Energy Deals Undermine Belarus Economy

The new oil and gas agreements with Russia will hurt export manufacturing, boost the trade deficit, and transform Belarus into a less productive "rent seeking" nation

The new oil and gas deals with Russia will undermine the foundations of Belarus' economic success.

Moscow's decision to start charging Belarus world market prices for energy is one of the most dramatic events in the recent history of the former Soviet republic.

The natural gas deal agreed between Russia's Gazprom energy supplier and Belarus on 31 December means that Belarus' old, deeply discounted rate of less than $50 per 1,000 cubic meters will double in 2007 and continue to rise over the next five years to the price paid by Western European customers.

The new oil arrangement will also cost Belarus plenty. After Russia shut down the Druzhba pipeline, which supplies Belarus and several other countries with Russian oil, in early January, Minsk agreed to pay a duty of $53 per ton on Russian crude used in Belarusian refineries.

Until this month, Belarus probably saved around $4 billion to $5 billion per year on the difference between market energy prices and the discounted rates Russia charged, a sizeable share of its $30 billion national product. This was the main source of the famed stability of that unreformed economy. The sharp reversal of these terms does not yet mean the imminent collapse of the Belarusian economy and the Lukashenka regime with it. What it will do is shatter the myth of the "Belarusian economic miracle" and make plain what the Belarusian economy has always been - an unprofitable one-company enterprise surviving from extracting monopoly rent from its geographic position.

MADE IN THE USSRTo see why these events are so important, one must understand just how peculiar the Belarusian economy is.

Belarus is a rare case of a country whose economy is almost entirely artificial. Most countries' or regions' economies have evolved in line with local factors such as natural resources, land, labor, capital, or conditions that promoted the growth of entrepreneurship and industry. Until the 1940s, Belarus, too, was such a place, naturally evolving in the agricultural and transport, but not manufacturing, sectors.

After World War II, however, Soviet central planners picked Belarus to be the union's assembly line and chemical plant. Belarus became a specialist in turning parts and energy into finished goods. Far from natural resources and makers of the parts used in its assembly factories, Belarus was not a natural location for such a massive industrial complex. It would not have emerged in the conditions of a market economy and was only possible in the planned economy of the Soviet Union, when nobody expected it to break up. When the USSR suddenly collapsed, the economy of Belarus, one of the most advanced among the Soviet republics, also became the most vulnerable. This predicament, well understood by Alyaksandr Lukashenka, became the dominant factor that determined the new nation's post-Soviet development.

Politically, the postwar years that transformed a humble peasant land into an industrial powerhouse became the golden age in eyes of many Belarusians. A curious national identity began to take shape at this time - an identity that combines a sense of proud difference from the country's Slavic neighbors with pride in belonging to a non-Western brotherhood.

The purely economic effect of the Soviet industrialization drive was even more important. Belarus' trade dependency, or the average of its exports and imports as a percentage of GDP, is about 60 percent. An economy with a trade dependency like that must ensure that its exports increase in line with imports. When the country's jury-rigged economic engine starts to misfire, though, incomes suffer, unemployment rises, and unrest begins. This is precisely what happened in the early 1990s to bring Lukashenka to power. Elected on a wave of discontent, he knew that his political survival depended on his ability to maintain the advantageous deals with Russia by any means. This required his personal control over the entire value chain, from purchase of materials to sale of output.

Accomplishing that has not been hard: also thanks to Soviet industrial planners, the entire economy is represented by a handful of very large enterprises, organized into ministries whose directors report to the president. These enterprises, including Belneftekhim (petroleum and chemicals), Minsk Tractor Works, Minsk Automobile, the Belaz heavy trucks works, and the Azot chemicals concern, employ hundreds of thousands and produce more than four-fifths of the Belarusian GDP. Belarus' economy is a Fortune 500-size holding company, with the president as CEO.

GROWING THE COMPANYThe former state farm manager-turned president Lukashenka proved a talented business magnate. He personally set salary levels, arranged credit, and appointed and removed line managers during hot-tempered conference calls. But his main achievement was the remarkable deals he struck with the country-company's main suppliers and customers.

Belarus Inc. went through two distinct stages. In the first, from the mid-1990s until around 2003, it restored its Soviet roots. Exports and imports increased, incomes stabilized, albeit with some trade deficit, and investment was minimal. Just as before 1991, imports and exports were mainly to Russia. Fueled by subsidized gas and oil acquired at the same prices paid by their Russian competitors, state-controlled Belarusian factories avoided much of the turmoil the Russian economy endured and maintained a degree of competitiveness in the Russian and eastward trade.

Starting from around 2001, and gaining full speed by 2004, Stage 2 kicked in. Although exports and imports, as well as GDP, continued to rise, things were changing. The positive trade balance with Russia reversed and has continued to fall, as goods made in Belarus were no longer valuable enough to offset the price of inputs, due to both the rising cost of inputs and the increasing competitiveness of goods made in Russia and other countries, in the eyes of Russian consumers. Exports to the West, however, increased dramatically thanks to refining duty-free Russian crude and reselling it to the West at ever-climbing market prices.

The second stage proved much more lucrative than the first: oil revenues were shared between the profits to Belneftekhim, the refining conglomerate, and duties to the state. The state budget could then be tapped to subsidize other, loss-making, subsidiaries of Belarus Inc. GDP grew at record pace, investment increased, incomes rose and the myth of the Belarusian economic miracle was born.

TOLL BRIDGE BETWEEN EAST AND WESTThe myth ended in the two weeks after New Year's Eve, when the discounts on Russian gas were reduced and oil discounts eliminated. The new trade terms with Russia are carving away at the foundations of Belarus' successful trade models. The gas price hike hits the manufacturing sector, making it even less competitive in the Russian and CIS market, where most of its products go and where it can compete only on price. The new oil deal will slice away most of Belneftekhim's profits - the $53-per-ton duty nearly cancels the $60- to $70-per-ton profit the refiner used to enjoy thanks to duty-free crude and means a dramatic loss of tax income to the state budget. In addition, the deal obliges Minsk to hand over to Russia the bulk of the customs duties it collects on refined oil products made from Russian crude.

It is probably too early to make a reliable forecast of the economic, and hence political, effects on Belarus. In the short term, the country does not necessarily stand to lose the fiscal windfall the Russian subsidies provided. Even if the ownership of the gas and oil pipelines passes to Russia entirely, the country still has the main source of its bargaining power - sovereignty over its land, which allows it to impose customs duties or transport tariffs on gas and oil passing through its territory.

Since about 20 percent of Russia's gas and half of its oil supplies to Europe pass through Belarus, this is a strong bargaining position, at least until Russia develops alternative routes like the Baltic Sea gas pipeline direct to Germany.

If Minsk manages to avoid provoking Moscow into imposing import tariffs on all Belarusian goods in the future, it can continue to enjoy what amounts to Russian subsidies to its industries.

However, the effects of the new trade terms will still be significant and could extend beyond the economic sphere.

Their main result would be to replace price subsidies to working factories with direct cash transfers into the state budget. This was already evident in the second stage of Lukashenka's Belarus Inc., when the trade balance with Russia began to deteriorate with Belarusian products increasingly unwanted there, leading to a shift in Russian support for the Belarusian economy from money to enterprises to the direct inflow into just one enterprise, energy refining, and directly into the state budget in the form of customs duties on refined products.

On the gas side, the government has already said it will pass on the price increase to enterprises. On the oil side, Belarus will receive some duty income from the Russian crude, but the refineries will become much less profitable.

As a result, the losses in the productive sector would become apparent, and the phenomenon economists call "rent seeking" become more and more entrenched. Rent seeking means getting value out of economic transactions without producing more goods and services. For Belarus, that means the economy will become dependent on extraction of payments for gas and oil flowing through its territory, a literal version of the popular vision of Belarus as a "bridge between East and West," a toll bridge in this case.

A rent-seeking nation is typically associated with a culture of entitlement and with falling productivity as money flows into the state budget although no value has been created. Middle Eastern oil states are the classic example. Such states are rarely governed by democrats. In Belarus, as money keeps flowing into state coffers it could mean further strengthening of the president's position as distributor of the proceeds.

That Belarus Inc. is unprofitable is evident from the balance of payments: the country's trade deficit is roughly equal to 5 percent of its GDP, higher than the global average.

This means the country is losing that amount a year in profits from its import-export business, even with the energy discounts. If the energy were purchased at market prices, this deficit would be 20 percent or more. Revenue from exports is simply not enough to cover the costs, including the salary raises promised and delivered by the president.

Belarus could still set its sights on becoming a successful trading economy run by authoritarian means - similarly trade-dependent Singapore or Malaysia come to mind. But knowing the ways of the Belarusian leader, unless Russia finds the stomach for a total trade war, Belarus can probably go on for some time before its economy needs a complete overhaul.