The global financial crisis that erupted in late 2008 had a profound impact on Belarus’s economy. The unprecedented external shock necessitated a strong set of corrective measures, including exchange rate adjustment. This Selected Issues paper analyzes whether the corrective measures in the exchange area are sufficient to restore current account sustainability. It examines various pieces of evidence, including basic indicators of competitiveness as well as the macroeconomic balance and external sustainability approaches. It concludes that the substantial misalignment observed in the end of 2008 has been largely corrected.

Abstract

The global financial crisis that erupted in late 2008 had a profound impact on Belarus’s economy. The unprecedented external shock necessitated a strong set of corrective measures, including exchange rate adjustment. This Selected Issues paper analyzes whether the corrective measures in the exchange area are sufficient to restore current account sustainability. It examines various pieces of evidence, including basic indicators of competitiveness as well as the macroeconomic balance and external sustainability approaches. It concludes that the substantial misalignment observed in the end of 2008 has been largely corrected.

I. Is There A Need for Further Adjustment in the Exchange Rate?1

The global financial crisis that erupted in the late 2008 had a profound impact on Belarus’s economy. The unprecedented external shock necessitated a strong set of corrective measures, including exchange rate adjustment. The central question is whether the measures in the exchange area are sufficient to restore current account sustainability. This paper attempts to answer this question by examining various pieces of evidence—including basic indicators of competitiveness as well as the macroeconomic balance and external sustainability approaches. The evidence points to the conclusions that (i) the substantial misalignment observed in the end of 2008 has been largely corrected and the need for further substantial exchange rate adjustment is not evident (although a small correction could be justified). Sustainability of the current rate, however, is conditional on maintaining tight domestic demand policies necessary to support the peg over the medium term.

1. Section A discusses several indicators of competitiveness placing them in the context of macroeconomic developments. Section B elaborates on the application of the macroeconomic balance approach based on a model used in the IMF’s CGER assessments. Section C applies the external sustainability approach—also used in CGER assessments—based on the simple intertemporal budget constraint. Section D offers concluding remarks.

A. What do Basic Indicators Tell us About Current Account Sustainability?

2. Prior to the crisis, basic indicators showed no signs of erosion of export competitiveness, suggesting that the exchange rate was broadly in line with equilibrium (Figure 1). The CPI-based REER—which can be regarded as an indicator of price competitiveness—had been depreciating steadily until August 2008. The REER based on the unit labor cost (ULC) suggests that cost competitiveness had been improving since Q1 2006. Exports grew at a fast pace—in the first half of 2008, they increased by 62 percent in value terms and by 13 percent in volume terms, suggesting that export competitiveness was broadly adequate.

Figure 1.
Figure 1.

Belarus: Indicators of Competitiveness, 2004–09

Citation: IMF Staff Country Reports 2010, 016; 10.5089/9781451805338.002.A001

Sources: National Bank of the Republic of Belarus; BelStat; and IMF staff estimates.1/ The index is constructed using data from 3 trading partners: Russia, the EU and the U.S.

3. The global financial crisis, which produced a strong negative shock transmitted mainly via trade and exchange rate channels from the sagging Russian economy, led to a loss of current account sustainability. During August-December 2008, the REER appreciated by 19 percent due to the depreciation of the Russian ruble. Exports in the fourth quarter of 2008 shrank by 12 percent relative to the fourth quarter of 2007 while imports declined by only 2 percent, and the population’s demand for foreign currency spiked, exerting strong pressure on reserves. The authorities intervened heavily to support the peg to the US dollar. These developments indicated a loss of competitiveness and pointed to a possible disequilibrium in the exchange rate.

4. The authorities devalued the rubel against the US dollar in January 2009 and repegged against the basket consisting of the Russian ruble, the US dollar and the Euro, but exchange pressures persisted. In the first five months of 2009, exports declined by nearly 50 percent while imports fell by only 30 percent, resulting in the current account deficit nearly twice as large as in the corresponding period of 2008. The pressures on reserves were exacerbated by substantial currency substitution driven by public expectations of another devaluation. Given the dwindling financial account inflows, the NBRB supported the exchange rate by substantial intervention amounting to over $1.1 billion in the first quarter and $1 billion of the second quarter, losing some $0.4 billion in gross international reserves despite inflows of some $1.9 billion.2

5. In June 2009, the authorities gradually adjusted the rubel against the basket bringing the REER closer to its pre-crisis level, widened the exchange rate band and tightened market interest rates. The exchange rate was gradually depreciated against the central parity of the basket by 5 percent (reducing the REER to the level of August 2008) and the band was widened from ±5 percent to ±10 percent to provide a buffer against the shocks. In order to revert the process of currency substitution, the NBRB pursued policies aimed at increasing the spread between domestic and foreign currency deposit interest rates. Currency substitution came to a halt and has been partially reversed since June, but overall pressure on reserves continued, with net international reserves falling (excluding the SDR allocation in the end of August) by $0.76 billion in the period from July to August 2009.

6. It should be noted, however, that the exchange rate pressures critically depend on the domestic demand policies pursued by the authorities. To the large extent, the expansion of the current account deficit in 2008 could be attributed to the widening of the gap between the domestic demand in Belarus and that of its trading partners. Whereas during 2004–07 Belarus domestic demand exceeded that of the trading partners by an average 4.5 percent, in 2008 the gap increased to 9.5 percent. Domestic demand has continued to be bolstered in 2009, with fixed asset investment expanding by over 17 percent in the first half of 2009, due mainly to vigorous lending under government programs and support of state-owned enterprises.

uA01fig01

Domestic Demand Growth in Belarus and Its Trading Partners

(Percent change)

Citation: IMF Staff Country Reports 2010, 016; 10.5089/9781451805338.002.A001

Sources: Belstat; and IMF, World Economic Outlook.

7. In the case of Belarus, assessing the need for further adjustment of the exchange rate is a challenging task:

  • The equilibrium exchange rate critically depends on domestic polices (e.g. looser monetary policy is consistent with a relatively depreciated exchange rate). Therefore, one needs to make a judgment regarding the current state of policies in order to estimate the “underlying” (structural) current account deficit that would persist if the effects of temporary shocks were washed out. In this paper, it is assumed that the authorities will follow the tight domestic demand policies agreed in the Letter of Intent for the second review of the Stand-By Arrangement (SBA).

  • In addition, there is considerable uncertainty about the effectiveness of exchange rate adjustment in an economy with strong features of central planning. The strong role of the state in allocating resources could weaken the expenditure-switching role of exchange rate policy relative to more market-based economies. Widespread practice of quantitative targeting, ranging from economy-wide targets (e.g. growth, fixed investment, inflation and credit growth), to micro-level quantitative targets given to key industrial enterprises remains a distinctive feature of Belarus. Quantitative targets and the soft budget constraints arising from the active role of the state in the financial sector may frustrate the price mechanism: profitable enterprises do not necessarily have an incentive to increase production beyond their “targets” whereas loss-makers may continue operating (which is illustrated by the increase of inventories in the first half of 2009 to about 95 percent of average monthly production from 50 percent a year earlier). These rigidities increase the exchange rate adjustment required to achieve a given correction of the current account relative to economies with more market-oriented systems.

These caveats suggest that using estimates of misalignment for designing an adjustment policy package should be done cautiously.

B. Macro Balance Approach

8. The macro balance approach focuses on a simultaneous achievement of internal and external balance. It has two essential components: the underlying current account associated with positions of internal balance in all trading partners (schedule UCA (REER) on the figure below) and the equilibrium level of savings-investment balance that is assumed to be independent of the exchange rate (S-I)E. The negatively-sloped UCA schedule shows a reduced-form relationship between the underlying current account and the REER: each point on that line corresponds to an internal balance in the economy as well as its trading partners. As an appreciation of the REER generally worsens the balance, the UCA schedule has a negative slope.

9. An external equilibrium is depicted by the “fundamental” savings-investment balance (S-I)E (often called the current account norm). It is the balance that is assumed to be independent of the real exchange rate and depends on the fundamental characteristics of the economy such as its level of development, population structure, etc. If the underlying current account deviates from the norm (e.g. REER is equal to R1), external factors start exerting downward pressure on the real exchange rate, moving the economy to the equilibrium Re.

uA01fig02

Illustrating the Macro Balance Approach

Citation: IMF Staff Country Reports 2010, 016; 10.5089/9781451805338.002.A001

10. What determines the position of the (S-I)E schedule? The literature has suggested a number of robust determinants of the savings-investment balance over the medium-term (Lee et al 2008). Examining the channels of transmission from these determinants to the current account balance suggests that all of them should be relevant in Belarus despite its particular economic structure.

  • Level of economic development. Less-developed economies have relatively larger investment needs and therefore should run a current account deficit. This has direct relevance to Belarus—the economy is in the early stages of transition and can benefit from further upgrading its capital stock, thereby justifying the need to run current account deficits.

  • Fiscal balance. A higher government deficit lowers national savings and therefore contributes to the current account deficit. Thus, an economy with a higher government deficit is expected to run a higher current account deficit over the medium term. The only case when this effect would not work is when private sector would offset a reduction in public savings (i.e. the case of Ricardian equivalence) However, given the relatively closed financial account for the non-government sectors of the economy, this effect should be applicable to Belarus.

  • Demographics. A higher share of economically active population should increase national savings and therefore improve the current account balance. This effect should hold in Belarus regardless of the central planning features of the economy.

  • Net foreign assets. Whereas the theoretical effect of Net External Asset Position (NEAP) on the current account is ambiguous, countries with higher NEAP tend to attract higher income from their foreign position thereby creating a positive association between NEAP and current account. This should be directly applicable to Belarus—as the economy accumulates liabilities, its debt payments should increase as percentage of GDP.

  • Energy balance. Higher oil prices decrease the balance of oil-importing countries, thereby creating a negative association between the oil balance and the current account. Again, this has direct applicability in Belarus given its reliance on natural gas and oil.

  • Output growth. Among countries at a similar level of economic development, stronger growth relative to trading partners should be associated with a lower current account balance.

11. This assessment takes advantage of the pooled regression results used in the Fund’s CGER exercise. There are two specifications. The first utilizes all regressors described above, and the second replaces the initial level of net foreign assets with a lagged value of the current account.

12. In order to assure the “sustainability” of the current account norm, the norm must be calculated using sustainable values of regressors. Therefore, baseline medium-term projections were used for fiscal balance, demographics, oil balance and per capita growth. The four-year average current account balance was used for the lagged current account in the hybrid model, and a NEAP value of 30 percent of GDP (observed at the end of the first quarter of 2009) was used in the pooled estimation model. Consistently with the approach used in CGER exercise, the fiscal balance, demographics variables and the per capita growth rate were expressed as deviations from trading partners’ averages. The pooled estimation model suggests a norm of -2 percent of GDP whereas the hybrid pooled models yields a norm of -2.7 percent of GDP. The derivation of sustainable values of regressors as well as contributions to the calculated norm are illustrated in Table 1.

13. The final step of the assessment calculates an appropriate adjustment of the REER that would close the gap between the underlying current account and the corresponding benchmark found above. Under the policies agreed in the second review of the SBA, the underlying (i.e. structural) current account deficit is judged to be close to 3.5 percent of GDP. Given the long-run elasticities of export and import volumes (eX, eM), the overall response of the CA balance to one-percent increase in REER can be found as follows:

eCA=eXXY(eM1)MY,

where the first term reflects the effect of a change in REER on exports, which, assuming no change in export prices, works through export volumes. The second term reflects the effect on imports via both volume effect (eM*M/Y) as well as the price effect (M/Y). Applying a long-run export elasticity of -0.71 and an import elasticity of 0.92 (which are the values used in the CGER assessments), the overall current account elasticity is -0.38. This implies that a 10 percent appreciation in REER would worsen the current account by 3.8 percent of GDP. It should be noted, however, that the elasticities in Belarus could be lower given the rigidities discussed in paragraph 7. Therefore, the adjustment required to bring the UCA to the norm could be higher.

Current Account Norms

article image
Source: Lee et al (2008).

*, **, and *** indicate significance at the 10, 5, and 1 percent level, respectively.

Sustainable value is calculated as GDP_PPP (BLR)/GDP_PPP (US)-1

Average current account balance for 4 years.

14. Both pooled estimation and hybrid pooled estimation models suggest that, under the baseline policies, there is no clear evidence that the exchange rate is substantially overvalued. Based on the underlying current account of 3.5 percent and the elasticity of 0.38, the models suggest an overvaluation of 2–4 percent, depending on the model specification. Given the large margins of error (including the fact that panel estimation was performed on a set of industrialized and large emerging market economies), results below 5 percent should not be used as evidence that exchange rate is substantially overvalued. Thus, the current exchange rate—perhaps with a small real depreciation within the current exchange rate band—could be considered sustainable.

Macroeconomic Balance Approach

article image
Source: IMF staff calculations.

15. For illustrative purposes, misalignment is also calculated for a scenario in which the current account deficit fails to adjust over the medium term and broadly remains at its expected level in 2009. The result suggests that a 18–20 real depreciation would be needed to bring the current account to its medium-term norm.

C. External Sustainability Approach

16. This approach checks whether external sector dynamics are consistent with stability of the NEAP. As the macroeconomic balance approach relies on many components prone to margins of error (underlying current account, elasticity, current account norms), it is instructive to cross-check the results with the external sustainability approach. This approach does not depend on behavioral assumptions and therefore can be applied equally to any type of economy. The approach checks the consistency of the current account with a given (“benchmark”) NEAP using a simple intertemporal budget constraint which states that change in the net foreign asset position (NEAPtNEAPt-1) is equal to the current account balance (CAt) plus the capital gains (KGt) as well as any capital transfers and remaining wedges between the current accounts and net financial flows (Et):

NEAPtNEAPt - 1 = CAt + KGt + Et

17. Abstracting from KGt and Et (which is a reasonable assumption in Belarus given the low level of capital transfers and the limited scope for valuation changes), and expressing CAt and the NEAP as percentages of GDP yields the following budget constraint:

btbt1(1+g)(1+π)=cat,

where bt and bt-1, and cat are NEAP and CA expressed in percentages of GDP and (1+g)(1+π) is the economy’s nominal growth rate. Thus, the current account balance consistent with the non-changing NEAP measured as a percent of GDP (bs) is found as follows:

cas=g+π(1+g)(1+g)(1+π)bs

18. Thus, the NEAP-stabilizing current account cas is proportional to bs with the slope depending on the medium-term values of real growth and inflation. The medium-term values of these variables are projected taking into account the established (most likely to be implemented) policies. Given the NEAP value of minus 31 percent of GDP (the level observed in the end of the first quarter of 2009) the NEAP-stabilizing current account deficit in Belarus is 3.6 percent and the resulting misalignment of the exchange rate is zero. Thus, in the framework of the external sustainability approach, the underlying current account is consistent with maintaining a constant NEAP position.

External Sustainability Approach

article image
Source: IMF staff calculations.

NEAP at the end of 2009Q1.

19. In the illustrative scenario of the persistent current account deficit, the exchange rate misalignment is sizeable. In order to maintain the NEAP at the benchmark level, the REER would need to depreciate by close to 15 percent in order to drive the current account deficit to its NEAP-stabilizing level. If the current account does not adjust, the NEAP is likely to grow to nearly minus 80 percent of GDP, raising doubts about its sustainability.

D. Concluding Remarks

20. The answer to a question whether a further correction of the exchange rate is needed is affected by the domestic policies pursued by the authorities. The disparity between the domestic demand in Belarus and its trading partners observed in 2008 and also during the first half of this year fueled the demand for imports and produced strong pressures on the exchange rate. If the domestic demand differential between Belarus and its trading partners is lowered as envisaged under the Fund program and maintained at a prudent level over the medium term, the current exchange rate—perhaps with a small additional correction within the current exchange rate band—could be maintained.

21. The external financing obtained in 2009 has allowed Belarus to mitigate the worst effects of the global crisis, but reliance on external financing to support domestic demand is unsustainable over the medium term. The support of domestic demand through government lending programs and other measures prevented sharp adjustment in the real sector—enterprises escaped shutting down their production and massive lay-offs were avoided. However, it would be difficult to maintain this approach for long if the effects of the crisis on Belarus’ trading partners, most notably Russia, prove to be persistent. In order to regain sustainability, the authorities should address the underlying cause of domestic demand persistence—the system of incentives based on attaining particular quantitative targets, combined with subsidized lending by state-owned banks, which makes traditional channels of adjustment far less effective than in more market-based economies. If the structural rigidities are not moderated, there is a considerable risk of being trapped in the “persistent current account deficit” scenario which would either require exiting the peg or introducing exchange restrictions when international reserves fall to a dangerously low level.

References

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1

Prepared by Dmitriy Kovtun, with input from Shuang Ding and Pritha Mitra.

2

The inflows are as follows: $800 from the IMF tranche, $500 from bilateral borrowing and $625 from privatization proceeds.

References

  • Hu, Z., and M. Khan, 1996, “Why Is China Growing So Fast?IMF Working Paper, WP/96/75.

  • Konuki, T., 2008, “Estimating Potential Output and the Output Gap in Slovakia,” IMF Working Paper, WP/08/275.

  • Oomes, N., and O. Dynnikova, 2006, “The Utilization-Adjusted Output Gap: Is the Russian Economy Overheating?IMF Working Paper, WP/06/68.

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1

Prepared by Shuang Ding, with input from Dmitriy Kovtun, Abdoul Wane, and Pritha Mitra.

2

The Human development index (HDI) looks beyond GDP to a broader definition of well-being. It provides a composite measure of three dimensions of human development: living a long and healthy life (measured by life expectancy), being educated (measured by adult literacy and enrolment at the primary, secondary and tertiary levels), and having a decent standard of living (measured by GDP per capita at purchasing power parity).

3

See Republic of Belarus: Selected Issues, IMF Country Report No. 05/217, June 2005.

4

Supported by government policies, energy intensity, as measured by tons of oil equivalent to produce US$1,000 of GDP adjusted by PPP went down from 0.76 in 1995 to 0.45 in 2004.

5

World GDP growth had been above 3 percent per year since 2003 until the current economic crisis; Russia’s economy grew by 6-8 percent per year during the same period.

6

Until recently, Belarus had been purchasing energy (crude oil and natural gas) from Russia at Russia’s highly subsidized domestic price. The total subsidy on energy imports in recent years is estimated at about $5.9 billion in 2007 and $8.2 billion in 2008. In the absence of these subsidies, energy import costs would have been higher by about 13 percent of GDP in both 2007 and 2008.

7

Preferential loans have been provided to individual citizens since 2000 when the Presidential Decree No. 185 was adopted.

8

TFP is a variable that accounts for effects in total output not caused by inputs. Technology growth and efficiency improvements are regarded as two of the biggest sub-sections of TFP.

9

A doubling of input will lead to a doubling of output.

10

Kt = Kt-1 * (1-δt) + It, where K is capital stock, δ is depreciation rate, and I is investment.

11

Based on data provided by the National Statistical Committee, which are consistent with labor share (0.5) calculated by Oomes and Dynnikova (2006) for Russia, and labor share (0.52) used by Konuki (2008) for Slovakia.

12

Russian firms were exempted from paying Russian export duties on the crude oil they supplied to Belarus until early 2007, when Russia imposed export duties on oil shipped to Belarus, and insisted that Belarus charge its own export duty on refined exports to the West. In 2006, the two country also agreed on a path to bring Belarus’s gas import price to the level Russia charges to its European customers by 2011.

Republic of Belarus: Selected Issues
Author: International Monetary Fund