Monetary Union Between Belarus and Russia: An IMF Perspective by Director, European II Department, John Odling-Smee
September 2, 20031
Director, European II Department,
International Monetary Fund
September 2, 2003
1. I would like to speak today about an issue of enormous importance for the Belarusian economy—the question of whether and how to join a monetary union with Russia. Although the monetary union issue has been on the table almost from the first days of Belarusian independence, momentum toward this end has picked up during the past two years. As we understand the current plans, the Belarusian rubel will be pegged to the Russian ruble next year, and Belarusian rubels will be exchanged for Russian rubles beginning in early 2005.
2. Belarus is not alone in considering the option of joining another country's monetary area, as witnessed by dollarization in a number of Latin American countries and discussions on monetary union in parts of Africa and the Middle East. Closer to Minsk, your neighbors in Poland and the Baltic countries are well on their way to joining the European Union, and ultimately the euro zone. You may reasonably ask, does it make sense for Belarus to join the ruble zone at this point? To forestall disappointment, let me say at the outset that I will not provide a clear answer to this question in my remarks today. We have studied the issue, and concluded that—on economic grounds alone—it is not really possible to say whether Belarus will benefit from monetary union. The union will provide substantial benefits, but also give rise to significant risks and problems. In that light, we have sought to ensure that the authorities in both countries know what they are getting into as well as possible. We have worked to help them understand—based on the experience of other countries in other currency unions—what policies need to be in place to make a currency union successful.
3. The currency union has raised many questions among policy-makers and the public. This should not be surprising, because the questions are complicated, and they do not all have clear and unambiguous answers. We in the IMF certainly do not have all the answers to these questions, but we have reached the following conclusions that I will develop more fully in my remarks today.
· First, from the standpoint of economic theory, there are both advantages and disadvantages to setting up a currency union between Belarus and Russia. On the one hand, the structure of the two economies is very different, with Belarus and Russia being affected very differently by, say, sudden jumps in world energy prices. On the other hand, a currency union between the two countries could be made to work—if done properly—and in the process provide important benefits to Belarusian producers and consumers. Our assessment of these costs and benefits does not point to a clear-cut conclusion on economic grounds. The arguments need to be weighed carefully by Belarusian policy-makers and the Belarusian public, and the ultimate decision is likely to be taken on political rather than economic grounds.
· Second, there are risks to joining a currency union—as indeed there are with any exchange rate peg. Some fixed exchange rate regimes have done very well, with Hong Kong being an example. But others—and here Argentina's recent history comes to mind—have not been as successful.
· Third, the key to making a currency union successful, given where the two countries are starting from, is a package of very strong fiscal policies and structural reforms in Belarus. Most of the changes that Belarus will need to make in order to ensure that the currency union is a success are those which we in the IMF have been recommending to your government for many years.
· Finally, joining a currency union does not imply an end to relations between Belarus and the IMF. Once they join the euro zone, Lithuania and Hungary, for example, will continue to be full-fledged members of the IMF, as are Ecuador and Panama, where the US dollar has replaced local currencies. In addition to possible lending operations, the IMF would continue to provide advice on economic policies and technical assistance to the Belarusian authorities on a range of issues—as long as Belarus remains a sovereign country.
4. I would like to go into each of these four questions in some detail.
First—"does it make economic sense for Belarus and Russia to form a currency union?"2
5. There are significant potential advantages to joining a currency union. First of all, Belarus would immediately "import" Russian macroeconomic policy. As long as investors do not doubt the credibility of the currency union, Belarus will essentially enjoy much of the positive investor sentiment that now applies to Russia. Inflation will fall to about half of current levels, and this should contribute to growth through increased private sector investment and access to international capital markets. We have seen throughout the transition countries that robust growth generally is not sustained without low and stable inflation.3
6. It is now clear from recent experience in Belarus—as well as elsewhere—that a country cannot indefinitely purchase high rates of real GDP growth at the cost of high inflation. For five years in a row, Belarus has had the highest inflation in the Commonwealth of Independent States (CIS). But in 2001 and 2002, only two CIS countries posted lower growth than Belarus: the Kyrgyz Republic, where a mining disaster caused a sharp decline in gold production, and Uzbekistan, where inflation was almost as high as in Belarus. All of the other CIS countries grew faster than Belarus. Hence, reducing inflation to Russian levels would be a strong signal to investors, both foreign and domestic, and would eventually lead to more rapid and durable economic growth in Belarus. Here I might add that we have advised the Russian authorities to bring down inflation more rapidly than they have been doing. If they were to do this, Belarus would also benefit.
7. A second potential advantage of currency union is the stimulus it will provide to bilateral trade with Russia. Empirical studies of other currency unions have shown that their introduction often produces a significant increase in mutual trade, and thus higher growth rates, owing mainly to reduced transaction costs.4 It would seem reasonable to expect that Russian investment in Belarus would grow, and that Belarusian exports to Russia would expand, once Belarus introduces the Russian ruble. However, it is probably impossible at this stage to make any quantitative predictions about the size of this effect. Russia already constitutes more than 60 percent of Belarusian trade turnover, so it is possible that the impact of this trade creation effect may be less pronounced than it has been in other currency unions.
8. A sharp increase in the pace of structural reforms is the third, and arguably most important, advantage offered to Belarus by a currency union with Russia. We have come to understand, based on our work throughout the world, that fixed exchange rate regimes require tremendously flexible labor and capital markets, an excellent business environment for private investment, and very tight fiscal policies. Your government and the National Bank of Belarus understand this very well, as do the Russians. The authorities of both countries have initialed a joint action plan that envisages a wide range of reforms designed to underpin a fixed exchange rate. These and other reforms would be advisable even without the currency union, as they would promote investment and growth. But the needs of the currency union might be the extra stimulus that will push the government to liberalize the economy fully and curtail its damaging interventions.
9. There are also some potential disadvantages to the currency union. First, according to the traditional theory of optimal currency areas, the members of a currency union should have similar economies, as they would be affected by shocks an a symmetric fashion.5 However, the economies of Belarus and Russia have obvious differences. Russia continues to be heavily oriented toward extractive industries, particularly oil and natural gas, while the Belarusian economy emphasizes processing industry, transportation and agriculture. Economic shocks—such as sudden spikes in energy prices or a severe drought—would seem to affect the two economies very differently. Under a currency union, Belarus would lose monetary policy as a tool for cushioning the blow of shocks that might affect the two countries asymmetrically. It would also give up control over the seignorage the NBB now captures by virtue of being the sole issuer of Belarusian rubels.
10. The theory suggests that flexible markets and substantial amounts of labor, capital and goods mobility can offset the effect of asymmetric responses to shocks. Labor migration can mitigate the impact of these shocks, and the open border between your two countries suggests that this factor may be important. However, we understand that there are significant rigidities in the Russian—and Belarusian—housing markets which may deter migration. Further, there are important differences between the largely privatized retail trade and distribution system in Russia and the state-dominated system in Belarus. These differences may lessen the impact of open borders.
11. Over the medium term, the Russian ruble could appreciate in real terms against other major currencies. Capital inflows to Russia have been very pronounced for some time, and these have put significant upward pressure on the exchange rate. Until recently, the Russian authorities seemed to prefer to accept some excess inflation, rather than risk any adverse impact on exports and industry of a significant appreciation. However, in 2003 we have seen significant real appreciation of the Russian ruble, and—if oil prices stay high and Russia continues to be an attractive destination for investment—there is a chance that the real appreciation will continue. If it does, once Belarus has joined a currency union with Russia, Belarusian industry will face increasing competitive pressure stemming from the higher value of the currency (a problem known as the "Dutch disease"). While this need not be a major problem—indeed, we have argued that the competitive pressure will eventually prove to be salutary for Russian industry—it could be very painful in Belarus. Further, while those regions of Russia that are hard hit by a loss of competitiveness would in principle have access to the Russian system of fiscal federalism, Belarus would not.
This brings me to my second big question—"what risks does the currency union pose for Belarus?"
12. Clearly, the currency union poses no significant risks for Russia. The Russian economy is many times larger than that of Belarus, and it seems unlikely that extending the "ruble zone" to include Belarus would have a significant impact in Russia. Indeed, the only danger for Russia would be if new institutional arrangements for setting monetary policy served to undermine the hard-won independence of the Central Bank of Russia. We have come to see central bank independence as a key element of stable monetary policy formation in IMF member countries, and we are heartened to see that the agreements reached between the National Bank of Belarus and the Central Bank of Russia would do nothing to weaken the status of the latter.
13. Without proper preparation, the risks for Belarus would be more significant. Most obviously, if Belarus enters into a currency union without adequate supporting fiscal policies and structural reforms, the NBB will eventually begin to lose reserves. As NBB reserves are already extremely low, it would not take long for inappropriate macroeconomic policies to lead to a catastrophic loss of reserves, leading eventually to dissolution of the currency union. As we have seen in Argentina and elsewhere, an uncoordinated exit from a pegged exchange rate regime can lead to large output losses and significant social dislocation.
14. The Belarusian financial sector poses a particular risk under a currency union regime. At present, the authorities regularly instruct state controlled banks like BelarusBank and AgropromBank to lend to specific sectors or enterprises, often at subsidized interest rates. The quality of the loan portfolio of banks subject to such political interference is likely to be poor, suggesting that there will eventually be a need to recapitalize and restructure them. Once Belarus enters the currency union, it will be much more difficult to finance the liquidity needs of financial sector reforms. Moreover, under a currency union, the NBB will essentially lose its ability to act as a "lender of last resort"—that is, to provide liquidity to prevent a problem in one bank from spilling over to the rest of the banking system.
My third big question, therefore, is—"what will it take to make this currency union successful?"
15. The short answer is that it will take the same sort of tight macroeconomic policies and deep structural reforms that the IMF has long recommended to Belarus. Indeed, to be prudent, if Belarus enters into a currency union it should probably pursue even tighter fiscal policies than we have traditionally advised. With very low reserves and very high taxes, there is no alternative to significant reductions in government spending. We believe that a sufficient spending decline can be achieved without major cuts in health, education and social spending (though recent work by the World Bank suggests that there are potential savings in those sectors as well). Agricultural spending should be curtailed, road construction could be slowed, and civil service wages could be constrained to grow more slowly. The government's housing construction program—which is now financed by substantial amounts of inflationary, direct NBB credit—could be downsized and restructured to more effectively target housing to the very poorest members of society.
16. The need for spending reductions is only enhanced by the authorities' current plans to reduce the tax burden on Belarusian business. We welcome the attempt to reduce the oppressive burden of taxation needed to finance the largest government sector in the former Soviet Union. However, harmonizing tax treatment throughout the currency union is not absolutely essential. Indeed, tax law is not identical throughout the European Union, nor even throughout the United States. But the much higher level of taxation in Belarus will, at the margin, tend to direct investment toward Russia. Thus, it will be essential to ensure that the fiscal adjustment needed to support the currency union takes place on the expenditure side of the budget.
17. A wide range of structural reforms will be needed to underpin the currency union as well. The agenda in this area is very wide, as evidenced by the fact that the European Bank for Reconstruction and Development consistently ranks Belarus near the bottom of all transition countries in terms of structural reform progress. Let me suggest a few important areas:
· The business environment needs to be improved dramatically;
· Subsidies to the agriculture sector must be sharply curtailed;
· Energy sector reform—including further increases in cost recovery, especially from the enterprise sector—needs to be advanced;
· Privatization and public enterprise reform must be accelerated, and bankruptcy legislation should be improved;
· Financial sector regulation and supervision must be tightened; and finally
· Labor market regulations must be reformed to ensure adequate flexibility. It almost goes without saying that the five-year-plan targets for wage growth in US dollar terms must be abandoned if Belarus is to join the currency union. They are simply unrealistic and destructive of Belarusian competitiveness.
18. These reforms will not be easy. But they are exactly the kind of measures that would be needed to ensure robust economic growth and rising living standards for Belarus over the medium term—the currency union with Russia notwithstanding.
My last big question is the easiest—"will the currency union have any impact on relations between Belarus and the IMF?"
19. The answer, essentially, is no; IMF member countries employ a wide range of exchange rate regimes, from purely floating to currency boards to currency unions. All IMF members have access to our policy advice, technical assistance and financial resources. This does not mean that we would necessarily reach a common understanding about economic policy priorities—so joining a currency union certainly does not guarantee that a stand-by arrangement would be in the offing. But it is worth emphasizing that the fact of joining a currency union would not preclude it either.
20. What exactly is the status of relations between the IMF and Belarus at the moment? The authorities would like to have a stand-by arrangement with the Fund. They feel that an IMF program would provide a positive signal to international investors. It would indicate that we are in agreement with the course of macroeconomic policies in Belarus. In fact, I regret to say, we are not in agreement with the macroeconomic policy stance of the authorities. Although there has been an improvement over the past several years, we have felt that inflation should be brought down more rapidly, supported by tighter fiscal and monetary policies and more aggressive structural reforms. Moreover, the policy of setting unaffordable wage targets in dollar terms is obviously not one that we could support. In other words, ironically, we would like Belarus to adopt policies that are more or less consistent with those needed to make a currency union sustainable.
21. Given that Belarus has a relatively long history of mixed performance under IMF programs, a track record of solid macroeconomic performance consistent with IMF advice would be needed before we could move to a stand-by. We have long been ready to consult with the authorities on the type of policies we could support, and that could lead to a stand-by. In the meantime, as we do in all member countries, we will continue to provide substantial amounts of technical assistance and the best economic policy advice on the key issues the government faces, including whether and how to enter a currency union.
22. On a personal note, I might add in closing that there is some poignancy to my speaking on this topic today. This trip to Belarus will be one of my last visits to the region as Director of the IMF department charged with overseeing relations with the 15 countries of the Baltics, Russia and the former Soviet Union. My tenure in this position has spanned the period from the break-up of the Soviet Union—and its ruble zone—to the possible creation of a currency union—a new ruble zone—between Belarus and Russia. There has been some controversy about the role of the IMF in the former Soviet Union, and the dissolution of the original ruble zone.6 But I would like to assure you that throughout the dozen years of our involvement in the region, the IMF staff has been guided by the objective of helping the people of these countries secure the highest possible standard of living. Throughout this period, we have consistently sought to provide the governments of the transition countries with the best possible advice that the economics profession has to offer. Likewise in Belarus today - it is our objective to provide unbiased, clear advise to you and to your government, drawing on our experience throughout the world. What you do with that advice is up to you.
Blejer, M., J. Frenkel, L. Lederman and A. Razin, eds. (1997), Optimum Currency Areas: New Analytical and Policy Developments, Washington, DC: IMF.
Fischer, S. and R. Sahay (2000), "The Transition Countries after Ten Years," IMF working paper No. 00/30.
Fischer, S., R. Sahay and C. Vegh (2002), "Modern High and Hyper-Inflations," IMF working paper No. 02/197 and Journal of Economic Literature, V40 (September), pp. 837-880.
Frankel, J. and A. Rose (2000), "Estimating the Effects of Currency Unions on Trade and Output," NBER working paper No. 7857.
Gulde, A., E. Jafarov, and V. Prokopenko (forthcoming), "A Currency Union for Belarus and Russia," IMF working paper No. 03/xx.
Mundell, R. (1961), "The Theory of Optimum Currency Areas," American Economic Review, V51 N4, pp. 657-665.
Odling-Smee, J. and G. Pastor (2003), "The IMF and the Ruble Area, 1991-93," Comparative Economic Studies, V44 N4 (Winter), pp. 3-29.
Richardson, T. (2003), " Belarus-Russia Union: Progress Report," Chapter IV of Republic of Belarus: Selected Issues, IMF Country Paper No. 03/119 (April), pp. 41-47.
Schipke, A. (2002), "Belarus-Russia Monetary Union," Chapter V of Republic of Belarus: Selected Issues, IMF Country Paper No. 02/22 (February), pp. 47-57.
1 Paper prepared for delivery at Belarusian State Economic University, September 2, 2003.
2 See Gulde, Jafarov and Prokopenko (forthcoming).
3 Fischer and Sahay (2000) and Fischer, Sahay and Vegh (2002).
4 Frankel and Rose (2000).
5 Mundell (1961).
6 See a set of articles, including one of my own, in a special issue of the journal Comparative Economic Studies in 2003.