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MACROECONOMIC SITUATION: BACK TO THE OLD ECONOMIC POLICY
Dzmitry Kruk
Summary
In 2012, the economic situation developed against the backdrop of high inflation expectations - the legacy of the crisis that hit the country back in 2011. Because of these expectations, the authorities chose the "stabilization growth" scenario in the first half of the year. During the first six months, the increase in production was driven by external demand, which was much needed to ensure macroeconomic balance. The positive shock - export of solvents and diluents, which generously contributed to GDP growth while setting the stage for the growth in internal demand - played an important role in keeping the economy balanced. However, the cessation of foreign supplies of solvents and diluents became a negative shock on two levels. First, the economic growth was directly affected. Second, the authorities had to modify their economic policy, changing to the "recovery growth" model. As a result, by the end of 2012, most of the price advantages in external competitiveness had been lost, and the country got back to its pre-crisis development trajectory. To avoid new challenges while using the old scenario, it is increasingly important to look for new sources of long-term growth and introduce structural reforms.
Trends:
• High and volatile inflation expectations as a key prerequisite for changes in economic policies throughout the year;
• Change in the growth mode from macro stabilization in the first half to the restoration of the income level in the second half;
• Positive shock brought about by export deliveries of solvents and diluents, which became key to the success of stabilization growth in the first half of the year;
• Loss of most of the price advantages that resulted from the currency devaluation of 2011;
• Return to the pre-crisis development trajectory, increasing importance of the search for new sources of long-term growth and need for structural reforms.
Introduction
There had been great expectations of the post-crisis year. First, given the frailty of the macroeconomic equilibrium achieved by
the start of the year (namely, a moderate inflation rate and unemployment that was close to the natural level), all economic agents were interested in having it stabilized.
Second, as macroeconomic stabilization tasks were accomplished in 2012, the year could also be perceived as an historic chance to build up a reserve for mid-term growth based on the price advantages brought about by the crisis of 2011.
Third, the need for new strategies and mechanisms of long-term growth became obvious. The currency crisis of 2011 revealed not so much the vulnerability of the Belarusian economy to short-term imbalances, as flaws in the institutional environment and structural disparities, which restrain the growth potential of the national economy.
Fourth, at the junction of the economic and social sectors, the year 2012 was regarded as a landmark in the evolution of the "social contract" that came to be in previous years — the question was whether the authorities would introduce major changes to the contract or attempt to revive it by pushing wages, boosting social transfers and imposing price caps. The economic policy aimed at a rapid increase in wages in real terms most frequently results in hikes in real unit labor costs, higher prices and stronger real exchange rate, which, for its part, leads to a loss of the advantages in price competitiveness, which were a natural result of the ruble devaluation in 2011.
Background for economic dynamics
The main obstacle to the stabilization policy of the state in 2012 was the high and volatile inflation expectation. The main reason was the fresh memory of the high inflation rate and ruble devaluation in 2011, which traditionally causes negative expectations to continue throughout future periods. Another reason for such expectations is the loss of the nominal "anchor" in the country's monetary policy — since they had to abandon the targeted exchange rate in 2011, the economic authorities were unable to offer a new "anchor" as a foundation for a new monetary strategy.
As a result, the policies pursued by the National Bank of Belarus (NBB) during most of the year were shaped by inflation
expectations, not the other way round. The NBB was able to influence those expectations only indirectly, seeking to cut the inflation rate in order to provide a positive trend for the expectations.
Because inflation expectations were uncontrolled in the framework of the selected macroeconomic mode, the monetary authorities had no effective instruments to improve the situation. On the one hand, high interest rates prevented growth in the real sector of the economy and limited exchange rate fluctuations, contributing to the strengthening of the ruble in real terms, whereas a more flexible rate is required alongside ruble depreciation in real terms (or at least prevention of its strengthening) in order to ensure an external equilibrium in the medium term.
On the other hand, a less stringent interest rate policy and reduction in rates escalated the threat of a new upsurge in inflation and necessitated a new ruble devaluation move. Therefore, the monetary authorities had to choose a lesser evil. This monetary dilemma stood behind the instability of the equilibrium in the financial market. Under the circumstances, the NBB sought a compromise between two poor options while cautiously lowering interest rates. The main consequences of such a policy were shortages of production and a growing foreign trade deficit.
"Stabilization" growth mode and related restraints
The loss of production resulting from a specific situation in the monetary sector manifested itself as a reduction in capital investments. Bank loans are traditionally one of the key sources of financing investments (in 2011, 33.9% of capital investments were financed from bank loans; preferential loans accounted for about half of the total financing).
Having made macroeconomic stabilization its main objective, the government had to limit the volumes of directed lending in 2012. Lending on market terms in the national currency is too heavy a burden for the domestic corporate borrowers, which is why loans were growing at a very slow rate (and decreased in real terms).
Investments from other significant sources of financing also went down (although not as markedly as bank loans), which
resulted in an overall decrease in capital accumulation by 9.8% year-on-year in 2012.
The second most important component of domestic demand — household consumption — was also somewhat depressed. In order to prevent imbalances in the future, it is essential for the post-crisis period to preserve the ratio between internal and external demand that was set as a result of the automatic correction (inflation and devaluation). In order to achieve this, external demand should be growing faster than internal demand, and the latter should be showing catch-up growth. Therefore, artificial income stimuli appeared to be rather dangerous, especially amid the vulnerable equilibrium in the financial market in the first half of 2012. Based on these considerations, economic policy measures should have been introduced to make household incomes directly proportional to external dynamics.
The prospects of the balance of external transactions did not look too bright at the start of the year. Because of the high degree of influence of the nominal exchange rate on prices, the real exchange rate at the beginning of 2012 was much higher (by 31.8%1) than in August 2011 (the time when the real effective exchange rate reached its all-time low), while remaining 25% below the level recorded in December 2010 (the all-time high to date).
The deal with Russia envisaging supplies of natural gas to Belarus at a reduced rate of USD 167 per 1,000 cubic meters (about 35% lower than the price that Belarus paid in 2011) became an important positive contribution to Belarus' foreign trade pattern in 2012. The agreement produced a significant stabilization impact on the balance of trade (in nominal terms, the country saved approximately USD 1.9 bn owing to the price cut) and the situation in the credit and financial sector. However, this amount was not enough to restore the real sector and the level of household incomes; therefore, even the best-case scenarios contained very cautious growth expectations and forecasts.
The indicator is calculated based on market nominal exchange rates amid the multiplicity of rates observed in 2011.
Positive "solvent" shock
Nevertheless, despite the substantial number of restraining factors, the results of the first six months proved quite positive — GDP grew by 2.7% year-on-year, mostly owing to positive external demand trends (net export). The main contributor to the growth in export was the new Belarusian "know-how", namely, the supplies of solvents and diluents, as well as better terms of trade in crude oil and oil products. In 2012, Russian crude oil suppliers stopped including a USD 45-47-per-ton premium in the crude price for Belarus; this resulted in a combined reduction of the cost of crude oil import by approximately USD 650 million.
These factors produced a massive favorable impact on the Belarusian economy in the first half of 2012. First, the production and export of these commodities directly influenced gross output — proceeds from export supplies in excess of import costs were interpreted as added value.
Second, the increase in export supplies of oil products, as well as solvents and diluents, generated additional demand for wholesale services, thus giving a boost to this segment. The changes in the real sector of economy brought about by these new factors can therefore be considered equivalent to a major one-off productivity gain.
Third, there was a positive impact of the "new" exports on the foreign trade balance and monetary environment — additional export revenues improved the situation in foreign trade, boosted foreign exchange supplies in the money market and allowed the monetary authorities to build up gold and foreign exchange reserves. The consequences of the positive "solvent" shock were crucial for the macroeconomic stabilization efforts. GDP started growing based on external demand, enabling the economic authorities to encourage internal demand so it caught up with the external dynamics without any major harm to external competitiveness, as real wages began to grow proportionally to the positive productivity shock, albeit a bit faster than they were supposed to. In the first six months of the year, wages went up by 6.9% year-on-year, reaching the pre-crisis level (December 2010 with seasonal adjustments) in April — May. However, because
this growth is commensurate to the productivity gain, real unit labor costs increased insignificantly.
Once restored to the pre-crisis level, household incomes created prerequisites for an increase in consumption. The only negative consequence of such a situation was the strengthening of the ruble in real terms. Amid additional inflows of foreign exchange revenues, the nominal exchange rate stabilized (and the economic authorities refrained from artificially weakening the national currency); however, the government proved unable to effectively limit the rise in prices.
As a result, at the start of the second half of 2012, the situation looked partially optimistic, as the recorded economic growth contributed to stabilization (i.e. no new threats to macroeconomic equilibrium were created) and prerequisites were created for household incomes and consumption to recover. However, the problem of inflation expectations remained unresolved; another concern was the strengthening of the ruble in real terms.
Switching the growth "mode"
The situation changed quite sharply at the beginning of the second half of the year, as export supplies of solvents and diluents had to be stopped. The cessation of profitable exports could be treated as a one-time shock for productivity, although this time the shock was negative. In that new framework, the country was unable to benefit from the potential of external demand any longer, as its "know-how" was exhausted and there was no chance for Belarus to keep on its foreign supplies of solvents and diluents, whereas other exports were growing at a slower pace because of the stronger ruble.
Therefore, the dilemma of the first half of 2013 — to grow without risks to macroeconomic stability building on external demand or accelerate economic growth through incentives to internal demand — transformed into the dilemma — to put up with a slump in production (with a view to facilitating mid-term growth and supporting macroeconomic stability) or provide additional stimuli to internal demand. The latter option was de facto chosen in the second half of the year.
The first attempt to encourage internal demand was to heat up the credit market in August and September — during these two months, banks' claims on the economy increased by almost the same amount as in the first six months of the year. The surge in the volume of loans (amid negative external trends and efforts to push up incomes) affected consumer prices and led to larger fluctuations of the nominal exchange rate. The response of the currency and deposit markets had a sobering effect on the economic authorities and prompted them to ease their direct pressure on the credit market.
Furthermore, price incentives to the credit market also stopped — the refinancing rate was not reduced in the final quarter of 2012, and the growth in the volume of loans slowed, restraining capital investments. In the fourth quarter, capital investments fell by 9.7% year-on-year, and in July-December, they decreased by 3.6%. Capital investments contributed minus 1.6 percentage points to GDP growth in the second half of the year and minus 4.1 points in 2012.
Policy towards a recovery of incomes. Loss of competitive price advantages
Another way for the economic authorities to encourage internal demand was through boosting personal incomes and household consumption. Amid unfavorable external processes in the second half of the year, boosting real wages building on productivity gains alone was impossible; however, the "recovery" potential of income growth remained quite high, because wages had fallen so significantly in the wake of the 2011 financial crisis that real unit labor costs dropped to a level markedly below the medium-term trend.
This meant that, based on fundamental conditions, there was a potential for boosting real wages well ahead of the required productivity gain. The political challenges, the intention to reduce outflows of workforce and human capital from the country (which became a phenomenon to reckon with in late 2011 and early 2012), as well as the need to avoid GDP losses (or slower growth) prompted the economic authorities to choose this option. The second half of the year was therefore marked by the policy towards a restoration of incomes.
In the third quarter, wages were pushed by 30.1% year-on-year, and in the fourth quarter, by 38.7%. As a result, real wages had exceeded the pre-crisis level as early as in the third quarter. However, in the second half of the year, wages were growing much faster than productivity, and unit labor costs rose from 40.3% in the second quarter to 48.1% and 52.3% in the third and fourth quarters, respectively (which compares to the average of 48.3% in 2006-2010).2
The price advantage of the Belarusian real economy — the small share of labor compensation in product costs - was thus lost within just six months. The contribution of higher wages to GDP turned out to be quite high. In the second half of the year, household consumption increased by 21.4% year-on-year, contributing an equivalent of 11.2 points to GDP growth. Owing to this component, the rapid growth in internal demand, too, contributed considerably to GDP expansion — internal demand went up by 11.7% in July-December, contributing 13.1 points to GDP growth.
Foreign trade deficit restored
Poor export prospects were manifested as early as the start of the second half of 2012; however, the increase in unit labor costs added to the factors affecting the price competitiveness of Belarusian exports. Furthermore, the real effective exchange rate had reached a very high level by July. Although the ruble exchange rate remained virtually unchanged throughout the second half of 2012 (the ruble depreciated against the euro and the Russian ruble and appreciated against the U.S. dollar), price competitiveness that used to be one of the advantages of Belarusian exports in late 2011 and early 2012, lost its power. Therefore, the growth in export supplies of most of the investment and consumer goods in volume terms slowed. Further, the situation in some of the traditional markets complicated because of unstable growth trends in the global economy. In some industries, reductions in external demand resulted in a buildup of inventories (which is why inventories of material floating assets
The share of labor compensation in GDP is adjusted for seasonal factors.
contributed to GDP growth), causing erosion of floating capital and additional problems.
When it comes to export problems, we should mention the brief spat with Russia over Belarus' commitments to supply oil products to that country, which brought about a reduction in Russian crude import and lower export of refined oil in September and October. Difficulties in the potash market produced an impact on Belarus' potash supplies — in volume terms, foreign deliveries were below the target (and 22.2% below the level recorded in 2011).
For its part, import supplies of both investment and consumer goods were growing amid an increase in consumption and attempts to "heat up" investment demand. As a result, net export supplies ceased to be the locomotive of GDP that is used to be in the first half of the year and became a major factor to slow economic expansion, with contribution to GDP growth at minus 11.5 percentage points in the two final quarters of the year.
In the second half of the year, GDP grew by 0.5% year-on-year. It grew in the third quarter by 2.7%, but fell by 1.9% in the fourth quarter. Production went up by 1.5% in 2012; the July-December trends "outweighed" those observed in the first half of the year, and this growth in production was based on internal demand (which contributed 4.1 points), whereas net export supplies made a negative contribution (minus 1.8 points).3
Conclusion
When summing up the macroeconomic trends in 2012, we need to pay special attention to the fact that growth "modes" were essentially different in the first and second halves of the year. In January-June, "stabilization" growth prevailed, based on external demand, whereas in the second half of the year, the authorities turned to internal demand to pursue "recovery" growth.
The change in the growth modes in the second half of the year prevented complete macroeconomic stabilization. First, inflation expectations remained high and volatile in the aftermath of the 2011 crisis. Second, the incentives introduced in the second
Statistical discrepancies account for the remaining 0.8 of a point.
half of the year made these expectations even more volatile. Third, the serious changes and fluctuations in the economic policy make the situation even more uncertain. Therefore, "vulnerability of economic equilibrium" as a characteristic can be well applied to Belarus throughout 2012 up until the beginning of 2013.
The choice of the speedy recovery of incomes in the social sector as a macroeconomic scenario confirmed the commitment of the authorities to the recovery of the "old social contract." At the same time, this policy led to a loss of many of the price advantages gained as a result of the ruble devaluation. At the end of 2012, Belarus was at the 2010 level by many major indicators (ratio between internal and external demand, real unit labor costs, and real effective exchange rate). This return itself poses no threat to macroeconomic stability, because at the end of 2012, the foreign trade deficit and savings to investments ratio were out of the critical area (and much better than, say, at the turn of 2010).
Furthermore, the positive shock of the first half of the year contributed to the "airbag" of gold and foreign exchange reserves, access to foreign loans, etc. However, the situation indicates that the country missed the chance to redirect the growth mode in line with the "external demand grows faster, and internal demand catches up with it" model. The period of major price advantages in external competitiveness turned out to be very brief, and we cannot say that the country managed to win over new markets and strengthen its positions there.
Therefore, the revival of the old "social contract" resulted in the recovery of the previous economic scenario and previous growth model. However, in this case the gap between the desired economic growth and the one generated by the current economic model will be broadening. In order to deal with this inconsistency, new sources of growth are called for, because the chance to restructure the economy using price incentives was missed.
In 2012, no important structural reforms were introduced to form new sources of growth (the most important moves made during the period were the limitation on directed lending and some cosmetic changes in the lending mechanism). However, at
the end of the year, the authorities de facto realized that reforms are inevitable. Therefore, the government has announced modernization targets for 2013 and plans to create a "new highly productive sector." Belarus' long-term growth will directly depend on the success of these initiatives.
