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MACROECONOMIC SITUATION: DIVING INTO A LONG RECESSION
Dzmitry Kruk
Summary
The country entered the year 2015 with weak prerequisites for economic expansion. The situation was further aggravated by the new currency crisis, which affected the economy in late 2014 and early 2015. To rule out a major financial meltdown the authorities had to revise their economic policies by imposing additional restraints. A new strategy was developed for the country's monetary policy: the fixed rate was replaced with the floating rate, and the money supply became the new 'nominal anchor.' The new format of macroeconomic regulation did help neutralize the threat of new financial shocks; however, it pushed Belarus into a deep recession. Throughout the year, the controversy between the objectives of financial stability and stabilization of money issue became increasingly heated. The situation became a reflection of deep seated structural problems in the national economy; however, the authorities never dared embark on institutional reforms. By the end of the year, new challenges to the country's economy became more obvious against the backdrop of the recession, which might take very long, with no prerequisites for growth recovery whatsoever.
Trends:
• Shift in the currency exchange regime to floating from fixed;
• Restraining economic policies, which helped prevent a new financial crisis, while affecting business;
• Excessive debt burden - both internal and external - on the financial system.
Introduction
At the very end of 2014 and in early 2015 the Belarusian economy was hit by yet another currency crisis — the country made the same mistake for the third time over the past six year. The reason behind the new crisis is the deviation of the equilibrium level of the exchange rate from the target set by the economic authorities. This time, however, this deviation was caused by external shocks stemming from the drop in oil prices and sudden depreciation of the Russian ruble, rather than domestic policies encouraging internal demand (as was the case in 2011).
The unexpected depreciation of the Russian ruble can partially exonerate the Belarusian economic authorities; however, it can only provide short-term moral relief. When it comes to the search for instruments to overcome the crisis, the external nature of the shock only worsened the situation. The devaluation move at the start of the year became the first phase of the campaign to adapt to the new external environment. This time, the authorities did not expect the weaker national currency to have any benefits (as it happened in 2011), such as improvements in the price competitiveness of Belarusian products in the main export markets. On the contrary, the demand for Belarusian-made products in Russia and the CIS became weaker (because their respective currencies lost almost the same portion of their value to the basket of foreign currencies as the Belarusian ruble did), whereas lower oil prices affected the balance of trade in energy.
Moreover, the new currency crisis was unfolding amid the 'compromised immunity' of the national economy. Even if there had been no external shocks, the list of internal challenges was so long that there was no chance of any substantial growth in 2015.
First, the potential for economic growth became weaker. In previous years, structural issues caused low GDP growth, but in 2015, they already caused a contraction in output. At the end of 2014 and beginning of 2015, the unreformed Belarusian economy hit the development 'ceiling,' and the accumulated structural disproportions pulled it downwards.
Second, old problems remained in the monetary sector. In 2014, owing to the relatively favorable external situation and targeted exchange rate, the National Bank of Belarus (NBB) managed to reduce interest rates. However, highly unstable inflation and depreciation expectations remained beyond the control of the central bank. Along with the high level of real and financial dollarization, these old problems contributed to uncertainties in the financial market.
Third, in early 2015, new concerns appeared over the number and combined amount of debts of the central authorities and the private sector. According to international standards, the level of the state debt remains within the acceptable margins (17.3% of GDP). However, the state budget was clearly affected by the
need to repay and service old debts, which started the trend towards a reduction in budget expenditures.
In the private sector, there were several prerequisites for the deterioration of the quality of debts. During the decade of the 'lending binge' non-financial companies were actively changing the structure of their capital by increasing the share of borrowed funds. Over the past ten years, the equity-assets ratio in the economy decreased to 57.3% from 79.4%. Since 2012, the cost of borrowing in real terms remained very high, resulting in a higher loan burden on companies and erosion of their floating capital.
Furthermore, in 2013—2014, many companies were taking loans in foreign exchange seeking to reduce the debt burden. In many cases, loans in foreign currency were taken by businesses that had no currency receipts. As a result, the quality of debts became dependent on exchange fluctuations.
Therefore, the original prerequisites for economic growth in 2015 were virtually nonexistent. It was apparent that the stagnation of personal incomes and, consequently, expenses and consumption, was unavoidable. Further decreases in external and internal investment demand were also very likely.
Up until the crisis of December 2014 it had been unclear whether GDP would be maintained at its previous level (with minimum growth) or the year 2015 would become the first year in the previous two decades to see a setback. The crisis made it obvious that Belarus was in for a recession spell. Two new priorities were added to the agenda: (1) How deep and long will the recession turn to be? and (2) Will the currency crisis evolve into a full-scale financial crisis?
New format of macroeconomic policy
At the turn of 2015, the authorities took administrative measures to address the new currency crisis, including currency restrictions, direct price controls, and new taxes and charges on foreign exchange transactions. However, drawing on the experience of dealing with the financial crisis of 2011, this time the authorities were aware that such measures would eventually contribute to uncertainty and undermine people's trust, thus disorganizing the entire financial market of the country.
Therefore, the NBB tried more adequate measures to respond to the new economic reality during the first weeks of 2015. In mid-January, the NBB announced a 'revolution' in the country's monetary policy. First, the central bank recognized the need to change from the targeted exchange rate policy towards the floating exchange rate model. The NBB will only interfere in the exchange rate formation process to 'extend' the periods of sudden fluctuations.
Second, the central bank announced a new nominal 'anchor' of its monetary policy — the broad money supply. The new, targeted money supply regime implied that inflation was a higher priority for the NBB than the exchange rate. In order to ensure the desired inflation level, the NBB undertook to limit the increase in money supply.
The change in the monetary policy regime is a landmark event for the country. The previous regime, based on the targeted exchange rate policy, had been in use since 2003 and was considered by the authorities to be a 'value in itself,' although the commitment to such a regime became one of the reasons behind the financial shocks. Therefore, the change to the floating exchange rate policy seemed a progressive move. By definition, the new regime rules out any gaps between the equilibrium and actual exchange rates (if the regime was applied adequately), such gaps being the main triggers of the previous financial crises. Therefore, the roles of the exchange rate changed for the country: it evolved from the unfortunate 'nominal anchor' into a 'shock absorber.'
Other innovations of the new monetary policy were not as unambiguous for the country. Monetary targeting has three major drawbacks. First, broad money supply cannot be directly controlled by the National Bank and can be changed by the behavior of economic agents. Therefore, the ability of the central bank to use it as a reliable 'nominal anchor' is doubtful. In 2015, the NBB failed to limit the growth in broad money supply, which increased by 37.2%1 on average, whereas the limit had originally been set at 30%.
The average annual growth rate of broad money supply (resulting from the increase in the foreign exchange component of broad money supply and depreciation of the ruble, by 56% vis-à-vis the U.S. dollar). In terms of the average monthly expansion of broad money supply, it grew by 40.9% in January—December 2015.
Second, this regime almost completely ignores the need to stabilize expectations of economic agents, which is crucial for Belarus, because inflation and depreciation expectations remained virtually uncontrolled by the NBB. The unreliable 'anchor' of broad money supply that cannot really be trusted is unable to contribute to the stabilization of expectations.
Third, the willingness to maintain the price stability by way of restraining money supply, especially amid high and volatile inflation expectations, can lead to excessive tightening of the monetary environment and economic activity. In other words, the crude and clumsy instruments and objectives of monetary policy can bring about unforced losses in terms of output.
The final drawback was completely disregarded during the first few phases, because the contribution of the new regime to financial stability overshadowed the rest of the objectives of the country's monetary policy. However, as the recession grew deeper, the NBB found itself under increasing pressure from the economy, which called for milder monetary policies.
In 2015, the tight monetary policy was supported by a series of restraints. In their incomes policy, the authorities kept the directive peg2 of wages and salaries to labor productivity. The budget policy of the economic authorities was also aimed at limiting incomes. Budget spending on wages and social security remained virtually unchanged in real terms compared with the year 2014 (an increase by 0.9%), whereas in previous years, the authorities allowed a more substantial increase in wages in the public sector. Wages and salaries were purposefully limited as part of the campaign to make up for the deliberate encouragement of wage pushes and demand in previous years.
Also in 2015, the authorities announced a policy to curb directed lending; however, the volume of such loans that banks extended to industrial companies and farms remained unchanged from 2014 at BYR 27.1 trillion. At the same time, directed loans decreased by 13% in real terms, i.e. adjusted for inflation, and the amount of preferential home loans almost halved even in nominal terms.
This practice was introduced in the second half of 2014 (Resolution of the Council of Ministers No. 744 of 31 July 2014).
On the other hand, the Development Bank of the Republic of Belarus was providing increasing amounts of directed loans — up by 65% in nominal terms and 45% in real terms — accounting for 22% of the overall amount of directed loans provided in Belarus in 2015. The amount of directed loans extended in 2015 remained almost unchanged from the year 2014 in nominal terms, whereas the decrease in real terms was proportional to consumer inflation. The procedure for giving and taking such loans changed very little: money was simply given to borrowers from approved lists.
However, even those slight restrictions on access to directed loans markedly affected many state-controlled enterprises. Mechanical engineering and woodworking enterprises became increasingly dependent on the refinancing of old loans. In order to improve their financial position, the government took an extraordinary step: the Finance Ministry de facto purchased from banks the debts of some engineering and woodworking companies in exchange for state bonds, and the original debts of state-run enterprises were restructured and extended. The ministry used the scheme to purchase and restructure more than USD 1.5 billion3 worth of debts.
The ministry thus addressed two challenges: (a) it supported major manufacturers and helped maintain the number of jobs and (b) dealt with the trend towards the worsening of the quality of assets in the banking sector. The effectiveness of this policy will depend on whether beneficiaries will be able to restore their capacity to pay in the future. The Finance Ministry essentially put its own payment capacity at risk in the foreseeable future by putting all its 'money' on its borrowers' ability to regain their capacity to pay soon enough.
Another important innovation in the state's fiscal policy is the new limitation on the government's capital expenditure. Although consolidated budget revenues have substantially increased (mostly due to the transfer of oil duties to the Belarusian, not Russian, budget, starting in 2015), the Finance Ministry is looking to limit budget spending and channel excessive revenues into the repayment of old debts. The most
Most foreign exchange-denominated debts were restructured.
affected article was 'capital expenditure,' which was slashed by 15.9% in nominal terms, or by 0.5 of a percentage point of GDP.
None of the above monetary policy innovations were voluntary, and all of them caused serious changes in the macroeconomic dynamics.
Decay amid recession
The new format of the country's economic policy introduced dramatic changes to the conventional picture of the Belarusian economy. In previous years, it looked like this: a substantial foreign trade deficit, overstated exchange rate, high inflation, low unemployment, GDP growth (albeit slower during the last few years). In 2015, the picture changed, with the external deficit at approximately 3% of GDP4, the actual exchange rate corresponding to the equilibrium rate, inflation growing slower, decline in employment, and growth of unemployment, amid GDP decline.
The economic authorities focused on the first three attributes, treating them as achievements of the new economic policy, which contributed to financial stability. Growth of unemployment and decrease in GDP was often characterized as a brief 'cleansing procedure,' which would not threaten the macroeconomic stability.5 However, it became clear in summer that the limitations would not be cancelled soon for fear of new financial shocks.
At the same time, these restrictive measures cause a deeper economic downturn, further growth of unemployment, and give rise to new threats. Therefore, the primary objective of maintaining the macroeconomic stability was soon forgotten, and the concept of the brief 'purging setback' was in stark contrast with the reality. GDP behavior and other economic
Which is close to the 'normal' level that is identified based upon the long-term ratio of savings to investments.
The traditional interpretation of macroeconomic stability implies low inflation, full employment, and financial stability. It is therefore wrong to apply the term 'macroeconomic stability' to the situation in Belarus in 2015 (deep recession and growth of unemployment), although the economic authorities made use of the term to characterize the status of the national economy.
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indicators increasingly implied that the country had entered a long period of recession.
Below are the main reasons behind the deeper economic slump.
(1) Worsening environment for long-term growth
Being well aware that even with no external shocks the Belarusian economy is lacking the foundation for long-term growth, companies became less inclined to invest. The problem, along with high interest rates in the money market, brought about a serious depression of investment demand.
At the start of the year, experts shared their expectations that some progress would finally be made in terms of long overdue institutional reforms. The recession, which was largely a result of structural challenges, could become a proper backdrop for reforms. The least that experts believed the state would do is remove some of the critical obstacles to the development of the national economy, including (i) the priority right of state enterprises to access capital; (ii) artificial support for state enterprises to help them survive; (iii) state property management mechanisms; (iv) insufficient flexibility of the labor market; (v) flawed social protection instruments for the unemployed.
In the first half of the year, the authorities were giving clear signals that such reforms were reasonable and acceptable and would soon be put in place. A draft 'roadmap' of structural reforms was developed in association with the World Bank. The authorities received the document as the basic framework to negotiate a new loan program with the IMF. However, the Fund's additional proposals that were aimed to make the reform irreversible put the negotiations in limbo.
A little later it turned out that there was no political will to introduce reforms. After the presidential election Aliaksandr Lukashenka sent a personal message making it clear that no dramatic changes would be taking place in the operation of the national economy. By the end of 2015 discussions about the need for systemic reforms had run out of steam.
At the same time, some forced measures, such as increases in transport fares at the end of the year, were interpreted by
the authorities as structural reforms. The list of arrangements that can partially be qualified as structural reforms included only the abovementioned limitation on directed lending, as well as the government's strategy to reform the system of state finance.6
At the same time, in 2015, a new trend was observed that can be characterized as 'self-made reforms.' Since the economic authorities were unable to provide broad support for non-financial enterprises and maintain a lending boom in the economy, many companies had to initiate bankruptcy procedures on their own or have their lenders do it. In 2015, the number of bankruptcy cases filed with economic courts increased by 25% year-on-year. At the end of the year, the share of state enterprises among potential bankruptcies remained relatively small; however, the list included several major state manufacturers, which are subject to the bankruptcy 'taboo' in the next few years.
(2) Legacy of past mistakes of Belarus's economic policy
Although the new monetary policy regime meets the needs of the country's economy more effectively than the old one, the problem of high inflation and depreciation expectations that cannot be controlled by the NBB still remains. Last year, the problem of the lack of trust in the NBB was aggravated by the low level of gold and foreign exchange reserves7, as well as insufficient autonomy of the bank in implementing its policies. Throughout the year, experts discussed the possibility for the central bank to mitigate its policies, which was mostly lobbied by non-financial state enterprises. Being faced with this dilemma — the threat of new financial shocks and further decrease in GDP — the NBB decided to focus on the former and
Resolution of the Council of Ministers No. 1080 of 23.12.2015. The document notably contains no direct action measures, but postulates objectives of future activities without mentioning any guarantees that could help achieve the declared objectives.
A substantial portion of reserves was spent on attempts to prevent the currency crisis of December 2014. Furthermore, reserves were additionally spent to make repayments of debts denominated in foreign exchange (both internal and external).
pursued a rigid and consistently restrictive policy, which further discouraged business activity.8
(3) Poorer quality of debts
The loan debt burden on companies that had grown a lot heavier in previous years affected the quality of debts amid the recession and ruble depreciation. First, the practice of directed distribution of resources should be blamed, as state-run enterprises were spending money on ineffective projects. The reduction in internal and external demand became an additional catalyst for problems with debt servicing by such enterprises. Second, the drop in demand made the quality of debts an increasingly important issue for 'market' borrowers, whose business model proved to be ineffective in the new environment. Third, due to the significant depreciation of the national currency in 2015 (by 37.6% to the basket of currencies), debt holders who had originally borrowed in foreign exchange and had no (or very few) sources of revenues in foreign currency also reported problems with debt servicing.
The deterioration in the quality of debts in the economy became another prerequisite for further economic decline. First, the companies that encountered problems in servicing old debts give up on their investment plans. If their frugality fails to stabilize the situation, they will have to cut costs as much as possible and even consider phasing down their activities. Second, the problem produced a proportional impact on the banking sector. Seeing the expanding share of troubled loans, banks are forced to create reserves to cover possible losses, which affects their capacity to lend. As a result, both channels cause a deeper economic slump.
The economy needs time to 'digest' the said factors. Therefore, by the end of the year, when these factors became even more apparent, the hopes of 'fast cleansing procedure' and recovery had been exhausted. The recession factors are obviously too strong and stable.
As a rule, in conditions of a recession, central banks seek to pursue milder policies to encourage business activity.
Change in macroeconomic indicators
Statistically, the year 2015 became the worst one in the past two decades. GDP fell by 3.9% year-on-year. In terms of demand, capital formation was affected the worst and dropped by 15.9% (negative contribution to GDP growth — 5.9 percentage points), which demonstrates the depressed nature of investment demand. Consumption expenditures by households and state organizations fell by 2.4% (negative contribution to GDP growth — 1.6 percentage points).
The only component that made a positive contribution to GDP — 5.3 percentage points — is external demand (net export). The positive effect of net export can be attributed to the fact that import in volume terms dropped faster than export did due to the floating exchange rate and reduction in both investment and consumer demand.
In terms of supply, all of the major industries showed a decrease in gross value added. In construction, output fell by 9.5% from the 2014 level (due to the fall in investment demand and limitations on concessional home loans). The manufacturing sector reported a 6.2% contraction in output (caused by debt problems and lower external demand). Retail was supported by the gradual adaptation of the consumption model to the new economic reality and showed the least decrease in output of all sectors, by 1.6%.
In 2015, wages dropped in real terms by 3.1%, and real disposable incomes decreased by 5.6%. Growth of unemployment became a new important characteristic for the economic status of households. Official unemployment statistics (1.1%) only cover registered unemployed individuals and cannot shed light on the real scope of the problem. The faster decline in employment can be used as an indirect indicator of the explosive growth of unemployment: the number of jobholders fell by 80,500 people in the period from December 2014 to December 2015.9
In foreign trade, Belarus reported a surplus for goods and services for the first time in many years (USD 174.3 million).
The reduction in employment does not mean that the number of jobless Belarusians increased by the same amount.
This result can be attributed to the depreciation of the national currency and the ongoing recession. Nevertheless, the surplus of foreign trade cannot be treated as an unequivocally positive outcome. The substantial decrease in import (which dropped faster than export did) can be treated as a 'cleansing procedure.' However, on the other hand, the fall in import supplies can have negative consequences and become an obstacle to the domestic production of goods and services, which 'service' import deliveries.10
In the monetary sector, the results of the year 2015 were not unambiguous, either. On the one hand, the NBB managed to prevent a full-scale financial crisis. Moreover, the average annual inflation rate slowed (owing to the NBB's efforts and fall in GDP) to 13.5%, which is quite acceptable by Belarusian standards. The significant depreciation of the national currency (by 37.6% to the basket and 56% to the U.S. dollar) was mostly caused by external shocks and did not result in major financial shocks.
On the other hand, the growing share of troubled loans became an increasingly serious reason for concerns in the banking sector; and many had doubts about the stability of banks in the new economic reality. Further, uncertainly remained in financial markets, which, along with the lack of trust in the official monetary policy, further increased the country's vulnerability to financial shocks.
In 2015, Belarus's gross external debt in absolute terms went down by USD 1.8 billion. However, because of the drop in GDP in the U.S. dollar equivalent the relative indicators of the debt hiked: the gross external debt to GDP ratio increased to 69.7% from 52.8%, and government external debt to GDP ratio went up to 23.6% from 17.3%. This rate of change suggests that the stability of foreign debt will become an important issue in years to come.
Conclusion
2015 became the year of payback for the reluctance of the authorities to adapt the national economy to the changing
By analogy with the 'sudden stop' of capital flows.
environment. Structural weaknesses were aggravated by large-scale external shocks, which brought the economy into a deep recession. The economic authorities had to respond, but the only change was the revision of the format of their macroeconomic policy, whereas when it came to institutional reforms, no practical steps were made whatsoever. The hope that those scarce measures would be sufficient to recover from the slump never came true.
The few positive effects of the innovations in the country's macroeconomic policy did not have enough capacity to effectively address the persistent structural shortages. Further, the old economic policy mistakes became a serious obstacle. As a result, the 'controlled recession' did not turn into a 'cleansing procedure' for the economy. On the contrary: the backdrop of the recession uncovered some new sensitive spots of the Belarusian economy: the fast growth in distressed assets in the banking sector and heavy burden of foreign debts (including the government debt). These challenges threaten the national economy with a 'recession spiral,' which will either make the recovery long and painful in the best-case scenario or further deepen the economic setback in the worst-case scenario.
