Macroeconomic situation: Locked in recession

Dmitry Kruk

Summary

The year 2016 was the second consecutive year of economic recession. Non-competitiveness of Belarusian producers was the main reason for the decline. The economic authorities refrained from any extensive institutional changes and, by doing so, did not in any way curb negative trends. They still prioritized the prevention of financial destabilization and pursued stringent monetary and fiscal policy. This helped to neutralize the threat of a new inflation and depreciation upsurge.

At the same time, the structural recession in combination with tough economic policy contributed to the actualization of debt problems. New threats to the country are seen in bad private debts, which deteriorate the quality of bank assets and increase public debt.

Also, 2016 saw a decline in social standards and household incomes leading to growing social tension.

Trends:
Introduction

In 2015, Belarus plunged into a recession for the first time in 20 years. Many expected profound institutional reforms, as there are no other ways to revitalize the economy. These expectations peaked in 2015. Government officials and the expert community had been talking about prompt changes since early 2016, although President Alexander Lukashenko made it clear that drastic changes in the economy were inadmissible. However, the country’s political leadership’s unwillingness to initiate reforms and the hope for an improvement or stabilization of the external environment changed the attitude to the recession: it was more often interpreted as a ‘forced yet controlled phenomenon’, rather than a ‘cure for imbalances.’

The opinion that a considerable part of disproportions was ‘cured’ and, therefore, it was already possible (and necessary) to gradually discontinue emergency belt-tightening measures in 2016, became more and more popular. As a consequence, according to the official forecast for 2016, the economy is expected to overcome the recession and show a tiny, but still an improvement by the end of the year with a GDP growth rate of 0.3%.

New old format of economic policy

The peak of uncertainty about how and where the country was going in its development and which direction will be chosen in the institutional and economic policy was observed in the first quarter of 2016. Prices of oil 1 and other commodities dropped to the minimum in January 2016, weakening the Russian ruble and affecting the price competitiveness of Belarusian exporters. Besides, in January-February, developing countries experienced capital outflows caused by an increase in the US Federal Reserve System’s interest rate in December 2015.

Sources of money for paying off the public debt remained undetermined in the first quarter. In 2016, the government was to pay around USD 3 billion in domestic and foreign debts, while the international reserves only totaled around USD 4 billion as of the beginning of the year. Therefore, the government got busy seeking new loans to refinance current liabilities. The IMF and the Eurasian Fund for Stabilization and Development (EFSD) were considered as potential donors.

In late Q1 and early Q2, the economic authorities finally decided to reject profound reforms hoping that the recession will end routinely by itself given that the external environment was improving: prices of oil and other commodities began to go up into a relatively comfortable range.

In March 2016, Belarus reached an agreement on a USD 2 billion stabilization loan (0.5 billion in the first tranche) from the EFSD on quite favorable terms that signaled that the economy will continue to develop sluggishly without reforms. At the same time, the monetary and fiscal policies remained stringent in 2015.

Situational decline turns structural

If a recession is caused by cyclical fluctuations, it is unpleasant, but not fatal. Firstly, in this case, the recession cannot last forever, because the phase of cyclical decline must certainly exhaust itself. Secondly, the economic authorities can influence its depth and duration. Rarely, a recession is driven by a structural decline. This implies that a contraction in output is not temporary, but persistent.

A number of studies of the Belarusian economic growth point at a steady drift towards decreasing trend (potential) growth in Belarus. As a rule, this is explained by the fact that the previously used growth mechanism based on accumulation of capital has exhausted itself, and the Belarusian economy is unable to ensure growth based on productivity gain. It is, however, often assumed by default that this trend has a ‘natural’ limitation and the trend growth rate cannot go to a negative area.

At the turn of 2014–2015, the rate of the trend (potential) output growth entered the negative area. It is hard to explain this phenomenon. At first, this seemed to be a temporary problem connected with the adaptation of the national economy to new realities in the global economy. In 2015, the negative impact of structural factors on the actual increase in output was insignificant, and the recession was primarily due to cyclical (conjuncture) factors.

However, the structural contraction in output intensified in 2016. As a result, by the end of the year, a 2.6% decline in output was determined by structural factors, while the contribution of cyclical factors was close to zero. In Belarus, the decline turned from situational (as it was predominantly in 2015) into structural.

This process can be characterized as disorganization of economic system elements. At the micro level, such diagnostics mean that many firms face not temporary shocks, but a complete failure of their business models. Therefore, they reacted not by a temporary reduction in output hoping for recovery in the near future, but cessation of operations or their large-scale reformatting. Compared to a cyclical recession, a structural recession generates more challenges and uncertainties.

Firstly, in this case there are no ‘automatic stabilizers’, which would limit the duration of the recession. A structural recession lasts as long as it takes until the economy has adapted to the new natural level of output. Secondly, the possibilities of counteracting such a shock are limited. Even if the economic authorities are capable of working out countermeasures, a long period of time is required to obtain a tangible effect from such measures.

The structural nature of the recession was a key trend in 2016. The government ignored the structural challenges that led to the fact that the concept of a ‘prompt controlled, purifying recession’ (controlled disposition of imbalances) ended in a fiasco, and the national economy continued shrinking. Structurally staying in a state of decline may turn on additional mechanisms of continuous decline.

While adapting to the negative environment and not seeing prerequisites for growth in the future, producers continued to reduce their investment demand. This directly influenced the decrease in output in 2016, simultaneously generating and postponing the effect of limited output in the future.

In turn, in order to adapt to a prolonged decline, consumers began to lower their savings rate in an attempt to reduce consumption. This also limits opportunities for investment and ultimately sets the trend towards limited production capacity and output in the future. It is very likely that such consequences of investment depression and a drop in the savings rate will be felt as early as 2017.

Finally, the prolonged stay in a state of decline was a catalyst for new threats in the financial sector. The contraction in output caused an increase in the debt burden (in relative terms), whereas the ability of economic agents to service these debts declined.

Old threats to financial stability are over... New ones have emerged

In 2016, the country’s economic policy – both monetary and fiscal – remained quite stringent. In the monetary policy, the ‘hardening capacity’ (the situation when the volume of the National Bank’s money supply is smaller and interest rates are higher than necessary to stabilize the output) was conditioned by the remaining ‘canopy of inflation expectations’ (the situation when inflation expectations are significantly higher than the actual inflation rate). Therefore, in order to prevent inflated expectations, the economic authorities were forced to bear some losses in output.

However, during the year, inflation expectations were decreasing and approached the actual level of inflation. As a consequence, tensions in the monetary environment and the foreign exchange market reduced despite the fact that the main reason for the decrease in inflation expectations was probably the depressed state of domestic demand, rather than growth of confidence in the national currency. The National Bank gradually reduced the refinancing rate (it fell from 24% to 18% per annum over the year).

The national currency stabilized (in nominal and real terms), in mid-2016 and even somewhat strengthened at the end of the year. By the fourth quarter of 2016, for the first time in 5 years after the currency crisis, there were signals of stabilization of the monetary environment. Inflation expectations came close to the level of actual inflation for the first time since 2012.

The rigidity of the fiscal policy stemmed from the need to pay and service the public debt. The government has to maintain a surplus of the consolidated budget to accumulate amounts needed to pay off the principal debt, i.e. spending is limited to correspond to available revenues and, if necessary, capital expenditures of the budget are cut. This situation, however, generates fiscal discouragement: despite the stability of revenues and budget expenditure in % of GDP, they shrank significantly in real terms (against the backdrop of the recession).

The forced tightening of economic policy contributed to financial stability. Approximately from the second quarter of 2016, it was already possible to say that the threat of a new inflation and depreciation cycle or a full-fledged financial crisis was mostly neutralized.

On the other hand, the old threats did not disappear, but were replaced by new ones. Staying in a prolonged structural decline and ‘sacrificing’ of a part of output for the sake of financial stability caused new challenges related to the quantity and quality of debts in the national economy.

Poorer quality of debts and heavier debt burden

Over the past year, the country experienced a rapid increase in distressed assets. In absolute terms, in one year, they increased from BYN 2.8 billion to 5.1 billion, which is a serious challenge to the banking system and the entire national economy. It is likely that the problem of bad debts is not fully reflected in statistical reports and is much broader than it seems. Some distressed assets, for example, can be transferred to off-balance sheet accounts of banks; assets of doubtful quality are simply not classified as problematic, for example, thanks to the availability of state guarantees, etc.

Unlike many other problems in the national economy, the authorities have openly acknowledged the problem with assets. The Asset Management Agency was set up in line with decree No. 268 signed in July. As a result of a segmentation of unprofitable agricultural enterprises, some of them were identified as subject to bankruptcy, and others subject to reorganization. It was intended to put Belagroprombank’s loans to agriculture on the Agency’s books, confer more powers on the Agency and thus resolve the bad debt crisis in the agricultural sector.

However, one of the key questions for resolving the bad debt crisis – who and how should accept the accumulated losses – remains unanswered. Decree No. 268 apparently tends to ‘dilute, conceal and hide’ the real losses to ‘clear’ the books of Belagroprombank. Therefore, the mechanism involves an exchange of assets between Belagroprombank and the Asset Management Agency at nominal, rather than market value. For the bank and debtors, such scheme is fraught with excessive acceptance of risks. That is, in this case, instead of fining ineffective borrowers, the state panders to their inefficiency.

From the perspective of the economy as a whole, this practice leads to excessive growth of public debt (debts of local authorities), because through this scheme the state buys out debts of inefficient borrowers at nominal value, which is substantially higher than the fair market value of the debts. At the same time, serious problems also arose with public debt management even without the influence of private debts.

The national debt burden grew significantly. In 2016, the ratio of state debt (including state guarantees) to GDP fluctuated around 47.0% of GDP, while in 2015 it varied from 34% to 40%. This was primarily due to the reduction in GDP in dollar terms as a result of a real reduction and depreciation of the exchange rate.

From the point of view of economic sense, the coming of relative public debt indicators to new highs may call into question its medium-term stability. The dominance of foreign currency liabilities, reduction of budget revenues from foreign trade, limited possibilities for refinancing debts, as well as the dubious prospects for growth of output undermine the stability of the national debt even more. International organizations (the IMF among them) began to voice doubts about this stability for the first time.

All these threats, challenges and issues related to the quantity and quality of debts were identified, but not resolved in 2016. Probably, debt problems will become one of the main ‘pain points’ for the national economy in the near future.

Macroeconomic indicators ‘in red’ and social tension

The cumulative losses from the recession over the past two years have reached alarming values. In 2016, GDP dropped 2.6% (6.4% in two years). 2 The decrease in output was predetermined by a decline in investment and consumer demand. The gross fixed capital formation in 2016 decreased by 16.7%. Investments decreased 29.6% in two years.

Household spending for final consumption in 2016 (–3.9%) decreased even faster than in 2015 (–2.4%). This trend can be explained by households’ awareness of a sustained decline in real incomes and the need to curb intensive consumption of reserves.

Net exports remained the only component of aggregate demand, which provided a positive contribution to GDP growth, as it was in 2015. In 2016, it brought in 3 percentage points (7.1 in 2015). On the one hand, this can be attributed to the elimination of disproportions and restoration of external equilibrium. On the other hand, in such a dramatic change in net exports (mainly because of a decrease in imports) one can see force majeure cuts in imports, which can be considered a shock for output.

In the sectoral context, agriculture was the only source of growth in 2016: added value increased 3.4%, providing 0.2 percentage points of output growth. Domestically-oriented industries continued to show a significant decline in 2016: construction (–15.9%) and trade (–7.4%) being in the lead in this respect. Output losses in construction over the two years totaled nearly 27.0%, which mirrors the depression of investment and cuts in directive financial injections into the industry.

The protracted decline had a negative impact on households. In 2016, real wages fell 4.0% (7.2% in two years). Indirect data suggest that the median wage and median income (which better characterize the welfare of an ‘average’ household) fell to a greater extent. After three years of decline, in late 2016, real wages modestly increased, which may indicate that they finally hit the bottom. A large-scale decline in employment and unit labor costs could be the decisive factor. However, the remaining potential for a structural downturn raises doubts that the period of drop in real incomes has ended.

Despite a considerable adjustment of the level of wages, tensions in the labor market persist. Most indicators, which characterize the state of the labor market (employment, new jobs, etc.), showed negative dynamics throughout the year. This situation can be described as continuing movement towards a new natural equilibrium, which is less favorable both in terms of volume (number of the employed) and price parameters (wages, real unit labor costs).

Summing up the results of 2016, Belstat for the first time published the unemployment rate in ILO terms: 5.8%. This rate cannot be regarded excessively high, yet it demonstrates the tension in the labor market.

It can be stated that the two years of the recession have led to a further decline in social standards and weaker financial standing of households that, probably, contributed to the growth of social tensions in society.

Conclusion

In 2016, the economic recession extended itself with predominantly structural factors as the driving force. There will not be an automatic recovery, which means that it could endure. Moreover, as long as the negative growth trend persists, it is unlikely and practically unattainable to ensure sustainable output growth.

Growth can only occur in case of tangible improvements in the external situation. But even in this case, the growth rates will be close to zero and unstable, i.e. a possibility of a return to recession will hang over the economy like a sword of Damocles.

In the current situation, the rate of long-term growth not only predetermines the medium- and long-term development outlook, but is also a key to short-term output and welfare dynamics. From the point of view of economic policy, this means that the task of increasing the rate of long-term growth is an absolute priority today.