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MACROECONOMIC SITUATION: GOING INTO CYCLICAL RECESSION
Dzmitry Kruk
Summary
The weak growth potential of the Belarusian economy became apparent in 2013. The economic authorities must have had too high expectations of the inertial growth mechanisms; therefore, virtually no structural reforms were put in place. The aftermath of the state policy focusing on the encouragement of domestic demand, which has been pursued for more than two years now, undermined the price competitiveness of Belarusian products in foreign markets. In the meantime, the instruments to stimulate other components of demand were limited. As a result, in 2013, the Belarusian economy went into a cyclical recession phase, which might be rather long.
The limited nature of monetary policy instruments and inconsistent targets became another major challenge, which led to a ‘trap for the monetary policy.’ A series of imbalances were accumulated throughout the year, calling for effective macroeconomic stabilization solutions.
Trends:
• Lower economic growth potential amid shortage of structural reforms;
• Transfer into the cyclical recession phase, aggravated by the growing external deficit;
• High and unstable devaluation expectations as a ‘legacy’ of the 2011 crisis;
• New challenges to macroeconomic stability, to which the government responds mainly by attracting foreign financing.
Introduction
The year 2013 became one of the worst years for Belarus in the last decade by most of the basic performance indicators. First, GDP grew by only 0.9% year-on-year (the original target for 2013 had been set at 8.5%). This growth rate is unsatisfactory for a country seeking to narrow the income gap with its neighbors and avoid the ‘poverty trap.’ Second, prices kept growing at a very high rate, with the annual consumer inflation rate averaging 18.3%. Third, the country had to face an enormous current account deficit once again (10.2% of GDP), which brings about a reduction in gold and foreign exchange reserves, escalates
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tensions in financial markets and permanently threatens macroeconomic stability.
The poor economic performance in 2013 was the result of many factors, which had a combined effect. The key reason was the lack of structural reforms in the economy, which were already long overdue. Discussions of necessary reforms, their scope, sequence and priority status became an increasingly important portion of the agenda of the country’s economic authorities. However, real actions were limited and sporadic. Therefore, the Belarusian economy essentially continued working while employing the old mechanisms, namely the dominance of the state sector, centralized distribution of resources, direct control of companies, commodity and factor markets.
Short-term challenges were added to the snowballing structural problems. First, the ‘legacy’ of the currency crisis in the form of high inflation and devaluation expectations stood behind the weakness of investment demand. Second, Belarusian producers were losing their competitive price advantages, which created prerequisites for a growth in the external deficit. Third, some external shocks caused additional losses in export proceeds. Fourth, repayments of foreign loans peaked in 2013, whereas access to new external financing remains limited. As a result, Belarus has entered the cyclical recession phase having no instruments to quickly overcome it.
Economic policy strategy:
focus on ‘traditional sectors’ of economy
The tendency towards a narrowing of the growth potential was first observed in the Belarusian economy in 2006 or 2007; however, it was the global economic crisis that made this trend obvious. The lack of growth potential is the main reason why Belarus is in need of structural reforms, which are absolutely indispensible and inevitable. The problem of the low growth potential was for the first time partially recognized in official documents in the Concept of socioeconomic development of Belarusfor2013—2015. The document mentioned two components that were supposed to provide economic growth — ‘traditional’ and ‘new’ sectors of the national economy.
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The first component of the strategy is the traditional sectors of the economy. The authorities believed that the national economy still had substantial growth potential. In its baseline scenario the government projected potential growth at 6%; however, in order to achieve this objective, it had to ensure macroeconomic stability and neutralize internal risks.
The second component of the government’s strategy was associated with the creation of a ‘new high-performance sector’ in the national economy, which, according to the government’s plans, was expected to provide approximately 2 percentage points of GDP growth as early as 2013. Moreover, it was planned that in 2014 and 2015, the contribution of the ‘new high-performance sector’ to GDP growth would match that of traditional sectors, thus ensuring potential growth in excess of 10%.
While admitting that traditional mechanisms are not good enough to secure the desired growth rates, the authorities nevertheless intended to “squeeze whatever was left in the old economy” and gradually create a ‘new economy’ that would coexist with the traditional sectors and generate additional growth. It was planned that the ‘new economy’ would become the main growth driver only in the long term. However, the traditional sector never became the ‘airbag’ that was supposed to enable the authorities to introduce structural reforms gradually. Therefore, the unreasonably high expectations of inertial growth predetermined the modest progress in structural reforms.
In the second half of the year, when it became obvious that the targets for 2013 would not be met and that the government’s concept would not be implemented as originally planned, the economic authorities pushed structural reforms higher on their agenda. The joint action plan of the government and the National Bank on structural reforms and arrangements to enhance the competitiveness of the national economy, approved in October 2013, comprised a truly significant list of intentions and objectives, which were supposed to be attained in late 2013 and early 2014. However, some of the arrangements in the economy that have been long overdue, especially in the distribution of resources, promotion of competition, etc. either remained beyond the scope of the action plan or were mentioned vaguely and randomly. Therefore, even if the plan is properly
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implemented, it is highly probable that its positive impact on the economy will be limited.
It appears that on the one hand, the idea of ‘structural reforms’ was repeatedly cited in the government’s official plans and documents (although there is no clear definition of the term). On the other hand, the government does not regard structural reforms as emergency measures and treats them as ‘supporting procedures for the long term.’ Such arrangements remain inconsistent and mostly apply to narrower segments of the national economy.
Macroeconomic dynamics: policy of encouraging domestic demand becomes ineffective
In order to secure more favorable GDP dynamics, the government opted for artificial demand promotion. In 2013, incomes policy became the first focus area to encourage domestic demand, as wages were boosted by 15.8% in real terms (individual disposable incomes went up by 15.4% in real terms).
The gap between labor productivity and wages kept broadening, and labor unit costs1 reached their all-time highs. This factor put additional pressure on consumer prices, affected the competitiveness of domestic producers and brought about additional demand for consumer import. The accumulation of such disproportions became quite alarming, and at the end of the year, the growth in wages slowed (in the fourth quarter of 2013, real wages shrank quarter-on-quarter for the first time since 2011* 2). By the end of 2013, the authorities had made up their mind to stop using incomes policy instruments to boost domestic demand.
Arrangements to promote investment demand provided another set of instruments to expand demand. In the first half of the year, the National Bank sought to intensify the main market instrument to finance investments — bank lending — through
Calculated as the share of labor compensation In GDP. Increasing labor unit costs mean that wages grow faster than labor productivity. The indicator is an important feature of the price competitiveness of domestic producers.
Fourth quarter on third quarter (based on seasonally adjusted figures).
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reductions in interest rates. However, the volatile inflation and devaluation expectations stopped the monetary authorities from further bringing down the rates: in the second half of 2013, the central bank had to tighten its interest rate policy in order to effectively deal with threats in the financial market.
Therefore, alternative sources of financing had to be found. First, the budget provided increasing amounts of funds to finance investments. Second, in order to involve more individual savings in home construction, the economic authorities introduced a new know-how: some state-run banks began offering home loans at reduced rates (12—16%, which compares to the average loan rates in the market between 30% and 40%), on condition that a portion of the home investment (as a rule, at least 25%), is financed from the investor’s own funds. Third, the government managed to take out loans from foreign banks. Fourth, the authorities launched measures to support the investment activity of enterprises by declaring the need for a systemic modernization.
The ‘modernization campaign’ envisages technical modernization of some enterprises, which they will have to partially finance on their own. As a result, deprecation costs hiked, causing an increase in overall production costs. On the one hand, such measures can prove effective in the long run, whereas on the other hand, the campaign to make enterprises invest in an unfavorable environment affects their financial position, which for its part can jeopardize short- and medium-term prospects of the real sector development.
The artificial encouragement of the components of domestic demand produced an adverse impact on net export by Belarusian companies. First, wage hikes, along with the increase in depreciation charges and — in some cases — interest payments on loans stood behind the significant rise in costs. Enterprises were able to make up for the hikes in combined costs by cutting other expenses (especially material costs) only in a limited number of sectors. Second, the consequences of the increase in costs domestically were aggravated by the general trend towards a decrease/stagnation of prices in the majority of external markets (while prices in the domestic market kept growing). Third, the national currency appreciated against the basked of foreign currencies in real terms.
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Fourth, throughout the year, the economy suffered from unexpected shocks. The worst one was the decision by Russian Uralkali to withdraw from the cartel with Belaruskali, which resulted in a drop in global prices of potash fertilizers. Further, the leading players of the potash market took a wait-and-see approach for a few months, which is why there were very few deals in the market.
Overall, the said factors resulted in a marked deterioration of the price competitiveness of Belarusian products (in addition to the structural shortage of competitiveness), resulting in a significant decline in export and growing demand for import. As a result, the contribution of net export to GDP was negative.
The efforts to encourage domestic demand thus caused an almost equal aggravation of external demand (net export). The increase in composite demand thus nearly came to zero. These negative trends affected most of the sectors of the national economy, causing contractions in production. Growth was only recorded in the industries that directly depend on consumer demand (retail, repairs, construction, hotels and restaurants): the situation was positive for those few sectors amid growing personal incomes. Therefore, in this new environment — the changing framework for long-term growth and unfavorable foreign trade situation — the effectiveness of the policy to encourage domestic demand markedly decreased, whereas the negative interrelation between domestic and external demand increased. This brought about a deeper cyclical recession in 2013.
A trap for monetary policy
In 2013, the ineffectiveness of the country’s monetary policy in the current economic environment became especially apparent. The National Bank failed to put in place a consistent policy against a backdrop of high and unstable inflation and devaluation expectations. The latter — along with the traditional problem of the high level of financial dollarization — created a sort of a trap for the monetary policy. This trap can be defined as a set of contradictions in the objectives and designation of monetary policy instruments.
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The first set of contradictions pertains to the regime and level of the exchange rate. The vision of the economic authorities is that because of the high dollarization of the economy, the best ‘nominal anchor’ in the economy is the exchange rate. Therefore, in order to stabilize expectations, it is necessary to focus on a fixed exchange rate regime. On the other hand, a reasonable current account deficit — which requires a floating exchange rate — is an important prerequisite for ensuring financial stability.
The ‘protection’ of the current level of the exchange rate against the backdrop of the high external deficit may be perceived as an insecure policy, which the authorities will have to ultimately give up. Therefore, this policy aggravates expectations making them even more volatile, instead of stabilizing them. Throughout 2013, the external deficit kept expanding, becoming a reason why the national economy slipped into the cyclical recession. The need to overcome this recession by employing the exchange rate methods is another argument why the authorities should change to a floating exchange rate.
This means that on the one hand, the monetary authorities need a rather stable exchange rate, which, if given up, would pose a threat to financial stability. On the other hand, the introduction of a floating rate would also be a desirable move. In 2013, the economic authorities de facto tended to artificially curb the exchange rate, which, however, discouraged economic agents that showed little trust in the official economic policy (resulting in a high level of dollarization and unstable expectations). The policy to prevent further depreciation of the ruble brought about a broader gap between the actual and equilibrium exchange rates. This further undermined trust in monetary policy and aggravated the cyclical recession.
The second set of contradictions pertains to the interest rate policy. While seeking to maintain a stable exchange rate, the monetary authorities had to reduce the shocks appearing in the financial market using interest rate policy methods. Therefore, in this case, interest rates must be determined based on market tendencies — higher inflation expectations are neutralized by higher interest rates and the other way round.
In 2013, high interest rates on ruble-denominated deposits had to be maintained amid high inflation expectations. On the
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other hand, high interest rates meant an even deeper cyclical recession. Furthermore, to smooth out recession, interest rates should be set independently, rather than depend on fluctuations of expectations. In short, various substantiations for various interest rate policy moves prompted the authorities some ambiguous conclusions: interest rates must be low and high simultaneously, whereas the National Bank is supposed to renounce is monopoly in setting interest rates and retain it.
Because of this trap, the official monetary policy failed to become an effective instrument to overcome the cyclical recession. It turned out that it had an opposite effect: some of the desperate monetary policy measures resulted in a deeper recession. Even the setback in production failed to neutralize threats to financial stability. Those threats were partially mitigated by the marked reduction in gold and foreign exchange reserves (by approximately USD 1.5 billion in 2013) and new external loans.
Conclusion
The main result of the year 2013 is the increase in disparities that threaten financial stability. The first and most obvious problem is the growing current account deficit and difficulties in financing that deficit. The second problem is the commencement of the cyclical recession phase (internal deficit), which can affect living standards.
In addition, the financial situation at most of the companies working in the real sector worsened, which can affect the stability of their financial flows and lower the employment rate. The scope of those problems significantly increased at the end of the year, making it harder to maintain the status quo.
The situation observed at the end of the year — a combination of internal and external deficits — is considered to be very unfavorable, because there can be no single ‘recipe’ for stabilization policy. ‘Painless’ ways to tackle disparities are simply non-existent.
A universal recipe is to devaluate the national currency. Howeer, even theoretically, this instrument is not enough, because it should be accompanied by efforts to influence domestic demand. Anyway, the nature of this influence is complex, as it
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may change depending on the relationship between the internal and external deficits. In Belarus, this problem is further aggravated by the trap of monetary policy.
There are some good reasons for the economic authorities to be concerned that even a slight depreciation of the national currency could upset the financial market and set in motion an inflation and devaluation spiral. A substantial portion of the joint action plan of the government and the National Bank is centered on a scenario of a controllable macro correction in the framework of the said restrictions.
The economic authorities outlined their vision of the situation the following way. Despite the broad range of prerequisites for stabilization based on exchange rate instruments, the authorities plan to minimize the use of this toolkit in order to prevent crises in the financial market. Instead, they will focus on instruments to restrain domestic demand to effectively neutralize the external deficit, especially those to curb investment demand by way of introducing imitations in the lending market. The economic authorities made quite a realistic indication that this instrument alone would not be enough to deal with the external deficit challenge. Therefore, they will finance the deficit that remains by making use of external sources (investments, privatization revenues, and new loans). The authorities de facto began implementing this plan during the final months of 2013.
Despite the seeming feasibility, this stabilization plan has serious short- and long-term threats. First, there will be no prerequisites in the short term for the economy to withdraw from the cyclical recession, which might even get worse.
Second, the strategy to respond to the external deficit challenge using foreign sources of financing suggests that the economy will remain vulnerable to shocks if the country should fail to find foreign financing soon enough.
Third, if the external deficit remains, the gap between the actual and equilibrium levels of the exchange rate will remain as well, meaning that the chance of financial destabilization will remain in place permanently. Monetary policy itself becomes virtually unpredictable, while its potential in neutralizing new shocks will narrow.
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In the long run, these trends increase the likelihood of a large-scale stagnation and emergence of a ‘poverty trap’ (outflow of the best-qualified specialists amid low incomes, which will cut potential for further growth). Furthermore, the policy of taking new loans may very soon result in a situation when the debt burden gets too heavy and becomes an obstacle to future growth.
