5.60 In Belarus, as in other CIS economies, firms with revenues starting from the equivalent o f US$150,000 become a target for the intensified enforcement o f regulations and formal and informal payments.12' However, unlike their counterparts in other transition economies, Belarusian entrepreneurs report the existence o f a second ceiling above which it i s impossible for a private firm to operate (irrespective o f readiness to pay regulatory costs) without strong political backing and connections. This revenue ceiling was reported at a level o f US$3 million in2004 but was lowered to US$1 million in2003, which point to the fact that, increasingly, smaller companies needpolitical support to survive. 5.61 The anti-private business attitude o f the regulatory regime does not mean that state or semi-state companies are less affected by the burden o f administrative control. SOEs and incorporated firms with state participation are often subject to more detailed interference, which includesnotjust supervision over strategic management decisions, but also the monitoring o f daily operations through output and wage targets as well as numerous other performance indicators. Full employment is perhaps the strongest "proof" o f the superiority o f the Belarusian economic model, particularly when compared with neighboring Poland, Lithuania and Ukraine, where unemployment is high. Although inthe 2004 EWS survey the perception o f deterioration is not as strong as it was in2003, it i s still quite s i nificant. lZFNeedless to say, however, f i iengaged inhighly profitable activities such as trade infuel, tobacco and alcohol, and telecommunications services, attract the attention o f officials, irrespective o f their size. 174 5.62 Even in privatized companies, the state can retain or re-introduce a "golden share," which represents a major risk o f the re-emergence o f detailed administrative control in most Belarusian firms. The golden share gives the state the authority to appoint its own members to the supervisory board and can exercise a veto power in a wide range o f activities, including restructuring, liquidation, changes in charter capital, and the appointment o f managers. This contributes to the lack o f investment attraction o f privatized enterprises, particularly for foreign investors. 5.63 Administrative restrictions on the activities o f private firms are enforced by the ad hoc use o f business regulations through a number o f instruments, such as inspections, re-registration, licensing and permit requirements, etc., conducted by different state institutions. Discretionary interpretation and application o f regulationsmakes it easy, for example, to use the licensingmechanismto delay new market entry rather than to protect consumers. The relative distortive effect o f such actions i s reflected in the perception o f corruptibility (ie., aggressive actions by regulatory and enforcing institutions to receive incomes through the use o f their control position). The focus group discussions rated sanitary inspection and customs as the most corrupt agencies, closely followed by the police. 5.64 The EWS surveys also indicate that the inability o f the "courts to protect fiom unfair state practices" i s significant and has been growing in recent years.'21 The judiciary i s highly dependent on political powers. There are an increasing number o f reports o f the unfairness and bias in the'courts for both economic and political reasons, the strong dependence o f judges on the authorities, and the discrimination o f private enterprises inthe resolution o f disputes. Managers and entrepreneurs also point to the fact that it i s almost impossible to win labor disputes in courts --the judges are biased in favor o f employees' rights. The problems with the judiciary are compounded by fiequent changes inthe laws and regulations. 5.65 Indeveloped economies the role of thejudiciary system inthe business environment is placed above the administrative authority. Enterprises have the right to challenge administrative decisions in courts, and court decisions become a very important part o f future business regulations. In Belarus, however, the judiciary system appears to have become an extension o f administrative control over the economic activities o f enterprises irrespective o f their ownership and size. E. CONCLUSIONS 5.66 Over the last few years the government has made some progress in the simplification o f business registration and licensing, as well as in the regulation o f export activities. The Government i s planning to continue streamlining and simplifying the processes for starting a business and i s considering the introduction of a "one window" registrationprocess to facilitate new market entry. 5.67 However, these improvements go in tandem with deterioration in other areas o f the business environment. The remaining excessive government interventions in the activities o f the enterprise sector crowd out the positive impact o f the latest reforms. Belarusian business people have strong negative perceptions o f the trends in the country's investment climate. The survey results do not yet show any significant positive outcomes fiom what the government considers as important shift in its policy direction. 5.68 The existing business environment represents a major risk for the sustainability o f the country's economic growth and undermines the country's growth prospects through a number o f channels. First,the high costs of compliance with administrative regulations mean that a significant amount o f resources is 121EWS surveys, 2002-04. 175 diverted from more productive use. Second, the high costs o f entry deprive the economy o f the major benefits associated with the flexibility and innovation that only new firms could generate. Third, the high incidence o f government interference damages Belarus' investment image, poses a risk for its international economic isolation, limits its opportunities for attracting FDI, and more broadly greatly reduces the potentialbenefits from global integrationenjoyed by its neighbors. 5.69 In addition to more fundamental changes in the business environment that would accelerate privatization and provide for a real hardening o f budget constraints for state-owned enterprises, the following three areas should be considered as priorities for an immediate reform: 0 Liberalizing the procedures for new entry. Reducing the time needed for business registration and simplifyingthe procedures for entry are objectives that that the government could accomplishwithout a fundamental overhaul o f the underlying system o f regulations. 0 Limiting discretionary administrativeinterference.The government needs to change the incentive system for the regulatory agencies to discourage their discretion in enforcing regulatory requirements. Among other things, this means a drastic reduction o f "unplanned tax inspections" and similar interventions, which are the most detrimental to the business climate. In addition, entrepreneurs should be offered an independent channel through which they can report to the central administrationany irregularities o fregulatory interventions. 0 Liberalizing employment and wage regulations. Enterprises experience problems when they needto rationalize employment, while administrative wage increases clearly undermine their competitiveness. Enterprise managers need greater decision making power regarding labor and wage issues. Combining this policy with a renewedimpetus to support new market entry would limit the potential negative effects on overall employment. 5.70 Moreover, the analysis suggests that there may be a serious internal conflict between government's plans to reform the business environment and its reliance on the existing economic model for development. The adopted economic model requires massive administrative interventions at the micro level, which unavoidably raises the costs o f doing business inthe country and imposes serious limitations on how muchthe business environment could be improved without dismantling some central components o f the existing control system. 5.71 An important lessonthat can be drawn fromthe analysis o fthe business environmentintransition i s that its improvement cannot be carried out quickly and solely by the introduction o f a package o f "good" regulations. A considerable amount o f political will to change the prevailing government attitudes to business and enhancement o f public-private dialogue are needed, as well as deeper reforms o f public administration, the civil service, and the judiciary. In addition, some elements o f the business climate such as informal payments are deeply rooted in the broader cultural environment and have proved to be especially slow to change. This, again, supports the premise o f the long-term nature o f the reform o f the business environment. 176 CHAPTER 6 PERFORMANCEAND PROSPECTSOF THE AGRO-FOOD SECTOR A. OVERVIEW OFTRENDS THE AGRO-FOODSECTOR IN 6.1 This chapter reviews the performance o fthe agriculturaland food processing sector since 2000. It analyses the main bottlenecks for future development in the sector and outlines recommendations to support the sustainable development o f the sector. Introduction 6.2 The performance o f the ago-food complex, especially since 2000, i s an excellent illustration in many respects o f the "Belarus puzzle". On many levels, but particularly in terms o f output and productivity growth and trade, there has been significant improvement. At the same time this has apparently been achieved without dismantling the key features o f the former Soviet system o f command and control. The central questions concern what were the drivers o f the impressive performance o f the ago-food complex, and whether the sources o f the recent growth are sustainable. 6.3 The recent growth in agricultural output and exports can be explained by improvements in competitiveness as a result o f a reduction in relative price distortions, and modest structural reforms, supported by exchange-rate adjustments and a doubling o f budget expenditures. The household sector has been particularly dynamic and has contributedimpressivelyto the sector's performancerelative to its land resources. However, price levels are still highly distorted, with some prices effectively taxed and others heavily subsidized relative to "world" levels. 6.4 The sustainability o f the sector's performance i s open to several questions. The recent growth in state budgetary support i s evidently unsustainable from a fiscal perspective as i s the buildup o f future liabilities that have arisen because o f soft financing. While there i s fbrther potential for a competitive re- alignment o f producer prices, any developments in this direction are effectively capped in the short to medium terms by pervasive inefficiencies inthe processing sector. 6.5 To sustain high growth rates in the sector, as outlined in the government program, agriculture exports will need to expand significantly, which would require a major improvement in the sector's competitiveness. This requirement i s reinforced by the need for Belarus to diversify away from virtually exclusive reliance on Russia as its export market. Itwill have to compete with exports from the EUwhose agricultural products are protectedby generous export subsidies. Belarus' ability to match these levels o f export subsidies i s constrained by its desire to adhere to WTO "Amber Box" subsidy restrictions. Even if it wished to match these subsidies, Belarus' own fragile fiscal circumstances would militate against this course o f action. 6.6 Under these circumstances, the only feasible and sustainable path to ensure greater penetrationo f export markets would be for Belarus to set in train the conditions that would ensure a competitive agro- food sector that i s not reliant on unsustainable subsidies. The suggested sequencing o f reform gives priority to the removal o f price caps on food products; fixed trading margins and fertilizer subsidies; more effective targeting o f support to efficient entities, especially by enforcing a hard budget constraint; a more 177 aggressive and supportive foreign direct investment (FDI) policy targeted at upgrading the efficiency o f the processing sector; andmore decisive farm restructuring. Recent Performance Trends 6.7 In2004 the volume of agricultural output had grown by 12.9 percent. This was the fifthyear of successive growth in the sector. The growth inthe volume o f agricultural output over the period 2000-04 averaged about 6 percent. 6.8 This outcome was in fact a continuation o f a longer-run trend of the superior performance of Belarusian agriculture relative to Russia and Ukraine. Compared to that o f its neighbors, Belarusian agricultural output declined less during 1995-99 and grew more rapidly during the first half o f the current decade. A s . a result, Belarus' agricultural output was short o f attaining its 1991 volume by only 8 percentage points, while the gap was about four times larger for both Russia and Ukraine (Table 6.1). Nevertheless, since 1990 Belarus has consistently emerged as the least reformed among the transition countries.'" Hence, the "Belarus puzzle." Table 6.1: Average Annual Growth (Decline) inGrossAgricultural Output inBelarus,Russia and Ukraine, 1995-2004(percent) 1995-1999 2000-2004 Belarus -3.2 5.7 Russia -4.1 3.9 Ukraine -6.1 5.5 Source: Statistical Committee of the CIS. 6.9 Output growth has been recorded for almost all commodities but it has been especially strong in the crops sector (Table 6.2). The production o f livestock products has been driven by a modest increase in milk and meat production. Owing largely to weather factors, the performance o f the major crops (grains, potatoes and sugar beet) has been highlyvariable. Table 6.2: ProductionVolume Index for Selected Agricultural CommoditiesinBelarus (1999=100), 2000-04 I 2000 2001 2002 2003 2004 Total agriculture 109 111 112 119 135 Including Grains (bunker weight) 133 141 164 149 192 Sugar beet 124 142 97 162 260 Potatoes 116 104 99 115 132 Vegetables 106 109 116 154 156 Milk 95 102 101 99 109 Meat* 90 95 93 93 98 Eggs 97 93 86 83 87 Sales (live weight). Source: M S A . Rozelle and Swinnen (2004). 178 6.10 Over the same period, land productivity has grown marginally faster than agricultural output (Table 6.3). The growth inland productivity resulted from a combination o f the growth inthe volume o f agricultural output and administrative measures aimed at the withdrawal o f the least fertile lands from agricultural production. Over the past five years the state converted about 10 percent o f the marginal arable land into meadows, pastures, forests, and etc. thereby achieving a more concentrated input use on more productive lands.lZ3 Table 6.3: GrowthinOutputVolume, LandandLabor Productivity,2000-04 I 2000 2001 2002 2003 2004 Agricultural land (inthousand hectares at the beginning o f the year) 9,175 9,142 8,993 8,924 8,885 Arable land (thousand hectares at the beginning o f the year) 6,140 6,085 5,663 5,558 5,511 Rural labor force (thousand persons) 1,407 1,402 1,404 1,404 n.a. Average annual employment inagriculture (thousand persons) 625 586 532 489 480 Production volume index (2000=100) 100 102 103 109 123 Agricultural land productivity index (2000=100) 100 102 105 112 127 IArableproductivity landproductivity index (2000=100) 100 103 112 121 137 Labor index (2000=100) I 100 108 122 139 172 Source: MSA. 6.11 With a 15 percent average annual growth, the gains in labor productivity have been impressive. While the rural labor force has remained more or less stable, the numbers o f those engaged in agriculture have fallen by almost a quarter o f the 2000 levels. As a result, since 2000 the share o f agricultural employment inthe national economy has declined from 14percent to 11percent. 6.12 It is important to note that, in contrast to the government-initiated process for the retirement o f arable land, the reduction inagricultural employment was not directly controlled by the state. Like Russia and Ukraine, Belarus faces the demographic challenges o f a declining and aging rural population. However, it appears that demographics have played only a partial role in the reduction in agricultural employment as it has declined muchmore rapidly than the rural labor force.'24 6.13 Being closely related to primary agriculture, ago-processing has also recorded a sizable output growth. In fact, its performance has been superior to that o f primary agriculture. For example, while the output o f livestock products has been declining, the growth in the milk and meat branches o f the food industryhas beenpositive and has accelerated from 2000. 6.14 The number o f processing enterprises has dropped and the level o f employment has been more or less stable (Table 6.4). Given these developments, the growth in output has been achieved by better capacity utilization, especially in meat production, and by greater labor productivity. In spite o f these improvements, capacity utilization remains chronically low by international standards despite the '23On a per capita basis, Belarus ranks fourth among the CIS countries in terms o f land availability. Belarus has about 0.56 hectares of arable land per capita, which is lower than the ratios in Russia, Ukraine and Kazakhstan. However, this indicator is significantly higher than the EU average o f about 0.2 hectares per capita (pre-2004 accession). '24During 1990-95 the rural labor force declined by 11percent. 179 relatively small scale o f Belarus' ago-processing units. In addition, the capital stock o f the sector has been substantially eroded, as i s revealed by the exceptionally highlevels o f depreciation. Table 6.4: Developments inthe Belarusian Food-ProcessingSector, 2000-03 2000 2001 2002 2003 Number o f enterprises 475 493 478 461 Employment infood processing (thousand persons) 128 127 127 126 Percent change inthe inthe volume o f food processing 6.7 4.3 5.3 output O f which: - flavoring industryoutput 10.6 8.3 7.5 4.3 - meat anddairy output growth 1.6 10.4 1.1 5.0 Capacity utilization inmeat processing enterprises (%) 40 41 41 45 Capacity utilization indairy processing enterprises (%) 54 52 50 55 Depreciation rate of capital stock inthe meat and dairy 46 48 49 processing sector (%) Source: MSA. 6.15 Belarus i s a net food importer and in 2003 the net agriculture and food trade deficit amounted to US$557 million, or 3.2 percent o f GDP. With an improvement in the competitiveness o f the ago-food sector in recent years, the value o f net imports has decreased rapidly from about 5 percent o f GDP in 2000. Inthe agricultural trade with Russia, Belarus' trade balance was marginally positive in2003. 6.16 Overall, food and agricultural exports grew 2.7 times faster than imports (Table 6.5). The growth inexports surpassed, by a factor of almost three, growth inthe volume of food industryoutput. Exports have exceeded the growth in the volume of primary production by a factor o f about four. In 2004, according to the Ministry o f Agriculture and Food, agricultural and food exports grew by a further 60 percent. Looking ahead, the state program envisages a further targeted reduction in food imports - to not more than 10 percent o f domestic consumption--while food exports are planned to exceed imports by a 'factor o f three. Table 6.5: Belarus FoodTrade, 2000-03 (US$ million) Year Agriculture % o f Agriculture % o f Nettrade %ofGDP and food total and food total balance exports exports imports imports 2000 503 6.9 1,116 12.9 -613 -4.8 2001 605 7.5 1,098 13.3 -493 -4.0 2002 635 7.9 1,223 13.5 -588 -4.0 2003 832 8.4 1,389 12 -557 -3.2 Source: MSA. B. STRUCTURAL CHANGE AND POLICY DEVELOPMENTS 6.17 It is useful to benchmark the assessment o fthe current policy context against the views presented inthe WorldBank's mostrecent study (2000) onthe ago-food sector inBe1ar~s.l~~ 125World Bank, 2000. 180 6.18 As far as the primary sector was concerned, the 2000 World Bank study concluded that neither significant internal restructuringhad occurred since the previous Bank study was publishedin 1994126nor had there been any serious attempt to break up traditional post-Soviet farms into more manageable units. The 2000 study noted the apparent exceptional productivity o f household plots, which accounted for about 40 percent o f output, yet these plots occupied only 14 percent o f the land area. At the same time, private farms were o f marginal importance and accounted for only 0.8 percent o f the land area. In2000 the number o f private farms more or less matched the number o f state-controlled farms, which was substantially less than the ratios observed for both Russia and Ukraine. Private farms were considered relatively efficient, but they didnot enjoy the same level o f subsidization as state-controlled farms. 6.19 State interference inall o f the elements o f the food chain was extensive. Price controls applied to some 118 "socially important goods." Rigid procurement quotas operated to inhibit the development o f independent retail outlets for food products. External trade in agricultural food products was effectively restricted through the tortuous licensing system and penalizing foreign-exchange surrender requirements on the proceeds o f exports. 6.20 The 2000 study concluded that "the overall economic and policy environment remains the major impediment to creating market-based agricultural enterprises." State interference in decision-malung was pervasive and the sector was subject to substantial implicit taxation. Production targets were emphasized over productivity and profitability objectives. The authors o f the 2000 report put forward a six-point program for the reform o f the agro-food sector, which comprised the following elements: Macroeconomic reform, especially the alignment o f the exchange rate with economic fundamentals Genuine farm restructuring and landreform 0 The development o f de-monopolized food processing and input-supplyindustries The creation o f institutions supportive o f the market economy A clear division o fresponsibility between the commercial role o f state-controlled farms and their traditional social role inrural areas The promotion o f private sector development in rural areas as a solution to over-employment and low productivity in agriculture. 6.21 Against this background, the main policy developments since 2000 and the likely trajectory o f policy over the mediumterm are examined. AgriculturalPolicyInitiativessince 2000 6.22 Agricultural policy developments over the period 2001-05 have been governed by the government's Program for the Improvement o f the Agro-Industrial Sector o f the Republic o f Belarus, 2001-05. This program emphasized measures to (i)improve farm productivity, (ii)facilitate the restructuring o f farms, and (iii)address the problem o f loss-making enterprises. The third element addresses the problem o f loss-making state-controlled enterprises by merging them with profitable entities. 6.23 The current program, the State Program for the Revival and Development o f Rural Areas, 2005- 10, (the State Program) i s consistent with the thrust o f the 2001-05 Program. The emphasis in the new Program i s twofold: the development o f rural areas and the creation o f a competitive export-oriented agro-food sector. The intent i s to liberate the agro-food sector from its traditional requirement to support `26World Bank, 1994. 181 the social and cultural infrastructure o f rural areas and to transfer these obligations to local authorities which should allow the agro-food sector to focus on enhancing its efficiency. 6.24 Like its predecessor, the new Program continues to espouse food security as a central objective o f policy for the agro-food sector. This objective provides a powerful motivation for continued substantial state involvement inthe production system. Policy i s again focused on the enhancement o f the productive efficiency o f both the primary and the processing sub-sectors through support for physical capital investment, improved investment in land drainage and soil fertility, improved livestock breeding, enhanced training o f agricultural producers and increased investment inR&D. 6.25 There are several innovative aspects to this component o f the Program that deal with the revival o f rural areas. Inparticular, the proposal to concentrate state infrastructure investment around strategically located "agro towns" has the potential for significant public returns. 6.26 A novel aspect ofthe Programis the objective o flocating productive activity onthe most suitable soils and o f supporting this objective with suitably differentiated subsidies. The Program also stresses the importance o f appropriately motivating enterprise managers by performance-based payments and the establishment o f appropriate wage and salary differentials v i s - h i s other employees. 6.27 On the processing side, there is a modest commitment to reduce the number o f dairy processing factories from 114to 58. However, the Program i s committed to retainthe existing numbers and locations o f the beef processing factories. There i s recognition o f the need to substantially upgrade the technology o f the processing sectors. Price Policy 6.28 Price policy, as it applies to the primary sector, has changed significantly, owing to a reduction in the level o f state procurement. Beginning in 2002, state procurement was substantially reduced, from more than 50 percent o f the value o f agricultural output in 1998 to about 12 percent. However, it remains highfor some commodities (for example, in2003 the share o f state orders was 100percent for flax fiber, 95 percent for sugar beet, and 77 percent for rapeseed). 6.29 Allied to the reduction in state procurement, price policy has changed from a system o f fixed procurement prices to "minimum" or "floor" prices. At the producer level, the minimum prices are calculated and announced by the Ministry o f Agriculture and Food following the approval o f the Ministry o f Economy. In contrast to these positive developments in price policy, however, the government has made greater use o f price premiums for selectedcommodities. 6.30 In2003, when producer price premiums were not paid, the actual pricesreceivedbyproducers were close to the legislated minimumprices. While the state withdrew from purchases, alternative non- monopolistic marketing systems were slow to develop, and consequently a largely undeveloped marketing infrastructure continues to impose an implicit tax on primary producers. 6.31 In2002 food product prices at the processor level were liberalized. However, in early 2004, in response to the growth in the border prices for food products, price caps on selected "socially important" products were re-introduced. At the end o f the same year the list o f "socially important" commodities was extended to include beef and pork. 6.32 However, the current price-setting mechanism in food processing i s more flexible than inprimary agriculture, as agro-processors are free to establish their own prices as long as they remain below the 182 legislatedcap. The cap does not apply to all commodities and agro-processors are free to decide on their output mix and to produce more o f a commodity that i s not subject to such price controls. These price controls were conceived as an anti-inflationary measure in response to the prevailing adverse external environment and are not supposed to be permanent features.'27 StructuralChanges 6.33 At one level, a widespread restructuring o f agricultural enterprises has occurred since 2000. By early 2004 state and collective farms practically ceased to exist in Belarus (Table 6.6). 12' They were largely replaced by cooperative farms. However, these new entities are still hndamentally under state control and hence the significance o f this restructuring i s limited. Nonetheless, one of the major positive elements o f this restructuring was the transfer o f responsibility for the provision and maintenance o f social infrastructure from agricultural enterprises to local authorities. According to estimates o f the Ministry of Agriculture and Food, the value of financial benefits arising fiom this transfer amounted to 145 billion BYRin2004. Table 6.6: Legal and Organizational Types of Larger Agricultural Enterprises, 2000 and 2003 Organizational types 2000 2003 Kolkhozes 1,720 37 Sovkhozes 463 13 Agricultural production cooperatives 15 1,169 Unitary enterprise 199 591 Joint stock companies o f various type 41 331 Total 2.438 2.141 Source: Ministryo fAgriculture and Food. 6.34 As o f January 1, 2005, 48 enterprises had been sold to private investors and 27 enterprises had also been leased to private farmers. A further 511 loss-making enterprises were merged with other entities. While the latter initiative has undoubtedly reduced the number o f loss-making enterprises, it could have done little for the underlying profitability fundamentals, as the managers o f the new agglomerates were not empowered to undertake any significant restructuring of these unprofitable businesses. More important, since most o f the loss-making entities were merged with profitable entities from entirely different business specializations, there were no evident synergies that could be exploited. 6.35 These structural changes have resulted in a modest redistribution o f land from the state to the private sector. The number o f private family farms had been declining up to 2001, when the numbers began to increase. Currently they stand at 2,493. From 2000, the average size o f private farms doubled by 2003, from 33 to 72 hectares, owing to the relaxation o f land-leasing regulations. Correspondingly, as a result o f sales, lease and amalgamation with other enterprises, the number o f agricultural enterprises declined (Table 6.7). 12'The price caps were biased towards livestock products (Le., milk, beef and pork), the prices of which have risen due to combination of the following: growth ininternational prices; greater protection o f Russian producers against livestock imports as well as the disorganized commencement o f the new import quota regime inRussia. "* "Agricultural enterprises" or "Agricultural organizations" comprise all non-private farms includingthe remaining Kolkhozes (collective farms) andSovkhozes (state farms), as distinct from "private farms" and "household plots." 183 Table 6.7: Number and Average Size of Agricultural OrganizationsandPrivate Farms, 2000-03 2000 2001 2002 2003 Numberofagricultural organizations 2,414 2,400 2,338 2,230 Total land area, thousand hectares 9,23 1 8,818 8,708 8,661 Average size o f land area, hectares 3,824 3,674 3,725 3,884 Numberofprivate farms 2,525 2,397 2,399 2,493 Total land area, thousand hectares 86 93 130 180 Average size o fprivate farms, hectares 33 39 54 72 Source: MSA. 6.36 The emergence o f a greater degree o f private ownership and more long-term leases has been hindered by the absence of clear property rights. Developments in this sphere will inevitably be exceptionally slow, given the long legacy of absolute state ownership and control over enterprises in Belarus. However, important steps have been taken to develop a comprehensive land valuation and registry system which may facilitate more fundamental restructuring. Private property rights for household plots (up to 1 hectare) can be registered and market transactions are now allowed. The State Committee on Land Resources and Cadastre serves as a "one stop shop" registry for all such land transactions. 6.37 The efficiency o f land use under public control remains significantly lower than inthe privately operated entities. The private sector accounts for only 17 percent o f agricultural land which, when considered in conjunction with its output share, implies either that it i s an exceptionally productive sector or that not all its resource use i s fully costed. Producers in the private sector, especially the household sector, have close ties with state-controlled entities in terms o f inputs and service provision as well as in securing market outlets (Table 6.8). 6.38 At the agro-processor level, a significant portion o f the traditional state-owned enterprises were corporatized. In 2003 the share o f such enterprises in the food-processing industry was 71 percent by volume o f production and 66 percent by level o f employment. The increased share of private enterprises was achieved mainly through corporatization o f the existing enterprises, as the number o f enterprises remainedrelatively stable. Table 6.8: Structure of Agricultural Output and LandHoldingsby Different FarmCategories, 2000-03 (YO) 2000 2001 2002 2003 Total agricultural output (incurrent prices) Share o f agricultural organizations 61 61 57 51 Share o f private farms and households 39 39 43 49 Total agricultural land Share o f agricultural organizations 84 84 83 80 Share o fprivate farms and households 16 16 17 20 Source: MSA. 6.39 The data analysis reveals that a monopolistic element remains strong inthe sector: 21 enterprises are defined as monopolies, amounting to nearly 5 percent o f all enterprises but contributing nearly 24 percent o f output. 184 Input Supply 6.40 Most o f the agricultural inputs are produced domestically. As well as supplying its own indigenous sector, Belarus has a significant export trade in farm machinery and especially in potassium fertilizers. In recent years the production o f tractors has outpaced the rate o f their supply to agriculture (Table 6.9). Similarly, the domestic consumption o f mineral fertilizers has not kept pace with their production. 2000 2001 2002 2003 Production Mineral fertilizers (`000 tons) 4,056 4,379 4,495 4,953 Tractors 22,470 22,688 24,3 16 26,665 Utilization Application o f mineral fertilizers (per 100 ha o f arable land) 169 138 146 149 Tractors (per 1000 ha o f arable land) 15 15 14 13 6.41 Almost all inputs and farm services are still produced and distributed by state-managed enterprises. The notable change has been the restructuringo f the input supply industryas the state tried to consolidate the numerous organizations and agencies supplying inputs or performing services for agricultural producers. During 2003-04 the number o f such entities was reduced by 341 units, with the number o f resultant redundancies amountingto 7,730 jobs (including 3,345 middle managementjobs). 6.42 Inthe majority of the districts in the country, mechanized groups have been set up as regional ago-service enterprises and at processing enterprises. They perform 78 percent o f all farm mechanization work and about 10 percent o f all transportation services in the country. There i s also a commitment to improve the basic quality o f the machinery stock by permitting machinery imports in priority areas (for example, cattle raising and dairy production). DomesticTrade 6.43 Economy-wide, the role o f the private sector in domestic retail and wholesale trade has expanded and has reached about a third o f the total trade turnover. Likewise, inthe agncultural sector, following the reduction inthe level o f state procurement, the share o f the private sector trade turnover has also grown. 6.44 At the same time, greater involvement by the private sector continues to be hampered by the fixing o f trading margins, from 10 percent to 24 percent o f processor prices. Margins are capped at 10 percent for "socially important" products. 6.45 Administrative restrictions remain common for trade in agricultural and food products. The typical interventions by the national and local governments range from occasional restrictions on inter-regional trade to requirements placed on the representation o f domestically produced (or sometimes regionally produced) food items bytrade outlets. Economy-wideAdjustments 6.46 The unification o f the exchange rate and Belarus' commitment to join the WTO represent two major developments beyond the scope o f agricultural policy that could potentially have a positive impact on agricultural performance. The resolution o f the overvalued exchange rate by 2001 was the single most significant positive change for agricultural exporters. Of major importance also has been Belarus' 185 commitment to join the WTO, and in the context o f agriculture, the acceptance o f reasonably stringent commitments regarding agricultural subsidies. c. EXPLAININGOUTPUT AND PRODUCTIVITYGROWTH AGRICULTURE IN 6.47 Large gains in productivity growth account for the output growth observed since 2000. The increasing importance o f private farms together with strong price incentives for efficiency and productivity gains among agricultural enterprises explain the large productivity gains in Belarus agriculture. These two main sources o fproductivitygrowthprovidedthe foundation for the resumption o f agricultural growth. 6.48 As indicated earlier, large gains in average land productivity and labor productivity have taken place since 2000 (Table 6.3) which helps to account for the rapid growth in agricultural production (Figure 6.1). Beyond land and labor, productivity gains also appear to have been pervasive across a wide range o f agricultural inputs.Improved efficiency in the use o f agricultural inputs and the resulting partial productivity gains since 2000 are illustrated by a reduction in the use o f many agricultural inputs by agricultural enterprises (Table 6.10). For example, the consumption of electric power and fertilizer by agricultural enterprises has been reduced by a quarter o f its 2000 levels. The reduction in petroleum consumption has been even more pronounced. The consumption o f diesel fuel has shown the least decline. The reduction in fertilizer applications for individual crops validates the finding of improved efficiency in grain production (a 3 percent reduction), while efficiency gains in sugar beet production show a 19 percent increase. The gains observed in the productivity o f individual inputs, including land and labor, suggest significant gains intotal factor productivity growth over the period. Figure6.1: VolumeIndexof AgriculturalOutputby FarmCategory, 1990-2004 160 140 - 120 - 100 60 - -- 1990 1991 1992 1993 1994 1995 1996 1997 1998 1999 2000 2001 2002 2003 2004 Volume of output (total) 'Volume ofoutput(state) x/ 1, Volume of output (private) o`ource:MSA. Table 6.10: Use of SelectedInputsinAgriculturalProductionbyAgriculturalEnterprises,2000-03 2000 2001 2002 2003 2003 as YOof 2000 Power (mlnkWth) 1,808 n.a. 1,479 1,358 75% Diesel fuel (thousandtons) 655 579 525 515 79% Petroleum(thousand tons) 189 147 127 110 58% Fertilizer (thousandtons of effective matter) 1,022 787 764 755 74% Source:MSA. 186 6.49 The relaxation o f controls on private sector farming and the doubling o f private agricultural land have had a dramatic impact on land productivity and agricultural output growth. Although the amount o f land operated by private farms doubled between 2000 and 2003, the privately owned share o f agricultural land (most o f which belongs to the household sector) remains small, reaching only 20 percent in 2003 (Tables 6.7 and 6.8). Despite this small share o f land, almost half (49 percent) o f the total agricultural output growth since 2000 has come from the private sector (Figure 6.1). With only a small share o f agricultural land currently operated by private farmers, this suggests that there remains much potential scope for raising agricultural output further. 6.50 Farm managers o f agricultural enterprises were given increased flexibility in the management o f their farm operations, which allowed them, for example, to take marginal land out o f production and also, increasingly, to shed some labor. Both o f these measures helped boost average land and labor productivity. Increasingly, strong price incentives prompted farm managers to take advantage o f their increased management flexibility by capturing efficiency gains in the use o f farm inputs, and to raise productivity on their farms. 6.51 Since 2000, farm profitability has come under increasing pressure as input prices have risen much more rapidly than output prices. The extent o f the price-cost squeeze, or the "internal terms o f trade" (ITT) experienced by primary producers, is illustrated by the 30 percent decline in the price o f agricultural commodities relative to the price o f agricultural inputs. The decline inthe UT provided a strong incentive to private farmers and farm managers to use inputs more efficiently and to capture offsetting efficiency and productivitygains inan attempt to maintain the profitability o ftheir agricultural operation (Figure 6.2). Figure6.2: RealProducer Prices andITT inBelarusAgriculture, 2000-03 120 2000 2001 2002 2003 -Real producerprices - - Internalterms o ftrade Source: MSA. 6.52 The incentives to improve productivity varied across commodities depending on the severity o f the price-cost squeeze prevailing for each commodity. Figure 6.3 indicates that the price-cost squeeze was much more pronounced for import-competing commodities such as grains and sugar beet than for exportable commodities such milk, potatoes, vegetables and beef. For exportable commodities such as milk and potatoes, output prices actually improved relative to input prices, while for other exportables such as beef and vegetables output prices almost kept pace with increases in input prices..For import- competing commodities, however, inputprices increased much more rapidly than commodity prices. 187 6.53 These commodity-specific movements in the ITT are associated with changes in the levels o f profitability o f individual commodities produced by agricultural enterprises (Table 6.11). For example, the profitability o f milk, potatoes and vegetable production improved over the period: inthe case o f milk, profitability improved but remained negative (see below), Grain producers managed to maintain their profitability levels in 2001 and 2002 despite a significant price-cost squeeze, which suggests that productivity gains in the grain sector have been particularly large. The 13 percent reduction in fertilizer application together with the 12 percent increase ingrain production between 2000 and 2003 are a further indication that such productivity gains may have been realized. In 2003, the profitability o f grain production fell dramatically, partly as a result o f the price-cost squeeze and partly because of the drought- related drop inoutput. Figure6.3: Realproducer Pricesfor SelectedCommodities,2000-03 200 180 - - -Milk 160 -Potatoes 140 -Beef 120 -Vegetables 100 -Pork 80 -Eggs 60 -- Poultry 40 I- Sugarbeets 20 -Grains 0 2000 2001 2002 2003 Source: MSA. Table 6.11: Profitabilityof Salesfor SelectedAgriculturalCommoditiesbyAgricultural Enterprises, 2000-03 (percent) 2001 2002 2003 Vegetables 32 40 39 Sugar beet 8 -13 15 Potatoes -1 13 9 Grains 23 22 8 Eggs -3 4 5 Milk -25 -10 -1 Pork -3 1 -3 Beef -26 -23 -34 Total -9.3 -5.0 -6.2 Source: MSA. 188 6.54 Profitability levels rather than changes inoutput prices explain output growth. Profitability levels resulting from changes in input terms o f trade and productivity gains are closely related to the output response. Those commodities for which profitability remained high (such as grain, sugar beet) or improved (such as vegetables, milk, potatoes) witnessed the largest production increases. Those commodities whose profitability remained poor (pork) or deteriorated further (beef) experienced the smallest growth in output, or even a decline inproduction (for example, eggs). By contrast, changes in output prices, caused in large part by the devaluation o f the exchange rate, are unlikely to have explained much, if any, o f the supply response in agriculture. Farmgate prices did change significantly between 2000 and 2004, but their movement does not seem to explain the observed changes in agricultural output (Figure 6.3). 6.55 As a result o f the devaluation o f the exchange rate, the output-price distortions within the agricultural sector were reduced. The unification o f the official and the market exchange rates in 2000 resulted in a substantial depreciation o f the currency. This devaluation automatically improved the competitiveness o f the agricultural sector on the world market, and this helps to explain the growth in agricultural exports and the deceleration in the rate o f growth o f agricultural imports. The devaluation o f the exchange rate also enabled the government to raise farmgate prices in real terms, although the increase was marginal (Figure 6.2). 6.56 The small increase in the average farmgate price in real terms, however, masks significant differences in price movements across commodities. The pass-through o f the exchange rate devaluation on farmgate prices was not applied consistently across commodities. In particular, the prices o f exportables (milk, beef, vegetables, potatoes) were allowed to increase much faster in real terms than those o f importables (grain, sugar beet). The prices o f those exportable commodities such as milk, beef, potatoes and vegetables increased significantly in real terms, while those commodities competing with imports such as grain and sugar beet saw their prices decline in real terms (Figure 6.3). Inshort, relative prices within agriculture changed significantly after the devaluation and became more favorable to export-oriented commoditiesrelative to import-substitutingcommodities. 6.57 Nevertheless, the aggregate productivity improvements have not been able to offset the worsening ITT for agriculture. Aggregate profitability dynamics indicate that the negative trend in ITT has prevailed over improvements inthe efficiency o f production and has ledto overall financial losses. In these circumstances, future growth in agricultural output i s likely to necessitate a continuous (and increasing) access to budgetary support for the purchases of inputs and services for agricultural enterprises and/or further increases infarmgate prices from their presently suppressed levels. D. THEAGRO-FOOD COMPLEX IS COMPETITIVE, BUT THE SOURCES OFITS APPARENT COMPETITIVENESS ARE NOT SUSTAINABLE 6.58 Despite significant productivity gains at the farm level, the competitiveness o f the agro-food complex rests inpart on the cross-subsidization o f the processing and marketing industryby the fanning sector and, increasingly, the taxpayer. This regime cannot be sustained for long. If we look at the food chain as a whole, farm prices are depressed and are increasingly kept below international prices. Consumers do not benefit from these low farm prices since consumer prices are in line with international levels, The benefits o f this taxation o f the farm sector accrue to food-processors, but seem to be lost in marketing and processing inefficiencies. At present, the implicit taxation o f agricultural producers i s the primary factor behindthe competitive position o f Belarusianproducts inthe Russian food market. Unless processing and marketing inefficiencies are removed, raising farm prices to world market levels i s not possible without renderingBelarus' food productionuncompetitive. 189 6.59 Farm prices are depressed below international levels. The extent o f the implicit taxation that i s inflicted upon primary agriculture through the enforcement o f low producer prices i s presented in Table 6.12. Belarus' agriculture i s being taxed increasingly by commodity prices that are below world market levels. The evidence regarding the profitability o f agricultural enterprises indicates that from 2001 agricultural enterprises recorded negative rates o f profitability.''' In contrast to the poor record of profitability o f the farm sector, the processing sector has turned in a consistently positive but low level o f profitability. The contrasting profitability o f the two sectors i s consistent with the cross-subsidization o f the upstream segments o f the food chainby the farm sector. Table 6.12: Estimate ofthe Implicit Tax on Agricultural Producers2000-03 (percent of output) 2000 2001 2002 2003 Estimated implicit tax on agricultural producers from lower than international 5 -5 -4 -7 prices ("?) Profitability o f agricultural production (%) 3 -7 -4 -6 Profitability o f food processing (%) 9 8 6 6 Sources: MSA and World Bank staff calculations. 6.60 According to preliminary results, in 2004 the negative profitability was reversed with an average gross margin o f 7 percent. The aggregate profitability level for 2004, however, masks the reduction inthe number o f loss-making enterprises that have been amalgamated with non-agricultural entities as well as the increased levels o f budgetary support (see below). 6.6 1 Belarusian agricultural producers receive much lower farm prices than their Russian counterparts for most agricultural c o m m o d i t i e ~ '(Table 6.13). Wheat, rye and sugar beet are the exceptions. ~ ~ Belarusian farm prices for these import-competing commodities have historically benefited from much higher prices compared to Russia or the world market, but the price difference has been coming down significantly over the last four years. For exportable commodities, Belarusian prices are well below Russian levels: 60 percent below inthe case o f beef, and 40 percent below inthe case o f milk, pig meat, and poultry. Inthe case o f milk, however, the gap between Belarusian and Russian prices has narrowed considerably since 2000. Convergence toward more competitive prices i s occurring, albeit at a relatively slow pace relative to the gap that exists interms o f price levels. 6.62 Farmers also pay more for their inputs. Interms o f inputprices, Belarusianagricultural producers suffer a competitive disadvantage with respect to tractors, electricity, natural gas and wages since their domestic prices are well above Russian prices (Table 6.14).13' One clear source o f competitive advantage arises with mineral fertilizers (mainly potassium), which are supplied to producers at a substantial discount relative to Russian producers. The trends inthe prices o f most inputs, including wages, exhibit a clear trend toward convergence with Russian levels, reducing the competitiveness tax imposed on farmers. 129 The information on the profitability o fthe private sector is unavailable. I 3 OAs most trade is with Russia, Russianproducer prices are the most relevant benchmark against which to assess the competitiveness o fthe Belamian sector. 13' Since Russian energy prices are underpriced it would be incorrect to infer that Belarusian energy prices warrant a reduction. 190 Table 6.13: Levels of AgriculturalProducer PricesinBelarusandRussiafor SelectedCommodities, 2000-03 (BYRper ton) Year 2000 2001 2002 2003 Average ratio Milk Belarus 74,000 114,000 194,000 249,000 Russia 135,446 195,973 292,267 333,711 Ratio to Russian prices 0.55 0.58 0.66 0.75 0.64 Ratio to World prices 0.59 0.59 0.84 0.89 0.73 Beef and Veal Belarus 363,000 647,000 1,035,000 1,119,000 Russia 885,298 2,064,579 2,610,3 15 2,590,660 Ratio to Russian prices 0.41 0.31 0.40 0.43 0.39 Ratio to World prices 0.39 0.59 0.72 0.52 0.56 Pig meat Belarus 688,000 1,249,000 1,617,000 1,768,000 Russia 997,394 2,279,533 2,776,827 2,794,252 Ratio to Russian prices 0.69 0.55 0.58 0.63 0.61 Ratio to World prices 0.83 0.84 0.94 0.76 0.84 Poultry Belarus 718,000 1,115,000 1336,000 1,742,000 Russia 1,101,141 2,032,690 2,566,642 3,335,438 Ratio to Russian prices 0.65 0.55 0.60 0.52 0.58 Ratio to World prices 1.30 1.52 2.05 1.78 1.66 Wheat Belarus 113,000 136,000 155,000 178,000 Russia 66,072 91,461 84,028 162,574 Ratio to Russian prices 1.71 1.49 1.84 1.09 1.53 Ratio to World prices 1.32 0.91 0.79 0.62 0.91 Rye Belarus 87,000 104,000 118,000 118,000 Russia 63,543 80,75 1 59,759 93,728 Ratio to Russian prices 1.37 1.29 1.97 1.26 1.47 Ratio to World prices 1.53 0.89 0.53 0.49 0.86 Sugar Beet Belarus 33,000 41,000 49,000 65,000 Russia 17,158 31,316 42,758 57,585 Ratio to Russian prices 1.92 1.31 1.15 1.13 1.38 Ratio to World prices 2.96 2.28 2.42 2.54 2.55 Sources: MSA, Rosstat, World Bank staff calculations. 191 Table 6.14: SelectedAgriculturalInputPriceLevels inBelarusandRussia, 2000-03 (BYR per unit) 2000 2001 2002 2003 Tractors, unit Belarus 9,484 35,808 31,613 31,607 Russia 8,960 14,840 22,215 28,010 ~ Ratio 1.1 2.4 1.4 1.1 Total mineral fertilizers, ton Belarus 23,000 66,000 96,000 153,000 Russia 54,071 112,688 184,084 349,827 Ratio 0.4 0.6 0.5 0.4 Electricity, `000 kW Belarus 40,000 75,000 80,000 78,000 Russia 11,360 24,766 40,698 63,384 Ratio 3.5 3.O 2.0 1.2 Natural gas, `000 M3 Belarus 76,000 80,000 92,000 110,000 Russia 13,619 25,387 39,610 64,126 Ratio 5.6 3.2 2.3 1.7 Wages Belarus 43,243 78,200 113,000 139,600 Russia 36,036 62,459 100,290 145,905 Ratio 1.2 1.3 1.1 1.0 Source: MSA, Rosstat staff calculations. 6.63 As regards yield indicators, in 2003 Belarus enjoyed a yield advantage relative to Russia in all commodities except milk (Table 6.15). Belarusian milk yields were remarkably constant at about 90 percent of Russian levels. With the exception o f cereals and beef, the extent o f the yield advantage has, however, lessened somewhat inrecent years.'32 132Belarus' productivity indicators grew further in 2004: 19 percent for milk, 9 percent and 3 percent for daily weight gains for beef and pork, and about 22 percent for cereals and 34 percent for sugar beet. N o t presented, as 2004 data for Russia not available at the time o f writing this report. 192 Table6.15: ComparativeTrends inPartialProductivityIndicatorsfor Selected Commodities, BelarusandRussia 2000 2001 2002 2003 Milk(kg/cow) Belarus 2,154 2,408 2,507 2,611 Russia 2,341 2,551 2,878 2,976 Ratio 0.92 0.94 0.87 0.88 Cattle (daily weight gain, g) Belarus 346 383 406 421 Russia 333 361 385 383 Ratio 1.04 1.06 1.05 1.10 Pigs (daily weight gain, g) Belarus 373 399 407 400 Russia 187 232 254 256 Ratio 1.99 1.72 1.60 1.56 Cereals (post processing, 100 kg/ha) Belarus 19.4 19.9 24.7 24.2 Russia 15.6 19.4 19.6 17.8 ~ Ratio 1.24 1.03 1.26 1.36 Sugar beet (industrial, 100 kg/ha) Belarus 292 313 228 275 Russia 188 199 219 228 Ratio 1.55 1.57 1.04 1.21 Sources: MSA. Rosstat staff calculations. 6.64 Consumers do not benefit from low farm prices, The size o f the food consumers' subsidy i s very small as the prices for the main foodstuffs are broadly competitive or in line with Russian levels (Table 6.16). On the face o f it, taking processor and retail prices together does not indicate that there are significant internal inefficiencies in the retail sector. However, government interventions in the form of price caps on processor prices and fixed trading margins disguise the true situation. 193 Table6.16: RetailPricesfor SelectedFoodstuffs,Belarus andRussia,2000-03 (BYR) 2000 2001 2002 2003 Average ratio Beeflkg Belarus 1,501 2,6 16 3,356 4,019 Russia 1,777 3,362 4,153 4,983 Ratio 0.8 0.8 0.8 0.8 0.8 PorWkg Belarus 2,359 3,291 3,538 4,103 Russia 1,970 3,788 4,635 5,558 Ratio 1.2 0.9 0.8 0.7 0.9 Poultrylkg Belarus 1,728 2,641 3,571 4,295 Russia 1,645 2,721 3,342 4,674 Ratio 1.1 1 1.1 0.9 1 Butterlkg Belarus 1,886 3,25 1 4,596 6,182 Russia 2,330 3,429 4,584 5,93 1 Ratio 0.8 0.9 1 1 1 Cheeselkg Belarus 2,447 4,272 5,623 7,112 Russia 2,871 4,927 5,877 7,549 Ratio 0.9 0.9 1 0.9 0.9 Sugarlkg Belarus 571 763 957 1,321 Russia 527 711 1,114 1,237 Ratio 1.1 1.1 0.9 1.1 1 White breadlkg Belarus 561 679 88 1 1,173 Russia 411 655 821 1,260 Ratio 1.4 1 I 1.1 0.9 1.1 Source: MSA, Rosstat staff calculations. 6.65 Food processors benefit from low farm prices. Processor output prices in Belarus appear to be aligned with prices in Russia (Table 6.17). The ability o f the current price policies to depress most farm prices below world levels enables the processing industry to survive without addressing its internal inefficiencies. Inefficiencies arise inpart from the low capacity utilization and the limited economies o f scale associated with the small size o f the processing operations, both o f which are critical determinants o f the competitiveness o f the food processing industry.Other indicators of inefficiencies inthe processing industry are the low and declining level o f the gross margin which prevails in the industry despite the heavy cross-subsidization it enjoys from primary producers and the increasing depreciation of the capital stock. (Table 6.4). 194 Table 6.17: Processor Prices for Selected Foodstuffs, Belarus and Russia, 2001-03 (BYR) Beeflton 2001 2002 2003 Average ratio Belarus 1,261,698 2,302,492 2,673,096 Russia 2491,762 2,873,791 3,439,874 Ratio 0.51 0.80 0.78 0.69 Butterlton Belarus 1,868,510 3,23 1,506 4,003,680 Russia 2,727,943 3,467,945 4,626,844 Ratio 0.68 0.93 0.87 0.83 Cheesekon Belarus 2,381,022 3,581,337 4,423,035 Russia 3,123,427 3,801,881 4,980,784 Ratio 0.76 0.94 0.89 0.86 Wheat flourlton Belarus 265,225 298,555 318,665 Russia 224,755 220,260 477,809 Ratio 1.18 1.36 0.67 1.067 Sources: MSA, Rosstat staff calculations. IncreasedBudgetarySupport Substitutesfor Lack of Profitabilityat the FarmLevel 6.66 Burdenedwith depressedfarm prices and highinputprices, anddespite significant productivity gains, farm profitability remains negative for agricultural enterprises as a whole and cannot generate the cash flow it needs to invest insustained productivity growth. Increasingly, taxpayers through the budget have to subsidize farm operations and investments in farm inputs and productivity-enhancing investments. Large agricultural organizations are the principal clients o f the current institutional setup in agriculture and thus are also the principal beneficiaries of budgetary support. In addition to subsidized inputs, credit and periodic debt-write- offs, agricultural enterprises benefit from lower levels o f taxation and other budgetary obligation^.'^^ As the private sector (comprising households and private farms) operates largely outside o f the sector's institutional framework, it i s excluded from most o f the support activities. The availability o f subsidies to the private sector is largely due to their less-than-perfect targeting. 6.67 A schematic representation o f state support to the agro-food sector i s depicted inFigure 6.4. The solid lines indicate support measures that have a reasonably transparent explicit cost, while the broken '33 According to Gusakov (2004), in2002 the tax burdenon the agricultural enterprises was approximately 2.5 lower than elsewhere inthe national economy. 195 lines depict measures that have implicit costs which, though no less real and no less important, are difficult to quantify with any precision. 6.68 Estimates o f the explicit costs o f state support since 2000 are given inTable 6.18. Support to the ago-food sector accounts for about 30 percent o f all budgetary support to the national economy, between 10and 12percent o f all consolidatedbudget expenditure and 3 to 4 percent o f GDP. 6.69 Against a background o f a decline in both the area o f agricultural land and the labor force, the amount o f state support has grown even faster on a per hectare and, particularly, on a per worker basis. In 2005 it is anticipated that in U.S.dollar terms the amount of budgetary support will reach about US$1 billion in total or US$101 per hectare.'34 In other words, the level o f state support to the agro-food complex more than doubled inreal terms between 2000 and 2004. Figure 6.4: Schematic Depiction of the System of State Support for the Agro-Food Sector inBelarus Budget support R&D& service - I 'public - ...................... Unspecified L r II I I I I I I I I I I I I I processors --- ----- households I I I I I '----------------------- Source: Adapted from Babitzky (2004). 134 The value o f state budgetary support i s normally calculated per hectare of land managed by larger agricultural enterprises only (Le., excluding the land under cultivation by households and private farmers). Since, in one way or another, all farming categories benefit from state budgetary support (albeit to a varying degree) it was decided to present the figure relative to the land area managed by all types of agricultural producers. Another reason for doing so i s to permit more consistent international comparisons. 196 2000 2001 2002 2003 2004 2005 Value o fbudgetary support (Billion BYR incurrent prices) 381 642 820 1,528 1,970 2,337* Budget support as a share o f GDP (%) 4 3.8 3 4.3 4 n.a. Support as a share of gross agricultural output (%) 14 15 13 19 17 n.a. Support as a share of cash receipts (%) 36 40 44 62 n.a. n.a. Budget support per worker (inconstant 2000 US$) 653 771 827 1,425 1,728 n.a. Budget support per hectare (inconstant 2000 US$) 44 49 49 78 94 110 6.70 The level o f state support is well within internally determined legislative limits.'35The government i s also committed to a cap on market-distorting levels of support under the WTO of US$504 million per annum or about U S 5 7 per hectare (i.e. about halfthe current 6.71 There are two main sources of budgetary funding for the ago-food sector: regular state budgetary allocations and the proceeds of the National Fund for Support of Agricultural Producers, Food and Agricultural Science (the "Support Fund").The Support Fundhas been the single largest source of funding and has accounted for about two-thirds of all fundinginthe sector for the past five years (Table 6.19). Table 6.19: Sources of Budgetary Expenditure to the Agro-Food Sector, 2001-05 (billion BYR) 2001 2002 2003 2004 2005" National Fund for Support o f Agricultural Producers, Food and Agricultural Science 258 307 595 1,180 1,370 Local Fundfor Support o f Agricultural Producers, Food and Agricultural Science 220 267 374 0 0 Local budgets 121 157 420 605 510 Nationalbudget 43 89 139 185 457 Total budgetary expenditure 642 820 1,528 1,970 2,337 Including National level expenditure 301 396 734 1,365 1,827 Local level expenditure 341 424 794 605 510 Local as % o f total 53 52 52 31 22 *Projection. Sources: Ministryo f Statistics and Analysis and Ministry o f Agriculture and Food. 135The level o f state support to agriculture and rural areas in general is limited to 15 percent o f consolidated budget expenditure. 136According to the WTO Agreement on Agriculture, the base Aggregate Measure o f Support (AMs)is subject to a commitment on its reduction over a specified period. The base A M S excludes subsidies in excess of 10 percent (5 percent for developed countries) o f the value o f production and also excludes subsidies that are deemed to be non-, or minimally trade distorting. Examples include publicly financed R&D, capital investments and certain input subsidies. 197 6.72 The level o f hdingprovidedthrough local governments was increasing until2004 andthen reduced markedly as a result o fthe structural change infavor o f centralized funding. The Support Fundis financedby a 2percentturnover tax levied onall economic sectors. Before2004, theseproceeds were split betweenthe local and national budgets. Since 2004, all Support Fund expenditure has been mediated through the national budget. 6.73 This change inthe funding mechanism does not represent a lesser role for local governments in the management o f the sector; rather, it reflects the intent o f the government to allocate a greater proportion o f funding to country-wide programs, which are usually more focused. Historically, the difference between expenditure at the central level and expenditure at the local level has been the type o f support supplied at each level. As a rule, budgetary allocations at the central level tended to be spent on special programs with clearly defined beneficiaries, while spending at the local level tended to have a large discretionary element. The Program o f Revival and Development o f Rural Areas, 2005-10, foresees even greater centralization o f agricultural sector expenditure inthe future. 6.74 The recent trend toward centrally determined state subsidies helps to ensure greater concentrationand specialization inagricultural production, processing and sales. As a consequenceo f this tendency, the number o f beneficiaries o f state support i s expected to decline as the state tries to concentrate its support among the most viable units. Poultry andpork production are the first two sub-sectors inwhich the state has managed to concentrate most o fthe output andsales among fewer large enterprise^.'^' 6.75 State support comprises several measures, and their number changes almost every year. New activities are added while other activities are abandoned. The budget finances in excess o f 30 different measures, However, because o f their similarity, these measures can be grouped into a few categories (Figure 6.5). Figure6.5: Sources of State Fundingof Support to the Agro-Food Sector in 2004 (top) and 2001 (bottom) (in constant 2001 US$ millions) I 250 200 I 150 100 50 I~~~~~~~~ Programs Capital Credit Subsidy Social R&D pd PublicServicesUnspecified 13' As of 2003, 5 percent of 1,054 pork enterprises produced 73 percent of all pork and 16 poultry enterprises specialized inpoultry meatproduction producing 94 percent o f all poultry. 198 250 150 100 50 0 Capital Credit Subsidy I SocialR&D and Unspecified Investments Pnce Subsidies Programs Publlc Servlces RepublicanBudget LocalBudgets Source: World Bank staff estimates on Ministryo fFinance data. Credit Subsidies 6.76 Credit subsidies are the largest and the fastest growing component o f state support (Table 20): Moreover, they possess a larger number o f negative characteristics than other support measures. Apart from creating serious distortions inthe banking system and compromising the government's intentions to target support effectively, they also leadto an accumulation o f massive future liabilities. 6.77 As of December 1, 2004, the total level o f outstanding credit to agriculture from the commercial banks amounted to 1.1trillion BYR (equivalent to about 16 percent o f total commercial bank lending). According to some estimates, more than three-quarters o f agricultural lending represents directed credit.13*The majority of lending to the agro-food sector i s secured by the repayment guarantees o f either the central government or the regional governments. 6.78 Some of the credit i s extended through direct budgetary loans to agricultural and agro-processing enterprises, but the bulk o f all credit subsidies are channeled through Belagroprombank, which i s the principal agent o f the state inthe financing o f the sector. It i s difficult to estimate the share o f such credit that i s inarrears, as loans are frequently rolled-over and from time to time some are written off. Table 6.20: Credit Subsidies, 2001-05 2001 2002 2003 2004 2005 Discount rate o f the National Bank o f Belarus 48 38 28 17* n.a, rate (percent per annum, end-of-period) Total credit subsidy (billion current rubels) 60 98 213 560 730** Including Interest rate subsidy (Billion current rubels) 14 74 114 91 154** Debt write-off and other credit subsidies (Billion 46 23 99 469 576** current rubels) *Thirdquarter; ** Projections. Sources: Ministry o f Finance and MSA. 6.79 Credit subsidies comprise two main elements: an interest rate subsidy and debt cancellations, where the latter include budgetary loans that are in arrears and equity contributions to Belagroprombank. The interest rate subsidy includes the difference between the actual interest and the discount rate o f the National Bank of Belarus (NBB) discount rate plus a margin. It also includes the cost o f funds that are used to cover seasonal and other cash-flow emergencies. The sources for such funds are either an NBB credit, which i s deposited with Belagroprombank for subsequent on-lending to agricultural producers and 13'According to the estimates o f the Institute o f Privatization and Management, in 2003 about 75 percent o f all lending to agriculture was extended through directed credit (more than 50 percent o f which was subsidized). 199 ago-processors, or the sales o f government securities. As a rule, these interest costs are accounted and covered by the Support Fund. Average annual interest rate (%) Credit outstanding (Billion BRs) as o f December 1 2003 2004 2003 2004 Agricuiture 10.60 8.90 602 1,098 Construction 39.40 24.00 81 191 Trade and catering 39.20 24.00 346 623 Source: NationalBank of Belarus. 6.80 The level o f credit to agriculture has increased significantly, while the growth in the interest rate subsidy has been modest (Table 6.21). This can be explained by the reduction inthe NBBdiscount rate as well as by the reduction inthe average level o f interest rate subsidy, which was reduced by about a third in 2004. Incontrast, debt write-offs grew substantially and this growth is expected to continue in 2005. The main components o f capital subsidies to the ago-food sector are therefore difficult to estimate with precision. Interms o f short-term credit, some o f the repayment deficit can be reflected incosts only inthe following year, while the estimate o f bad debt i s complicated by the frequent extension o f repayment terms. 6.81 As o f December 2004, about three-quarters o f the outstanding lending to the agro-food sector (834 billion rubels) represented long-term commitments that accounted for about 29 percent o f all long- term credit inthe national economy. The growth inlong-term lending was exceptional (approximately 84 percent in2004 alone) and could not be explained by the value o f long-term credit resources provided by the state budget. Therefore, this figure i s likely to represent the level o f accumulated bad debt which had been frozen or rolled over. Thus, this figure represents a very large amount o f potential liabilities to the banking system and the national economy. 6.82 At present credit is effectively being extended to all agricultural enterprises regardless o f their credit history and the size o f their existing liabilities. This system i s clearly favoring the most unprofitable entities and thus the most inefficient agricultural enterprises. This compromises the stated efforts o f the government to render public support for the ago-food sector more targeted and transparent and thus more efficient. E. THESUSTAINABILITY OFTHE SECTOR'S PERFORMANCE Competitiveness 6.83 Developments in the internal and external competitiveness factors have played a significant role inthe performance o fthe sector inrecent years. The exchange rate adjustments that occurred in 1999 and 2000 had a positive impact on the performance o f the sector but the predominant factor was the endogenous improvement that occurred inproductivity, especially in the grains sector. The exchange rate adjustment facilitated this process rather than driving it. Loolung ahead, there i s little likelihood that exchange rate adjustments on the scale o f those o f 1999 and 2000 will be repeated, and therefore this factor i s not likely to play a similar role inthe mediumterm. Inaddition, the significant improvements in productivity that have occurred in response to the developments in the internal terms o f trade are not likely to be sustained, and more modest productivity adjustments in line with a much reduced price-cost squeeze are likely to apply in the medium term. In this scenario, short o f a significantly enhanced program o f structural adjustment, the impressive recent growth in output can only be maintained by 200 greater budget expenditure. However, the sustainability o f budgetary support to the sector at the level o f recent years i s highly questionable. There are evident internal and external fiscal limits (such as the WTO requirements) to the extent o f the subsidization o f the farm sector. Budget support i s also a highly inefficient way to sustain agricultural growth (the budget had to increase by about 170 percent between 2000 and 2004 to generate a 26 percent increase in agricultural output). The only viable solution i s to raise farm prices. However, raising farm prices without reforming the ago-processing industry and the marketing channels to eliminate the existing inefficiencies will render the agro-food complex non- competitive. Budgetary Support 6.84 Compared with the CIS counties as a whole, Belarus has the highest level o f budgetary support per hectare. However, this level i s much lower than the level o f support in some transition economies and i s considerably lower than the agricultural subsidies in most OECD member countries. In 2004, agricultural expenditure per hectare in Belarus was close to half o f that in Hungary, slightly over half o f that inthe CzechRepublic, and about one-sixth o fthe average EUlevel (Table 6.22). 6.85 Belarus' adherence to the WTO "Amber Box" limit o f about US$57 per hectare will place a cap on support measures that can sustain productivity growth at the farm level. Growth-enhancing public support measures such as agricultural research, education and training, technical advice and consulting, and investment in rural infrastructure and services will not be capped under the WTO, but the government's ability to finance them will depend on its capacity to create fiscal space by reducing the level o f farm subsidies and direct support to farms. Table 6.22: Volumes of Budgetary Support to AgricultureinSelectedCountriesin2003 Support per hectareof Agriculture budgetarysupport as agricultural area (US%) % of GDP Switzerland 1,913 0.95 Norway 1,681 0.79 European Union (12) 584 0.68 Hungary 203 1.44 United States 193 0.73 Czech Republic 159 0.81 Slovak Republic 135 1.03 Belarus 100 4.3 Poland 37 0.33 Ukraine 20 1.65 Russian Federation 19 0.95 N e w Zealand 10 0.22 6.86 As a percentage o f GDP, budgetary expenditure on the agricultural and food sector at over 4 percent places Belarus with the highest international share o f taxpayer support. Thus, the largest share o f the growth achievement o f the ago-food sector (51 percent o f total growth i s attributed to state- agricultural enterprises - the principal beneficiaries of the state support) was realized at a significant cost to the national economy. From a fiscal viewpoint, support to the sector on this scale i s clearly not sustainable and it i s most likely that scarce public resources could be much more efficiently spent elsewhere inthe economy. 201 The OrganizationofProduction 6.87 The healthy recent trend in the sector's output growth i s substantially underpinned by the performance o f the household farm sector. However, the growth o f household production largely reflects a reversion to subsistence-type agriculture, as the income conditions for rural dwellers have been challenging. Family labor and hidden transfers from the state-controlled farm sector have driven output growth. To grow and become competitive, private sector farms will have to be given incentives as well as the sources o f revenue to invest inthe form o f higher farm prices. As indicated earlier, higher farm prices without reform o f the ago-processing industryand marketing channels will render the ago-food complex non-competitive. Hence, without fundamental changes inthe price regime, the activity o f this sector will not provide a sustainable basis for adequate farm income development inrural areas inthe longer term. Severe CapitalConstraints 6.88 The difficult economic climate since the early 1990s has led to a virtual collapse in the capital stock o f the state-controlled farm sector. Substantial investment i s warranted, but the availability o f resources i s open to question and the wisdom o f their deployment (should such resources become available) i s questionable in the absence o f fundamental reform across the ago-food spectrum. The processing sector i s equally deficient in modernizing capital investment. The medium-term advancement o f the food industryand, inparticular, its capacity to significantly expand'exports i s severely constrained as a result. In the absence o f a much more positive attitude on the part o f the state towards external investment, it i s highlyunlikely that this capital deficit can be made good. Measuresto Reducethe Number of Loss-MakingEntities 6.89 Loss-making entities will arise inany system. The real issue i s how they should be handled when they do arise. Inrecent years the practice o f merging a loss-making-entity with a profitable entity solves the problem inan accounting sense but gives rise to clear efficiency losses. F. CONCLUSIONSANDRECOMMENDATIONS 6.90 Since 2000, the most notable changes in the structural adjustment o f the Belarusian ago-food sector have had involved the substantial reduction o f the state's role in agricultural markets and in asset ownership together with the associated relaxation o f the existing price controls. The volume o f state purchase was substantially reduced and many formerly state-owned food-processing enterprises were corporatized. In turn, these changes have brought about an important policy shift towards "minimum" prices for agricultural products and a less control over the prices o f food commodities. Other measures, such as the withdrawal o f unproductive land, the transfer o f the social burden to the local governments, and the rationalization o f input supply have brought important financial savings to the sector, although their full effectiveness can only be realized with complementary reforms. 6.91 State policy regarding the agro-food complex appears to have as its over riding goals the security and delivery o f affordable food for its citizens and the maintenance o f employment and reasonable income levels for rural dwellers. This policy with its evident internal contradictions gives rise to both budgetary and efficiency costs. At the same time, the state appears to be aware o f the need for reforms in the ago-food complex to ensure better value for taxpayer resources. These reforms, however, are conceived against a background that involves the retention o f the main features o f a centrally planned economy and, crucially, in respect o f the primary sector, the ownership and control o f the vast bulk o f agricultural landby the state. Inthe recommendations that are outlined below, the retention o f the existing command system i s taken as a given and the focus instead i s on reforms that are feasible within this 202 constraint. The recommendations are designed to maximize the contribution the sector can make to the national economy without requiring a continuationo f the current unsustainable level o f subsidies. 6.92 The greatest prospect for the enhancement o f the contribution o f the ago-food industry's contribution to material income generation lies with the development o f an export-oriented food- processing sector. Belarus' food-processing sector in all branches suffers from a severe lack o f capital, pervasive inefficiencies and lack of intrinsic competitiveness. This severely hampers the development o f a serious export-oriented sector, or at least one that i s not overly dependent on the Russian market. Success in food export markets requires substantial investment to underpin efficiency, and, most important, to ensure adequate product quality. Experience elsewhere has shown that modernization and efficiency improvements in primary agriculture can occur quickly once they are driven aggressively by the processing sector. There are far too many processing plants o f an inefficient size, especially inthe dairy sector, and most o f these plants have an outdated capital stock. The state has committed itself to reducing the number o f plants, but the proposed reduction i s nowhere near what i s requiredinthe medium term. 6.93 However, modernization can only come about with the support o f external capital and expertise. Consideration should be given to a joint state-private sector initiative, involving, for example, external participation, in the area of dairy processing. The successful development o f a number o f modem plants o f an efficiently-sized could have significant externalities, aside from the welcome level o f FDI that would accrue. Such investments bring clear benefits in terms o f technological transfer and know-how. The success o f any such investment will o f course require commitments inrelation to the procurement o f raw materials as well as autonomy inthe management o f the enterprise. It i s recommendedthat a scoping study be conducted involving the World Bank and the government o f Belarus to determine the feasibility o f this type o f venture. 6.94 Producer price levels need to be brought much more into line with international prices. While there has been progress toward a more appropriate alignment o f prices, there i s still considerable room for improvement. When prices in Belarus are benchmarked against world levels, competitive pricing would imply that there is significant scope for price increases inthe case o fmilk,beef and veal, pork, wheat and rye while price reductions are warranted in the case o f poultry and, particularly, sugar beet. As regards inputprices, while total inputprices are not significantly out o flinewith Russianprices-an outcome that has been substantially helped by exchange rate adjustments - fertilizer prices are substantially below competitive levels. While energy prices are very much inexcess o f Russianlevels, the latter prices do not reflect true resource costs andthus a downward adjustment i s not warranted. 6.95 Able managers o f state-controlled farm entities who are prepared to take on risks should be given much greater decision-making autonomy. It i s reasonable within the existing system for the state to lay out the responsibilities o f farm managers, but the quidpro quo ought to be the delegation o f much greater independence in the management o f these responsibilities. This autonomy should extend to managers having a veto on the acceptance o f the conjoining o f unprofitable entities. At the very least, when an unprofitable entity i s conjoined to profitable one managers should have autonomy in deciding on the adoption o f appropriate rationalization strategies. While the intent to strike a significant wage differential between managers and other workers i s a welcome policy development, the extent o f the differential that i s countenanced i s much too modest to encourage innovation and risk-taking and ought to be increased substantially. 6.96 Steps to align production more closely with optimal soil and location conditions should be pursued more aggressively. There should be more significant output shifts across regions at present if a greater impact i s to be achieved. 203 6.97 The private farm sector needs to be given greater opportunity to farm without undue interference from the state and on an equal footing with state-controlled entities. A number o f private farms have apparently been required to take on the management o f unprofitable entities. This unwelcome burden will hamper the efficient development o f the private sector. Moreover, the resulting amalgamated entities are burdened with an uncertain ownership status, which will hinder much-needed investment if the matter i s not clarified. 6.98 While the performance o f the household sector in terms o f output growth has been most impressive, there i s a clear need to ensure that the transfers from state-controlled entities are rendered more transparent. All transfers should be explicitly accounted for so that the true underlying productivity performance o f this important sub-sector can be revealed. 6.99 The productive efficiency o f primary agriculture in most countries i s underpinned by appropriate education and training, farm advisory and research services. Inmost countries these services are managed and funded by the state because they constitute public goods. The exception tends to be in the area o f technical advice and consultancy, where the gains from the services tend to accrue to the individual producer. These services justify private sector activity, or, at very least, close to full-cost recovery from the beneficiaries if the service i s operated by the state. Belarus appears to have the architecture o f a potentially effective service in place in the areas o f research and education and training. However, these services are designed inthe context o f a planned system, which has, in fact, been changing inrecent years (albeit to a limited extent). In the context o f an enhanced export drive, these services require an urgent review and overhaul as to their appropriateness for the challenge o f sustaining the growth achievements to date. Advisory and consultancy services appear to be not well developed. In an effective system the advisory service acts as the conduit o f new research for producers. This service i s the anchor of successful drives towards modernization for most countries. However, resources are scarce and ought to be directed inthe most efficient manner.,Theonly way for thisto be done effectively, short ofprivatizing the service, is by the recovery o f full-costs from users. Only efficient and profitable entities would be in a position to bear such costs, and hence the flow o f services would tend toward the efficient entities. 6.100 Similar concerns apply with respect to the supply o f inputs.It i s not always clear that all entities "purchase" inputs with the intention o f fully, ifever, settling accounts. 6.101 This raises another major concern regarding the fragility o f the Belarusian ago-food complex which involves the operation o f the sector's financing system. Soft loans appear to be a pervasive feature of the system. This not only hampers the development o f a serious banking industrybut it also nullifies any attempt to promote internal markets within the command economy system. As long as farms can have losses written off with relative ease, any attempt to (for example) impose full-cost recovery for state services or resources will not be effective. 6.102 Government support o f the agro-food complex i s extensive but i s not acceptably transparent. Unlike other neighboring countries, no comprehensive estimates are available o f the extent o f market and budgetary transfers that employ, for example, the OECD's methodology. A comprehensive assessment of the extent andnature o f transfers to the ago-food complex will greatly facilitate the analysis o f the effects o f state support and the monitoring o f government intervention. Likewise, the system o f state-managed financing o f the sector's capital needs requires to be filly revealed with a view to charting a path toward the fundamental reform o f the sector. 204 CHAPTER 7 DEVELOPMENTS ENERGY INTHE SECTOR 7.1 At the time of independence, Belarus inheritedan extensive electricity and gas transmission network and significant oil refining capacity. However, the country indigenous energy resources are limited and it i s therefore heavily dependent on imports o f primary energy fuels, essentially from Russia. In2004 net imports accounted for 87 percent o fBelarus' total primary energy consumption. 7.2 However, Belarus enjoys an important strategic location between the Russian Federation and the European Union, which enables it to play a key role as a transit route for energy exports from Russia to markets in Central and Western Europe. This role takes the form of the outright transit o f oil and gas and the conversion of crude oil supplied from Russia into refined product exports. 7.3 To obtain a better understanding o f the key issues that Belarus faces with regard to its energy sector, it i s instructive to look at breakdown o f the sector's strengths and weaknesses and the associated opportunities and threats it faces (Table 7.1). Table 7.1:Belarus-Energy Sector Breakdown Strengths Weaknesses Location as a transit country Limited indigenous energy resources Geographical proximity to its primary energy Highdependence onimported energy supplier Very heavy dependence o n Russia as a supplier o f Extensive wood resources primaryenergy Established electricity network Agingphysical infrastructure Established gas transmission network Limited oil and gas storage facilities Export refining capacity 0 Weak legislative and regulatory framework Limited commercial focus o f operations Opportunities Threats Increasedproduction o fdomestic resources Disruptioninenergy supplies from Russia (primarilywood) (particularly gas) Diversification of energy supply sources 0 Higher energy import costs Expanded transit activities and increasedtransit Deterioration inservice quality revenues Further deterioration o f the domestic infrastructure Increased security o f domestic supply as a result o f Fiscal pressures as a result o f explicit and implicit expanded storage facilities subsidies Increased efficiency through private sector participation 7.4 The government faces several key challenges in the energy sector, which could be summarized as follows: 0 To mitigate the risks associated with heavy dependence on energy imports sourced fromRussia 0 To ensure the provision o f acceptable levels o f energy utility services to domestic customers a To maximize the benefits associated with Belarus' role as an energy transit country a To protect the interests o f all stakeholders inthe sector. 7.5 This chapter reviews the main trends in the energy sector and discusses a number of available options to address the above challenges effectively. 205 A. DYNAMIC ENERGY OF SECTOR INDICATORS IN2001-04 7.6 Over the last 10 years, Belarus has been successful in sustaining the performance o f the energy sector. Comparedwith that o f other FSUcountries, the performance o f Belarus electricity and gas sectors has been strong from both the technical and the financial standpoints. The level o f investments has increased, technical efficiency improved, and the economy has realized a considerable amount o f energy savings. The incidence o f both quasi-fiscal subsidies and deficits has declined. These positive trends have been important factors inthe country's ongoing macroeconomic stabilization. 7.7 There are two major explanations o f this performance: (i) the stable governance and structure o f the sector since the mid 199Os, and (ii) a reasonable level o f funding available to meet operations and maintenance needs. In contrast to many other transitional economies, Belarus did not embark on drastic structural market reforms at the beginning o f the transition period. As a result, it avoided the mistakes and the associatednegative consequenceso fmarket failures that have sometimesaccompaniedthe initial stages o fr e f o m inthe neighboring countries (such as the siphoning off sector financial flows and shadow privatization). The preservation o f the monopolistic structure o f the sector together with an economy-wide command and control management style helped the sector to survive the hard times that affected its neighbors and largest trade partners inthe 1990s. Moreover, an adequate financing o f sector assets was supported by relatively large margins retained by the gas transmission and distribution companies. This contributed directly to the stable financing o f current operations andmaintenanceneedsinthe gas sector andindirectly (through the InnovationFundofthe Ministryof Energy) to the better maintenanceo fBelenergo's assets. 7.8 While the current sector structure and governance arrangements proved adequate duringthe early transition, they now require reforms, or they will hamper the sector and its overall economic developments in the years ahead. Presently, with a growing economy, restored payment discipline, improved cost recovery, and the ongoing elimination o f misbalanced tariffs, the Belarus energy sector i s well placed to embark on market reforms and structural transformations for improving its efficiency and bringinginprivate sector knowledge, experience and capital. Collections, tariffs, and misbalanced tariffs are discussed below, first for electricity and then for gas. Electricity Collections 7.9 Belarus has improved electricity collections significantly in recent years, with total payments at 100.5 percent and cash payments at 80.3 percent in 2004. The main efforts were focused on reducing a the non-monetary share of transactions and, as a result, the cash payments more than doubled as compared with 2001 when they were about 37 percent. Total collections exceeded 100 percent in both 2003 and 2004 (i.e., overall, Belenergo has been fully paid for current sales and has started to collect past debts). Payment performance is uneven among the various categories o f consumers, with households and the viable part of the industrial sector being disciplined payers and the agriculture sector and loss-making industrial enterprises exhibiting a below average payment pattern. The electricity sector's payment discipline incash terms, as reported by country official sources, i s still below the payment performance in Poland and Ukraine. However, ifwe consider the differences inthe accounting o f the cash payments, it i s likely that Belarus came close to reachingUkraine's level o f cash payments in2004 (95 percent). Tarvfs 7.10 Electricity tariffs inBelarus are regulated by the Ministry o f Economy, while inUkraine andPoland they are setbydedicatedregulatory bodies.The weighted averageretailtariff(WART)inBelaruswent upfromUScents 3.4kWh in2001 to UScents4.7 kWhin2004, andwasjust marginallylower than a deemedcostrecovery level o f aboutUS cents 4.8kWh. The tariff hike was drivenmainlybyincreasedgas tariffs which accountedfor alargepart o fBelenergo's productioncosts, anda larger share o flocal generationinthe country electricity balancethat is more 206 2000 2001 2002 2003 2004 Purchase Price, 30.7 31.1 30.6 36.9 46.7 T&D Surcharge 33.8 25.2 21.3 14.4 18.8 WART** 64.5 56.3 51.9 51.3 65.5 Retail tariffs for: Non-households 69 60.7 53.4 51.2 67 Households 9.2 13 27.5 52.8 57.3 13'The term "misbalanced tariffs" i s used instead o f cross-subsidies because both industrial and household tariffs are consideredto be below a deemed cost recovery level. 207 7.16 The government of Belarus has used its access to relatively cheap energy from Russia strategically. A considerable portion of the benefits associated with this low cost energy was not passed on to energy consumers but was left within the sector (through relatively high margins in gas and power distribution) and invested inthe reliability of the energy system. It i s interesting to note that the gas WART in Belarus has been higher than that in Ukraine, although Ukraine has been buying gas at significantly higher prices than Belarus (about US$50/1000m3). The lower WART inUkraine stems from the following factors: (i) under-pricingthe domestically produced gas accounting to about 20 percent of the consumption; (ii) selling the gas received from Russia at a transit fee below the purchased level; and (iii)charging lower T&D tariffs. Ukraine's transmission and distribution network i s substantially larger than Belarus', but Ukraine's T&D tariff with VAT was about US$lO/MCM, while inBelarus it ranged between US$/MCM14.4 and 33.5 during2000-04.140 Misbalanced tarwfs 7.17 As in the electricity sector, mispricing subsidies provided from industrial consumers to households went down significantly from 2001 to 2003. As a result, the ratio of the household tariff/industrial tariff to the increased nearly fivefold -- from 0.21 to 1.03. However it went down to 0.75 in 2004 because of an import gas price increase and frozen household tariffs. InUkraine this ratio was about 0.5 in2004, while inPoland it exceeded 1.5 in2002 (Table 7.3 and Figure 7.1.). 7.18 In addition to households, several industrial consumers benefit from preferential gas tariffs that are granted by Ministry o f Economy resolutions on an ad hoc basis. Moreover, the sale of LPG gas to households living inrural areas i s still underpriced. The practice of discounted gas tariffs for specific industrial customers i s not applied in Ukraine but, in contrast to Belarus, Ukraine consistently keeps householdtariffs significantly lower than both the economic cost and industrial tariffs. Figure 7.1: HouseholdandIndustrialTariffsfor GasinBelarus,Poland andUkraine, 2001-04 1 -a- Poland 0.5 +Ukraine 0 2001 2002 2003 2004 I Source: World Bank. B. ENERGYEFFICIENCYINBELARUS 7.19 Incontrast to many other CIS countries, energy efficiencyhas been a top priority for the Belarus government since the mid-1990s. This has resulted in a considerable reduction in the energy intensity of the national economy and an increased share of locally produced resources in the country's energy balance. 140Becauseo f such a dynamic variation inthe gas T&D tariff inBelarus, it i s likely that a portion o fthe T&D fees was utilizedbythe government to finance non-sector related activities. 7.20 The energy tariff adjustment to economic levels inthe FSU has been carried out slowly. Most o f the countries have been using depressed energy and infkastructure tariffs as a social mitigation tool during transition. As a result, the tariff approach to promoting energy efficiency has not been fully applicable in these countries. On the other hand, the energy saving potential was not truly recognized as a cost-effective energy resource and energy policies were traditionally driven by the supply side o f the energy market. 7.21 Right and economically sound tariffs for energy resources, and private ownership on the demand side, are the two most important complementary market conditions for promoting energy efficiency. When one (or both) o f these conditions i s not met, then administrative measures on the part o f a government could compensate for market failures and create incentives that would reduce the energy intensity in the economy. Belarus i s a good example o f convincing progress made inimproving energy efficiency by applying command and control mechanisms at the initial stage o f energy efficiency reforms and the country i s gradually moving to market-based mechanisms to further curb energy intensity. 7.22 The Belarus government's policy for reducing energy intensity has brought tangible results, with the energy intensity factor going down from 0.76 in 1995 to 0.45 in 2004 (Figure 7.2), as measured by tons o f oil equivalent (toe), to produce US$l,OOO o f GDP adjusted by purchasing power parity (PPP). As compared to neighboring countries, Belarus has a better performance than Ukraine and other FSU countries, except the Baltics (Figure 7.3). When comparing the energy efficiency performance o f Belarus and Ukraine, one should take into account that Ukraine's formal progress inthis area since 1999 i s largely due to a reduced share o f a shadow economy rather than a genuine reduction o f the country's energy intensity. However, Belarus will need to further support energy efficiency measures rigorously if it i s to achieve the level o f Europeancountries. 7.23 An important indication o f improved technical efficiency in Belarus' energy sector relates to the relatively low level o f energy losses in its networks. For example, electricity losses indistributionwere comparable to those inPoland and were much lower than inUkraine (Table 7.3). There were also positive developments infuel efficiency inbothpower and heat generation. Figure 7.2: Total PrimaryEnergy Supply per GDP (PPP), kg o.e./US$l,OOO 1995 1998 2000 2001 2002 2003 2004 Source:World Bank. 210 Figure7.3: GDP (inPPP)EnergyIntensity inSelectedCountriesin2002 I 0.I 1 I 0 6 0 5 fft 0 4 fs 0 0.3 0 2 0 1 0 Source: Key World Energy Statistics. The IEA, 2004. 7.24 The government's energy efficiency agenda included both administrative measures and economic incentives, and this combination proved to be an effective strategy inBelarus' political and economic environment. The strategy emphasizes energy conservation through a strict regulatory regime to promote rational energy consumption and to invest in upgrades o f the technical infrastructure. In 1996 the government introduced the practice o f setting energy efficiency targets for relevant ministries and other public entities. Energy efficiency in private enterprises i s encouraged through energy consumptionnorms. 7.25 Because of low energy tariffs and the dominance o f the public sector inthe economy, the government of Belarus has to use administrative interventions to promote energy efficiency. This i s done through a number o f actions, including: (i)establishing the accountability o f oblast governors for achieving energy efficiency targets and far close monitoring of this performance; 14' (ii) exercising administrative and financial sanctions against enterprises and managers that do not meet the agreed energy efficiency indicators; (iii) instructing sectoral ministries to use at least 20 percent o f their respective sector innovation funds to finance energy efficiency projects; and (iv) making available funds at the national level to co-finance energy efficiency projects. Inaddition, in2002-03 the government embarked on a program o f transferring small heat-only boilers from owner-operated industrial enterprises to the Belenergo generation companies. This measure helped to reduce the costs o f heat supply and to improve its reliability. 7.26 These energy efficiency activities have also been supported by legal, regulatory, and institutional frameworks. This i s achieved through the energy efficiency law; national, regional ~~ 14' Oblast governors regularly report to the country leadership on the social and economic development o f their respective oblasts. Governors' performance is largely assessed through the system o f 16 leading macroeconomic and social indicators, which include the indicator for energy efficiency performance. 211 and sectoral energy efficiency programs with specific and monitorable targets; and the establishment o f an energy efficiency agency - the Committee on Energy Efficiency (CEE). The CEE was established in 1993 and has been responsible for energy efficiency at both the national level and local levels. The role o f the CEE i s to implement and monitor government energy efficiency programs and regulations, including the compliance o f energy consumers with energy saving indicators. Incontrast to some other countries inthe region, where similar bodies were set up (e.g., in Ukraine in 1994), the CEE has far-reaching powers, including the right to allocate state funds in support o f energy efficiency projects and to impose fines on entities and managers that fail to meet energy efficiency targets. 7.27 Moreover, contrary to other CIS countries, Belarus has allocated a relatively large amount o f public finding to support the implementation o f energy efficiency projects. Total spending on such projects amounted to about 1.2 percent o f GDP in 2003. The government has recognized that a reduction in energy consumption requires investment in energy saving equipment and technologies. A specific financing mechanism i s based on centralizingperspective financing (a portion o f the energy sector InnovationFund) and providing the CEE with a mandate to allocate these funds among enterprises and entities to directly co-finance energy efficiency projects or subsidize interest rates on bank loans. Initially, these government funds were used to co-finance the bulk o f the project costs, but with time this financial support began to play a somewhat catalytic role, covering just a fraction o f full project costs with the rest funded by enterprises (Figure 7.4). 7.28 The energy efficiency reforms are also being supported through the creation o f economic incentives on the demand side. These incentives include raised energy tariffs, strengthened payment discipline, and the exemption o f financial gains stemming from energy savings from taxation while using the savings to pay back loans, to reinvest in further energy efficiency projects, and to reward the management and staff participating in such projects. Figure7.4: FinancingofEnergyEfficiencyProjectsinBelarus,2000-05 450 US$million 400 350 300 0 OwnFundsof 250 Enterprises 200 150 IFundsAllocatedby 100 50 0 2000 2001 2002 2003 2004 2005 Source: Committee on Energy Efficiency, 2005. c. DEPENDENCERUSSIAAS ON THE PRIMARY SOURCE OF ENERGY SUPPLIES 7.29 As is indicated inTable 7.4, Belarus consumes approximately 25 million metric tons o f oil equivalent (MMTOE) o f primary energy resources annually but produces only a little over 3 MMTOE. The balance has to be imported. Inaddition, Belarus imports crude oil for its refining 212 complex and then exports refined products.'42 As a result, the total imported energy in 2004 amounted to about 36 MMTOE.The import volumes were all sourced out o f Russia. Table 7.4: BelarusPrimaryEnergySupply and Consumption, 2000-04 2000 2001 2002 2003 2004 PRODUCTION crude oil (mt) 1.85 1.85 1.84 1.82 1.80 natural gas (bcm) 0.26 0.26 0.25 0.25 0.25 peat &wood (mt) 6.60 6.80 7.10 6.80 7.00 hydro (TWh) 0.03 0.03 0.03 0.03 0.03 TotalProduction(mmtoe)* 3.25 3.28 3.32 3.25 3.21 IMPORT crude oil (mt) 12.01 11.91 14.02 14.89 17.81 natural gas (bcm) 17.12 17.27 17.58 18.11 19.64 petroleumproducts (mt) 1.08 0.38 0.49 1.oo 1.14 electricity (TWh) 7.22 8.32 6.79 7.40 4.05 coal (mt) 0.43 0.43 0.33 0.30 0.30 Total Import(mmtoe) 28.92 28.52 30.58 32.53 35.99 EXPORT Crude oil (mt) 0.35 0.40 0.60 0.80 1.05 petroleum products (mt) 7.78 7.66 9.88 10.54 12.96 electricity (TWh) 0.00 0.00 0.23 0.75 0.80 TotalExport (mtoe) 8.13 8.06 10.54 11.53 14.21 Primary EnergyConsumption(mmtoe) 24.05 23.74 23.36 24.25 25.05 Annual Percentage Change 1.27% 1.63% 3.84% 3.27% Note: A ton of oil equivalent i s defined as 10 Gcal. The applied conversion factors are: coal, 0.39; crude oil and petroleum products, 1.0; natural gas, 0.81; peat and wood, 0.18; and electricity, 0.25. Sources: MSA and World Bank. 7.30 Existing infrastructure and Belarus' geographical proximity to Russia essentially ensure that Russia will be Belarus' primary source of energy supply for the foreseeable future. As i s indicated in Table 7.5, the 2004 cost o f energy imports to Belarus amounted to about 19 percent `42Exports o f oil products reached about 13 milliontons in2004, about two-thirds of the total output. 213 o f GDP. While the cost o f energy imports i s partially offset by energy exports, it does constitute a major cause o f a negative trade balance for the country. The energy import bill amounted to US$4,424 million in 2004 as compared to the energy export inflow of US$3,556 million. The bulko f energy export revenues, specificallyabout US$3,120 million, stemmed from the export of petroleum products produced at the two domestic refineries primarily from imported oil. The resulting energy trade balance deficit o f US$868 million (=4,424-3,556) represented about 33 percent o f the country's negative trade balance o f US$2,594 million in2004. Table 7.5: Cost of EnergyImports,2000-04 2000 2001 2002 2003 2004 2004 Gas % Bcm 17.10 17.30 17.60 18-10 19.64 price USD/1000m3 30.70 31.10 30.60 36.90 47.68 Gas subtotal, USDmillion 524.97 538.03 538.56 667.89 936.58 21.2% Mt 12.01 11.91 14.02 14.89 17.81 price USD/t 136.20 115.80 107.30 133.20 181.40 Oil subtotal, USDmillion 1635.76 1379.18 1504.35 1983.35 3231.46 73.0% Mt 1.08 0.38 0.49 1.oo 1.14 priceUSD/t 195.40 242.50 198.30 161.70 155.40 4.0% TWh 7.20 8.30 6.80 7.40 4.05 price U S centdkWh 1.79 1.78 2.10 1.94 1.94 Electricity subtotal, USDmillion 128.88 147.74 142.80 143.56 78.57 1.8% TOTAL, USDmillion 2,500 2,156 2,283 2,956 4,424 100.0% GDP, USDmillion 12,728 12,329 14,651 17,513 22,891 FuelandEnergyImportto GDP, % 19.6% 17.5% 15.6% 16.9% 19.3% Sources: MSA andWorldBank 7.31 While Belarus cannot avoid a high level o f future dependence on Russia for its energy supplies, there are actions it can take to reduce the overall risk associated with this level o f dependence: Belarus has the potential to increase the use o f indigenous energy resources, in particular wood and peat, although care would have to be taken to avoid any negative environmental consequences. 0 The introduction o f additional energy efficiency measures offers Belarus the opportunity to reduce the absolute levels of energy consumption. While Belarus has made essential progress over the last decade, there i s clearly the potential to raise efficiency. Opportunities exist to diversify Belarus' source of electricity imports. Specifically, arrangements to purchase electricity from Ukraine offer an alternative to imports from Russia. 214 Ultimately, Belarus' hture supply security will be best assured by underscoring the mutuality o f interests between Belarus and Russia. This mutuality o f interests arises because Belarus functions both as a transit country providing access for Russian energy supplies to countries inCentral and Western Europe and as a purchaser o f Russian energy supplies. Consistently demonstrating that it will perform as a "good" transit country, that capable o f providing a predictable, secure transportation route for Russian energy exports to Europe, i s the best way for Belarus to underscore this mutuality o f interests. D. DELIVERYOFACCEPTABLE UTILITY SERVICESTO DOMESTIC CUSTOMERS 7.32 As has been noted, Belarus inherited an extensive electricity network together with an established gas network. As in much o f the rest o f the FSU, however, these infrastructure facilities are in need o f rehabilitation and upgrading. The ability o f the utility service companies to deliver services o f an acceptable quality is, therefore, dependent on adequate investment to restore, upgrade and maintain these infrastructure facilities. The best way to ensure that such funds will be available andwill be appropriately deployed is to provide for the establishment of a solid financial footing for the utility companies that will ensure their continued financial viability. 7.33 To ensure the financial viability o f energy companies, the priority measures that need to be undertaken are as follows: 0 To eliminate the implicit subsidies in the sector through the introduction o f full cost recovery tariffs and appropriate measures to ensure full collections 0 To address the overhang o f debt obligations, bothexternal and internal. Subsidieswithinthe Sector 7.34 At the time o f the breakup o f the Soviet Union, energy supplies throughout the FSU countries were heavily subsidized. Despite significant reform efforts since then, inmost countries subsidies still remain, reflecting the legacy of the widespread expectation that energy should be provided at little or no cost. The three components that make up these subsidies are: (i) non- payment for energy consumed; (ii) tariff structures that do not cover the full cost o f the energy supplied; and (iii) excessive losses that reflect both operating inefficiencies and theft. 7.35 Incommon with the rest of the FSU, Belarus continues to generate implicit subsidies in its energy sector (Tables 7.6 and 7.7). However, Belarus has made significant progress in reducing the level o f implicit energy subsidies. As i s indicated in the tables below, implicit subsidies for electricity and gas combined (based on total collections rather than cash collections) were greatly reduced in the past years and went down from about 2.3 percent o f GDP in2001 to only about 0.2 percent in 2004. However, this understates somewhat the implicit subsidy, given the shortfall in cash collections and the unidentified nature o f discounts to specific industrial enterprises. Nevertheless, in terms o f cost recovery within the sector it represents a performance that i s among the best inthe CIS c o u n t r i e ~ . ' ~ ~ `43For example, in Ukraine an estimated electricity cost recovery tariff i s about US cents 4.7ikWh, while the actual retail tariff was only U S cents 3 . l k W h in 2004. However, in terms o f financial management performance, Belarus lags behind the Baltic countries, as well as such CIS countries as Armenia and Moldova. 215 Table 7.6: ElectricitySector Implicit Subsidies,2001-04 2001 2002 2003 2004 Actual WART*, U S cents/kWh 3.4 3.2 3.8 4.7 Cost Recovery WART*, U S centslkwh 4.1 4.1 4.2 4.8 Actual Collections 85.0% 97.8% 102.6% 100.5% Cash Collections 37% 45.6% 80.6% 80.3% Actual Consumption (net o f Losses), TWh 29.9 29.6 30.0 30.9 Subsidies from Mispricing, US$ million 202 258 111 22 Subsidies fromNon-payments, US$ million 154 21 -30 -7 Total Subsidies, US$ million 356 279 81 14 Total SubsidiedGDP, % 2.9% ,1.9% 0.5% , , , 0.lYO Note: *WART stands for weighted average retail tariff. Electricity cost recovery WART i s estimated based on gas price and resulting cost o f local generation, deemed cost recovery transmission and distribution (T&D) costs of US cents 1.3/kWh, network losses, and ratio between locally produced and the imported electricity indomestic consumption. **Cost Recovery WART i s a deemed cost recovery level o f tariff reflecting both recurrent costs and investment needs. The Cost Recovery WART i s different from the Production Cost (Sebestoimost') since the latter does not reflect the investmentneeds. Source: Ministry o f Energy. Table 7.7: Gas Sector Implicit Subsidies,2001-04 2001 2002 2003 2004 Actual RetailTariff, US$/lOOOm3 $46.90 $43.30 $42.30 $54.60 Cost Recovery RetailTariff, US$/lOOOm3* $41.10 $40.60 $46.90 $56.70 Actual Total Collections 94.90% 97.50% 107.90% 100.60% Actual Cash Collections 12.70% 22.40% 42.00% 83% Actual Gas Consumption, bcm 17.207 17.527 18.28 19.799 Subsidies from Mispricing, US$ mln. -100 -47 84 42 Subsidies from Nonpayments, US$ mln. 41 19 -61 -6 Total Subsidies, US$ mln. -59 -28 23 35 Total SubsidiedGDP, % -0.47% -0.20% 0.13% 0.15% 7.36 While average tariff levels for both electricity and gas are very close to full cost recovery levels, there remain tariff imbalances among customer categories (Table 7.8). Households pay lower tariffs than other customer categories despite the fact that the cost o f supplyinghouseholds is greater than the cost of supplying other customers. Therefore, tariffs need to be rebalanced if economic distortions, interms o f consumptionincentives, are to be avoided. Household tariff 3.3 47.7 Industrialtariff 5.4 55.8 Ratio HWIndustrial tariff 0.6 0.85 216 Domestic andForeignEnergyDebts 7.37 Although implicit subsidies in the electricity and gas sectors have currently largely been eliminated, Belarus' utilities have a legacy o f under-recovery o f costs which translated into financial shortfalls that led, in turn, to non-payments by utility companies for Russian energy supplies. As o f January 2004, accumulated payables to two utility companies, Belenergo (electricity) and Beltopgas (gas) totaled US$424 million and payables to Russian suppliers totaled US$201 million. The structure o f these debt obligations i s summarized inFigure 7.5. 7.38 A significant portion of the payables to Belenergo and Beltopgas are likely to remain unpaid. Consequently, there i s a need to develop an inventory o f receivables, identify what portion could be paid and write off the balance. Measures will then be required to structure the arrangements for securing payments for those receivables deemed potentially recoverable. Figure7.5: Belarus' DomesticandForeignEnergyDebtsas of January 1,2004* US$ 31 mln US$261 256.6 mln. S$68 95 mln. *Does not include oil and fuel. Sources: Ministry o f Energy, MSA, World Bank staff estimates. 7.39 Belarus has made good progress in recent years in paying for its energy supplies from Russia, and progress i s also being made to reduce past energy debts, as shown in Figures 7.6 and 7.7. Dealing with payment obligations to Russia i s clearly an important element inthe strategy to 217 assure energy supply security in the future. It underscores the importance for utility suppliers in Belarus to maintain a highlevel o f collections and to be assured that tariffs will cover all costs. Figure7.6: Belarus' Paymentsto Russiafor Figure7.7: Belarus' Paymentsto RussianGas ImportedElectricity Suppliers 140.0% 1 I 120.0% 120.0% 100.0% 100.0% 80.0% 80.0% 60.0% 60.0% 4 ------- 40.0% 40.0% 20.0% 20.0% 0.0% 0.0% + 2001 2002 2003 2004 2001 2002 2003 2004 Source: Belarus Infrastructure Monitoring Report by the IPM. April 2005. RussianSubsidizationof Belarus' Energy Sector 7.40 Belarus has been the beneficiary o f low-priced energy supplies from Russia for a number o f years. As indicated in Table 7.9, the prices paid by Belarus have been substantially below internationalprice levels. Table 7.9: Pricesof Energy PurchasesfromRussia,2000-04 Commodity 2000 2001 2002 2003 2004 Gas: US$/MCM Price paid by Belarus 30.70 31.10 30.60 36.90 47.68 Estimated price paid by Western Europe 85.00 100.00 93.00 104.00 135.00 Oil: US$/Ton Price paidby Belarus 136.20 115.80 107.30 133.20 181.40 International parity price 206.15 177.75 181.99 210.97 275.21 Electricity: centsIkWh Price paidby Belarus 1.79 1.78 2.10 1.94 1.94 South Eastern Europe price >4.00 >4.00 >4.00 >4.00 >4.00 Note: *Netted back to the Russianborder. **World Bank estimates based on the blend o f West Texas Intermediate, Brent Blend and Dubai. Urals parity prices are estimated to be lower than indicated inthe table numbers by about US$ 3harrel or US$ 191ton. *** South EasternEurope electricity market i s deemed to be more relevant than the EUmarket since Belarus' power system has better prospects for being integrated with the South Eastern Europe network than with UCTE. Sources: M S A and World Bank staff analysis. 7.41 Russia has demonstrated a willingness for the present to supply energy to CIS countries at prices below internationalparity levels. However, inthe longer term Belarus should be ready to face a significant price adjustment. Moreover, as Table 7.10 indicates, Belarus has enjoyed lower prices for gas than have other CIS countries. 218 Table 7.10: Priceof Gasat the Border of CIS Countries SuppliedbyRussia,2004-05 @JS%/MCM) Country 2004 2005 Armenia 54.00 54.00 Azerbaijan 52.00 60.00 Belarus 47.68 47.68 Georgia 60.00 60.00 Moldova 80.00 80.00 Ukraine (estimated) 56.40 70.40 Source: WorldBank staffanalysis. 7.42 Over 2000-04, the overall level o f Russia's subsidization o f the Belarus economy via discounted gas prices, when compared with a US$5O/MCM benchmark gas amounted to about US$1.1 billion (Table 7.10).'45 However, the annual amount o f these subsidies went down substantially from about 2.3 percent o f GDP in 2000 to just about 0.1 percent in 2004 (i.e. these subsidies have been largely phased out). Table 7.11: EstimatedEconomicGainof BelarusfromDepressedImport Gas Prices,2000- 04(US%) 2000 2001 2002 2003 2004 1 Actual purchase price, US$/MCM 30.7 31.1 30.6 36.9 46.7 2 Benchmarkgas price, US$/MCM 50.0 50.0 50.0 50.0 50.0 3 Volume of importedgas, bcm 17.1 17.3 17.6 18.1 19.6 4 Importgas price subsidies,US$ million 330 327 341 237 65 5 Transit fee discount, US$ million 33 33 37 42 44 6 Adjusted subsidies (=4-5), US$ million 297 294 304 195 21 7 GDP, US$ million 12,758 12,421 14,653 17,513 22,889 8 Subsidiesto GDP, % 2.3% 2.4% 2.1% 1.1% 0.1% Sources: MSA andWorld Bank staffanalysis. 7.43 Russia has beganto raise the prices o f gas sold to some o f the CIS countries and therefore it is likely that Russia will seek further increases inthe price o f the gas suppliedto Belarus. The increases in 2003 and 2004 allowed Russia to cover its short-run marginal cost o f supply to Belarus (reflecting the cost o f arrangements to purchase gas from Turkmenistan). Future increases are likely to be directed at bringingthe price o f gas sold to Belarus more inline with the price o f gas sold to Central and Western Europe, which may be twice as high as the current price level. range o f USS50 - $55/MCM. 7.44 Russia sought higher gas prices in 2004, with Gazprom initially insisting on a price inthe However, Belarus made the following concessions related to energy transit arrangements as a quidpro quo for a lower gas purchase price: 0 Belarus had originally requested an increase inthe gas transit fee for volumes transported through the Beltransgas trunk lines from US$0.60 per MCM per 100 kilometers to 144 This is about the average price paidbyUkrainefor gas importedfrom TurkmenistanandRussiaduring 2001-04. '45 The financing ofthese subsides was largelyabsorbedby Gasprom. 219 US$1.02 per MCM per 100 kilometers. Belarus ultimately settled on a fee o f US$0.75 per MCMper 100kilometers. 0 Belarus dropped its demand to buy 6 B C M o f gas from Russia at US$lOOMCM for resale into Europe. 0 Belarus agreed to recognize Russian property rights in the oil transit network Zapad- Transnefteproduct, which passes through Belarus and whose shares were impounded in September 2003, after Gazprommade a declaration o f gas price increases. 7.45 Gazprom has hinted at future increases in gas prices but has also indicated that price levels may be predicated on the outcome o f proposals to set up a joint venture involving Gazprom's operation o f the gas transmission lines through Belarus. E. MAXIMIZING THE BENEFITFROMBELARUS'ROLEAS AN ENERGYTRANSIT COUNTRY 7.46 Belarus' transit oil and gas network i s one o f the most important strategic assets in the country. It generates a steady revenue stream from the transit o f Russian crude oil and natural gas to Europe and strengthens Belarus' bargaining position vis-&vis Russia on prices on imported fuels, inparticular natural gas. 7.47 In order to ensure the sustainability of the benefits associated with Belarus' role as an energy transit route, the country needs to demonstrate that it can be regarded as a reliable partner worth being considered as the preferred transport route for the increases in the deliveries o f oil and gas to Europe that are likely to materialize inthe next five to ten years. Belarus also needs to ensure that the transport network (including the natural gas storage facilities) i s properly maintained and that investments to upgrade and expand the system are made as and when required. 7.48 Inthe past, Belarus has demonstrated that as a whole it can be relied upon as a transit route for natural gas'46. However, Russia's plans with regard to alternative gas pipeline routes indicate that there are some constraints in perceiving Belarus as the preferred transit route for Russian gas. Therefore, Belarus would benefit from further strengthening its reputation as a "good" transit country in order to be viewed as a fully reliable partner by both Russia and its gas customers inEurope. 7.49 The physical condition o f the transmission network i s also a concern, since investment by Beltransgas in the network has fallen well short o f requirements. In order to rectify this, Beltransgas would need to secure funding for future investments. Strategically, it would be important for Beltransgas to be able to borrow from commercial sources. However, to secure such borrowings, Beltransgas would have to demonstrate that it can be viewed as a reliable borrower. Typically, this would mean providing potential lenders with extensive operating and financial information, with the latter preferably being subject to audit. This in formation should conform to international accounting standards and should demonstrate that the management o f the company and the governance o f its revenue streams conform to good international practice. Alternatively, Belarus could seek funding for Beltransgas through entering into a joint venture or consortium arrangement with Russia and/or one or more o f Russia's European natural gas customers (Box 7.1). 146Except for the case o f pricing disagreements in2004 and the resultant suspension o f gas deliveries by Russia to Belarus (and, subsequently, of all gas deliveries to and through Belarus, for a short period). 220 Box 7.1: InternationalBorrowings by Naftogaz of Ukraine A good example of securing funds on international capital markets was recently demonstrated by the VINC Naftogaz of Ukraine. In September 2004, the company placed five-year US$500 million in five-year Eurobonds at 8.125 percent per year, and at present it i s holding discussions with the Deutsche Bank on the opening of a US2 billion credit line. Naftogaz succeeded in borrowing internationally through improved corporate governance and through the meeting of disclosure requirements via an audit conducted in accordance with the IFRS. The results of the audit are now publicly available o n the company's web site: http:llwww.naftogaz.com/files/sml4~NAK~circular~eng,pdf. Source: World Bank. Operation of the Network 7.50 Russia has actively promoted the concept o f a Belarusmussiajoint venture to operate the transit pipeline system. The potential benefits to Belarus include a one-time infusion o f funds to the budget as a result o f the sale o f a stake in the transmission network and the prospect that Belarus would continue to benefit from gas deliveries at prices below international parity level^.'^' Such benefits, however, would come at the cost o f reduced national control over the country's strategic asset. 7.51 An alternative to a joint venture arrangement, inwhich a share inthe network would be sold outright, would be a concession arrangement whereby the ownership o f the asset would remain in the hands o f the Belarusian government, but the right to operate the network and the obligation to maintain it would be transferred to a private operator for an extended period o f time (typically, between 15 and 30 years). A concession arrangement would have the advantage o f alleviating some o f Belarus' concerns relating to the sale o f its strategic asset, while at the same time it would transfer the obligation to maintain and upgrade the system to a third party. However, while concessions would bring in some up-front payments, they would be less than those obtainable from an outright sale o f a share in the network. In the event that a concession approach i s selected, care would have to be taken to ensure that the interests o f Belarus and o f the concession holder remain consistent throughout the life o f the concession by including, for example, appropriate incentives to upgrade and maintain the system as the end o f the life o f the concession approaches. Maximizing the Economic Rent Available from Transit Activities 7.52 The volume o f Russian gas transiting through Belarus has been increasing and reached 35.3 B C M in 2004, as can be seen in Figure 7.8. About two-thirds o f this gas was transported through the Yamal-Europe pipeline, which i s owned by Russia but i s operated by Beltransgas. The remainder was transported through the Beltransgas trunk pipeline system. The transit fees paid by Russia to Belarus amounted to US$0.46/MCM per 100kilometers for the gas transported through the Yamal-Europe pipeline system and US$0.75/MCM per 100 kilometers for the gas transported through the Beltransgas network. 14'Indiscussingthejoint venture optionRussiatentatively agreedto continue to supply gas to Belarus at discounted prices. 221 Figure7.8: RussianGas Transit throughBelarus'Territory,2000-04 Source: Ministry of Energy. 7.53 The transit fees o f US$0.75MCM are at about half the level applicable for transit through Poland and Lithuania and about 70 percent o f the fee applicable for transit through Ukraine. However, there i s an apparent linkbetween the low level o f transit fee payments and the low level o f prices charged to Belarus for the gas it purchases from Russia. The transit fee i s paid directly to Beltransgas, and so the only mechanism through which the state can benefit directly from the transit arrangements i s through Beltransgas' normal tax payments. 7.54 A distinction needs to be made between the transit fee arrangements associated with the transportation o f gas through the Beltransgas trunk line system and the transportation o f gas through the Yamal-Europe pipeline, which i s owned by Gazprom. Inthe case o f pipelines owned by a transit country, it i s normal international practice to set a tariff based on normal cost recoveryprinciples (i.e., the pipeline company recovers its full costs including a reasonable retum on investment). Under such circumstances, the state benefits from the taxes attributable to the profit associated with the transit activity. 7.55 Inthe case ofpipelines ownedbythe supplier ofthe commodity, different rules for tariff setting may apply. The pipeline owner may be taxed on the basis of a deemed profit attributable to its transit operations. Alternatively, a transit fee may be agreed upon between the pipeline owner and the transit country. Insofar as gas transit is concerned, a limited number o f examples exist o f transit fee operations. Three that represent appropriate benchmark operations are summarized in Table 7.12. As the table indicates, the transit fees paid to the host governments in all three cases are substantially higher than the fees paid to Beltransgas in respect o f the transportation of gas through the Yamal-Europe line. Table 7.12: Gas TransitFeeArrangementsinThree Countries Transit Source of Approx. Distance Transit Fee Country Gas km US$/MCM US$/MCM/100km Tunisia Algeria 370 -5 .OO 1.35 Morocco Algeria 450 7.00 1.56 Georgia Azerbaijan 250 2.50 1.oo Source: WorldBank. 7.56 In future negotiations on transit fee arrangements Belarus should keep in mind the distinction between the arrangements involving the Beltransgas trunk line system and the use o f the Yamal-Europe pipeline. Inthe latter case, Belarus should consider negotiating an arrangement 222 whereby a transit fee i s paid directly to the budget, with Beltransgas being compensated strictly for the costs o f operating the pipeline. F. PROTECTINGTHEINTERESTSOFSTAKEHOLDERSINTHE SECTOR The RegulatoryEnvironment 7.57 The companies operating in the energy sector in Belarus have de facto monopoly status. One company, Belenergo, operates in the power sector (and it also involved in heat supply) and two companies operate in the gas sector (Beltransgas i s responsible for transmission and Beltopgas i s responsible for distribution and supply). An acceptable regulatory environment, either in the form o f an independent regulatory function or through contractual regulatory arrangements, i s an essential pre-requisite for attracting private sector investment to the utility sectors. However, even where the sector i s controlled by SOEs, appropriate regulation has an important role to play. 7.58 Regulationnormally has two important purposes, namely: Protecting consumers from monopoly practices in those parts o f the sector that are not subject to competition. The regulator establishes prices and quality o f service standards and tries to stimulate a competitive market. To the extent that the regulator succeeds, new investments will be undertaken by the utilities and consumers will be satisfied with the quality o f service. If the regulator fails to set prices at a level that provide a fair, reasonable and acceptable rate o f return to investors, new investments will not be forthcoming and the quality o f service will deteriorate. Monitoring proper competitive behavior. Whenever the regulator determines that there i s not enough competition, or that there are anti-competitive practices, it should take action to prevent these practices from adversely affecting consumer prices or the quality o f service. 7.59 The range o f specific functions assigned to a regulator may vary, but in general, the following key functions are assigned throughout the world: Approving and setting tariffs Issuinglicenses Reviewing/approving system expansion, upgrading and rehabilitation plans by all regulated licensees Requiring the implementation o f a system o f accounts consistent with international accounting standards Requiring the filing of annual and other periodic reports containing all information necessary for the discharge o f regulatory responsibilities Specifying the quality o f service and reliability standards as well as customer service standards Carrying out inspections and enforcing licensing conditions and other regulatory requirements Overseeing the creation o f programs and incentives to promote maximum efficiency in the use o f utility services Cooperating with other government agencies in a transparent manner in implementing national priorities in such areas as national security, regional development, environmental protection and social welfare 223 0 Adjudicating disputes involving licensees and the government, between and among licensees, and between licensees and consumers 0 Carrying out a continuous and thorough program o f public interaction and information on mattersrelating to the regulator's mandate. 7.60 While not all o f these activities are required in an environment in which utility services are provided by SOEs that have de facto monopoly status, many o f the requirements remain appropriate and valid. 7.61 InBelarus, regulatory functions are assumed by the Ministry of Economy and not by a dedicated regulatory body. Establishing an independent regulatory agency and investing in capacity buildingfor this agency has the potential to promote improvements in efficiency within the sector, better quality service delivery, and greater assurance that the interests o f consumers and other stakeholder will be protected. It would also play an important role in helping to introduce a business climate conducive to investment at such time as Belarus elects to promote private sector participationinits energy sector. The Structure of the Sector 7.62 The structure o f the energy sector can have an important impact on sector efficiency and on ensuring that the interests o f consumers and other stakeholders are treated fairly. Both Belenergo and Beltopgas operate as vertically integrated monopolies with Belenergo supplying 100 percent o f electricity into the market and about 42 percent o f heat delivery and Beltopgas acting as both the supplier and distributor o f gas. 7.63 Vertically integrated operations o f this sort (particularly those operating as de facto monopolies in an environment o f limited regulation, as i s the case in Belarus) lack transparency and are therefore capable of hiding inefficiencies. It i s a common practice internationally to require that utility operations be unbundled (this, for example, i s a requirement under the EU directives related to electricity and gas delivery within the European market). While an outright unbundlingo f Belenergo and Beltopgas may not be considered an acceptable option at this time, a virtual unbundling o f operations through the separation o f assets into discrete operating companies would be desirable and could be affected under the overall control o f a holding company. Such operations should be corporatized and should be encouraged to function as independent commercial enterprises, but with a requirement to report financial and operating results through the holding company. 7.64 Overall, in a number o f fundamental dimensions o f structural reforms in the energy sector, Belarus lags behind almost all other FSUcountries. Thls is a major concern becauseinthe longer term these reforms are critical to sustain improvements in sectoral efficiency. Other CIS countries have recently moved more decisively towardprivate sector involvement inthe energy sector and have also enhanced their institutional framework to make it more transparent and accountable. The latter was achieved as a result o f (i) the introduction o f international accounting standards, and(ii) setting up the o fregulatory agenciesthat require companies inter alia to disclose their operating and financial results. G. CONCLUSIONSAND RECOMMENDATIONS 7.65 Since the mid-1990s Belarus has succeeded in sustaining and even improving the performance o f the energy sector. This has helped to advance macroeconomic stabilization and the growth o f the country's economy during the past decade. The investments in the sector were sufficient to maintain sector assets in a satisfactory condition, and modernization projects 224 contributed to improved energy efficiency. The incidence o f both quasi-fiscal subsidies and deficits declined, and this improved the financial viability o f energy companies. Moreover, the centralized sector structure and preserved command and control governance mechanisms helped the sector to survive the economic crises which badly affected many FSU countries and their respective energy sectors inthe second halfo f the 1990s. 7.66 However, the government o f Belarus will need to address the following five challenges in the energy sector if it i s to further support economic growth and exploit the comparative advantages o f the country. 7.67 First, reducing the overall risk associated with the excessive energy dependence on Russia. These risks can be mitigatedthrough the implementationo fthe following measures: 0 Increasingthe use o f indigenous resources, inparticularpeat and wood 0 Further improving the energy efficiency o f the economy 0 Diversifying electricity import 0 Performing as a "good" transit country. 7.68 Second, strengthening the financial viability and creditworthiness of the sector companies. While some progress was made inthis area inrecent years, more is needed to ensure that the utility companies are on a commercially sustainable footing. Specifically, the following policies are proposed: 0 Completing the phasing-out o f implicit subsidies inthe sector through the introduction o f full cost recovery tariffs for all categories of consumers and appropriate measures to ensure full collections 0 Restructuringthe existing stock o f debt obligations, both external and internal. 7.69 Third, maximizing the benefits associated with Belarus' role as an energy transit country. Belarus' oil and gas transit network is one o f the most important strategic assets o f the country, To ensure the sustainability and eventual expansion o f the benefits o f the transit business inthe future, Belarus has to convince Russia that it represents a reliable and preferable route for oil and gas export to Europe. To achieve this, Belarus will need to address the existing reputational issues and to provide for additional investments by securing commercial borrowing and/or considering options for entering into a joint venture or consortium arrangements with Russia and/or Russian's European natural gas customer(s). 7.70 Fourth, protecting the interests of the stakeholders in the sector. The power sector and part o f the gas sector are monopolized by VINCs, which are regulated by the Ministry o f Economy and not by a dedicated regulatory body. Establishingan independent regulatory agency and investing in its capacity building would help Belarus to promote both improvements in energy efficiency and better quality service delivery. It would also bring greater assurance that the interests o f consumers and other stakeholders are well protected. The regulatory reform would also be critical for setting up business conditions that are conducive to private investment in the sector when Belarus elects to promote private sector participation inenergy. 7.71 Fifth,attracting financing for rehabilitating and modernizing sector assets. Over the next decade the sector will face a growing demand for investments that unlikely to be met internally. In order to secure external financing, the energy sector structure and governance arrangements should be adjusted through structural and institutional transformations, such as unbundlingVINCs, introducing disclosure and corporate governance principles, and developing public-private partnerships. 225 CHAPTER8 PRIORITY DIRECTIONS REFORMS FOR 8.1 This final chapter summarizes the policy recommendations that follow from the analysis concerningeconomic growth inBelarus. 8.2 In the longer term, to achieve and ensure sustained growth in Belarus, the authorities need to make a determined push toward advancing a comprehensive reform program to accelerate the country's transition to a market economy. These efforts should address a number o f pending issues in all o f the core areas o f liberalization, macroeconomic stabilization (including price and exchange rate stability), privatization, and wide-ranging structural reforms. Despite their up-front costs, the structural reforms (including those involving public administration, legal and judicial matters, social assistance and insurance, and infrastructure) represent a critical element o f the sustainable growth strategy. Box 8.1 highlights major government reforms programs. Box 8.1: Major GovernmentReformand DevelopmentPrograms Many o f the recommendations offered in this chapter, such as a reduction in the tax burden and the modernization o f the tax structure, further disinflation, export diversification, FDI attraction, improvements in the business environment, etc., are in line with the objectives spelled out in the various government development programs, including the following: ------ Programo f Socioeconomic Development for the Period 2001-05 National Program o f Export Development for the Period 2000-05 Programo f Structural Changes and Increase inCompetitiveness o f the Republic o f Belarus Annual Programs o f State Support for Small Business Development National Programo f InvestmentAttraction into the Republic o f Belarus until2010 National Sustainable Socioeconomic Development Strategy for Belarus until2020. However, the programs often contain conflicting objectives and there has been no analysis o f trade-offs stemming from the attempt to meet many different objectives simultaneously (wage growth versus competitiveness; state support versus the tax burden; export promotion versus import substitution). In addition, no assessment o f the opportunity costs o f different measures aimed at meeting the same objective was presented. There i s also a substantial bias in the programs in favor o f administrative measures to reach the objectives, while the government discounts the potential benefits o f strengthening market incentives and freeing private initiative. Given that the government has began the preparation o f major programs for the next five years (including the Program o f Socioeconomic Development for the period 2006-lo), it is our expectation that the government finds the analysis and recommendations inthis report appropriate to be reflected inthese new documents. 8.3 The current international and domestic environment seems to be quite favorable to supporting a policy shift toward the acceleration o f structural reforms. At the moment, the government i s well equipped to mitigate the potential costs o f these reforms because the policy settings are largely determinedby the growing economy, the positive trends in the perceptions o f both the enterprise sector and the household sector, the favorable developments in the global economy, low debt, and strong administrative capacity o f the state. This situation could change: various pressures could become stronger and then the same reforms would become politically more costly and fiscally more risky. Inshort, the current window o f opportunity should be used in order to ensure that the authorities' growth objectives are sustainable. 226 8.4 Inthe case of Belarus,the levelof FDIattracted should be seen as an indicator that summarizes the economy's longer-term potential to sustain growth and competitiveness. Belarus seriously underutilizes the advantages o f its geographic location as a basis for attracting FDIandrestructuringitstrade patterns. Addressing this weakness shouldbe a policy priority. FDI inflows would ease the financing constraint, facilitate technology transfer, and provide access to new product markets. Privatization has been an important channel for FDI in the Central European countries and this link might prove important in Belarus as well. Even if there are concerns about widespread foreign ownership, liberalizing economies in the Far East, such as Vietnam, have generated considerable gains from channeling foreign investments through joint ventures. 8.5 This report, however, is primarily focused on a narrower set of key reform priorities, which could be sufficiently advanced within the very gradualist approach toward market transformation explicitly chosen by the government. Many o f the recommendations that follow are fully consistent with the objectives outlined in the various government development programs (Box 8.1). These recommendations an intended to help the government address the immediate growth challenges, as identified by the report's analysis, which otherwise may undermine the sustainability of the current growth and poverty outcomes. 8.6 The focus of the report's recommendations is on two inter-related challenges that the government must address in order to strengthen the competitiveness o f the economy as a source o f sustainable growth: 0 Imposing stricter market discipline on the existing enterprise sector in order to accelerate its restructuringand productivity growth at the micro level 0 Encouraging the expansion of both new and fully restructured traditional firms that have proved to be quite competitive without state support. Market Discipline 8.7 The main strategy for disciplining traditional enterprises couldbe summarized as follows: 0 Restructuring and drastically downsizingthe existing system of state support to the real sector, including strengthening discipline in the financial sector through discontinuing the regular recapitalization o f state-owned banks and winding down directed credit programs and moving the residual quasi-fiscal activities from the banking sector to the budget. This would help sustain the fiscal balance under lower statutory tax rates. Moreover, this would improve the incentives for enterprise restructuring and equalize business conditions among different types o fbusiness entities. 0 Acceleratingthe exit of non-viable firms. A shift toward a more pro-business economic policy inBelarus should employ at least some highly visible cases o f bankruptcy and the liquidation o f non-viable large enterprises. Such liquidations would be important to support several other improvements. First, they would send an important signal to the entire real sector and thus would have an important incentive effect. Second, they would bring some additional fiscal savings. Third, they would release economic resources for new firms. 0 Advancing trade liberalization to expose domestic enterprises to the discipline o f international competition. The immediate priorities include eliminating the existing non- 227 tariff restrictions on imports and reducing the use o f restrictions on trade with Russia that are inconsistent with the Customs Union agreements. 0 In the agriculture and food processing sector, taking additional steps to harden the budget constraint. These include: (i)the elimination o f implicit subsidies, especially those that are allocated through distorted input prices; (ii) better targeting o f government support toward more efficient farms and the equalization o f access to state support between private and state farms; (iii) a more aggressive reduction in capacity in food processing; and (iv) a more cautious approach toward merging profitable and non- profitable farms. Inthe last case, at the very least, managers o f consolidated fams should be allowed to implement appropriate rationalization strategies. The government needs to develop aggregate measures o f agricultural support usingthe OECD methodology. There i s also a clear need to ensure that the transfers from state-controlled farms to the household sector are rendered more transparent. 0 Ensuring further strengtheningof the financialviability and efficiency of the energy sector companies. While some progress was made in this area in recent years, more i s needed to ensure that these companies are on a commercially sustainable footing and thus could meet a growing commercial demand for energy in a cost efficient way. Specifically, the following policies should be seen as priorities in the sector: (i) completing the phasing-out o f implicit subsidies through proper tariff adjustments; (ii) restructuring the existing stock o f debt obligations, both external and internal; and (iii) diversifying electricity import. 0 Preparing the pilot program of large-scale privatizations to cover several efficient SOEs (including state banks), which could be privatized competitively in an orderly and transparent way. EncouragingNew BusinessGrowth 8.8 The competitiveness of the Belarusian economy is greatly constrained by the unnecessary business costs associated with current government policies. The economy i s also affected by depressed new entry that undermines its flexibility as well as its capability to withstand potential shocks. There i s an urgent need for policy adjustments along the following primary directions: 0 Reducing the tax burden and reforming the tax structure. The priority i s to reduce the incidence o f the most distortive taxes, such as turnover and payroll taxes. The latter would create additional incentives to accelerate the pension reform that might include an increase in the retirement age. The existing implicit taxes on the industrial sector should be phased out as well. This will require steps to advance the divestiture o f enterprise social assets, to eliminate tariff cross-subsidization in utilities, and to provide o f agricultural inputs at fixed low prices. 0 Liberalizing employment and wage policies. Enterprise managers need more decision making power on labor and wage issues, while the government should discard its use o f administrative controls to attain wage increase targets. Combining this policy with a renewed impetus to support new market entry would limit its potential negative effects on overall employment. 0 Advancing price liberalization by phasing out the residual price control, including downsizing the list of enterprises that are subject to price control as monopolists, as well as the list of regulated export prices. This also includes hrther liberalization o f interest 228 rates. In agriculture, producer price levels need to be brought much more into line with international prices. In an economy that has been increasingly internationally integrated, the government could rely on competition as a primary tool for avoiding excessive price growth. Reducing the level of day-to-day regulatory costs. By launching a more efficient dialogue with the enterprise sector, the government should be able to identify and reduce various unnecessary costs that stem from inefficiencies in the regulatory regime. The priority areas for action may include: (i)reforming tax administration to make the system simpler, more stable and predictable; (ii) halting the recent trend o f deterioration in customs administration, which includes addressing the issue o f customs valuation practices; (iii)liberalizing the procedures for new entry (by reducing the time needed for business registration and simplifying the procedures); and (iv) reducing informal market protectionism and trade barriers at the regional level. It i s also recommended to streamline and consolidate the tariff schedule, which would help reduce both the administrative costs o f customs clearance and the risko f conuption. 0 Limiting discretionary administrative interference. The government needs to change the incentive system for the regulatory agencies to discourage their discretion in enforcing regulatory requirements. Among other things, this means a drastic reduction in "unplanned tax inspections" and similar interventions, which are the most detrimental to the business climate. In agriculture, able managers on state-controlled farms should be given much greater decision-making autonomy. Also, businessmen should be offered an independent channel to the central administration to report irregularities in regulatory interventions. This i s something that the government could accomplish without a fundamental overhaul inthe underlying system o f regulations. 0 Accelerating reform in the standards system. Although the needed legislative fkamework i s mainly inplace, slow reform implementation has not yet permitted a switch from the excessive compulsory regulation inherent in the ex-Soviet GOST system to the modem two-tiered system o f internationally compatible mandatory technical regulations and voluntary standards. 0 Consolidating recent progress toward a stable macroeconomic environment, including tightening monetary conditions to lower inflation and taking additional measures to scale down government interventions in the economy (including quasi-fiscal activities) minimize the fiscal deficit and thus lower government financing requirements and interest rates. Sustained macroeconomic stability i s critical for strengthening enterprise incentives for restructuringand investment. 8.9 The government should advance its international integration efforts in the direction of both the WTO and the CIS. The experience o f other transition economies suggests that the trade negotiations, especially those for WTO membership, could become an important driver for a number o f domestic reforms. The government should be prepared to advance its trade negotiations by reducing the current level o f subsidization in agriculture and industry, including exporters, and, as mentioned above, by reducing the existing non-tariff restrictions on imports. In addition, much more progress i s needed in liberalizing and de-monopolizing a number o f sectors, such as financial services and telecommunications. 8.10 The government must invest considerable resources in improving the country's investment image if it is serious about attracting sizable foreign investments. As a starting point, the government should make highly visible decisions to address the most common concerns o f the private sector. For example, the golden share rule should either be abolished or as 229 a minimum, the existing legislation should be modified in line with the international experience. Its future application should be legally restricted to a narrow set o f cases that directly relate to the strategic interests o f the state. It would also be advisable to establish a specialized institution for investment promotion which would employ best international practices in this area and could support a broad communications campaign to develop Belarus' image as an attractive location for business and investment. Some degree o f administrative control over Free Economic Zone (FEZ) operations should be preserved to ensure that residents o f these zones do not abuse their tax customs duty advantages. 8.11 The government could make more extensive use of the Chinese experience of gradual liberalization from the 1980s. In particular, the use o f the FEZ mechanismby China as a primary tool for FDI attraction in the early stage o f liberalization seems to be quite applicable under Belams' circumstances. The strengthening and expanding o f the existing FEZs in Belarus could be undertaken relatively easily given the accumulated experience. At the same time, an intensive promotion o f FEZs, especially those at the borders with Poland and Lithuania, could be a practical way for Belarus to benefit from new opportunities that emerge as a result o f the recent EU expansion. However, as international experience suggests, to be successful FEZs must be properly set up and managed, and their development should be integrated with the national reform program: the zones should be seen as an instrument o f advancing economy-wide reforms, not as an alternative to reforms. FEZs should be given considerable operational autonomy, and the government should encourage competition between different zones. Private management o f the zones should also be en~0uraged.l~~ As mentioned above, some administrative control over FEZ operations should be preserved to ensure that residents of the zones do not abuse their tax customs duty advantages. 8.12 Attracting foreign investments is of special importance for the future rehabilitation and modernization of the energy sector. Over the next decade the sector will face a growing demand for investments that probably cannot be met internally. In order to secure external financing, the energy sector structure and governance arrangements should be adjusted through structural and institutional transformations, such as unbundling the existing monopolies, introducing disclosure and corporate governance principles, and developing public-private partnerships. Establishing an independent regulatory agency and investing inits capacity building would make the sector more attractive to external investors while it would also help to promote both improvements inenergy efficiency and a better quality service delivery. 8.13 Belarus also has an opportunity to maximize the benefits associated with its role as an energy transit country. In order to ensure the sustainable expansion o f its transit business, Belarus must convince Russia that it represents a reliable and cost efficient route for oil and gas export to Europe. To achieve this, Belarus will need to address the existing reputational issues and also to provide for additional investments by securing commercial borrowing andlor considering options for entering into a joint venture or consortium arrangement with Russia and/or Russia's European natural gas customer(s). 8.14 The food processing industry represents a sector that should become a major beneficiary of FDI. 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