Alarm bells have been going off in Belarus, which may be cut off from the generous Russia has granted the republic for decades. Like with so much in Central and Eastern Europe (CEE), it began with energy: the Russian reform of its oil sector – known as the “tax manoeuvre” – paved the way for the abolition of export duties over 2019-2024, offsetting the cost through tax increases elsewhere.

Minsk has been seriously worried by the proposals. Given that the country was enjoying tariff-free oil exports from Russia on account of their privileged trading relationship, the tax manoeuvre winds back a subsidy of the Belarusian oil sector. Estimates of the costs to the Belarusian budget by 2024 range between $8-12bn. The state-owned sector, which is dominated by energy-intensive industry, is already overleveraged and could take a hit.

Negotiations over bilateral economic issues began in the summer, but despite agreements in other areas, Moscow held out on the tax manoeuvre. Once tabled in the autumn, Minsk demanded, with increasing anger, compensation; to, which Moscow responded – with typical legalism – that any such compensation would be conditional on deeper integration, as stipulated in the terms of the 1999 “Treaty on the Union” between Belarus and Russia.

After a series of heated exchanges, during, which Belarusian President Alexander Lukashenko warned that Russia was risking its only remaining Western ally by threatening its sovereignty, a more conciliatory tone was struck: in February, Lukashenko remarked that unification could be achieved with ease on the technical level, but questioned the popularity of such a move.

The signals were mixed, to say the least, reflecting first and foremost the increasingly volatile interdependence between Russia and Belarus. In this sense, the flaring tempers were just another episode of post-Soviet theatre.

Neither side is likely to initiate a full “political merger”. Moscow, in particular, rarely prevaricates when taking sweeping external policy moves, as its actions in Georgia and Ukraine demonstrated. Therefore, reasonable doubt exists that talk of “unification” is nothing more than a distraction. Nonetheless, negotiations show that Russia and Belarus are facing a strategic juncture in their relations. If Moscow is serious, Minsk is between a rock and a hard place; Russia remains by far its most important trading partner and foreign investor, making any radical rupture (such as Belarus leaving the Eurasian Economic Union) highly unlikely.

Minsk must choose between sacrificing its prized sovereignty for money or accepting a period of economic weakness. More likely, the choice will not be so black and white; the economy in Belarus may suffer in the 1-2 year outlook, but Moscow will ultimately compromise, accepting technical preparations for integration that will keep its geopolitical options open. Indeed, Minsk may be prepared accept a period of economic challenges, with its extensive experience in muddling-through and crisis management. Moreover, we expect that following a dampening in growth, Belarusian GDP will recover to the extent that it will outpace Russia, amounting in 2020 to at least 10% higher in real terms compared to 2015, compared to Russia’s 6%.

Natural partners for “economic & political merger”?

Technically speaking, deeper economic integration could occur between Belarus and Russia with relative ease. However, the long-term economic and political incentives are less clear.

At first glance economic integration could make sense given the extent to which Belarus relies on Russia for its oil and gas, as well as its domestic market.

If “direct investments” from Cyprus are included, it is clear that Russia dominates the foreign direct investment stock in Belarus (60-70%). Similarly, Russia accounts for 50-55% of its foreign trade. Closer integration with Russia could also resolve Belarus’s chronic currency and balance of payments crises.

However, in the long-term Belarus and Russia’s economic structures are insufficiently complementary such that much additional value could be created. Mineral raw materials are the dominant export and import commodity in Belarus and, of course, the dominant export commodity in Russia. In this respect, further integration would not bring many additional trade gains. So even in view of Russia’s economic dominance, it cannot control Belarus with economic "soft power" alone.

Minsk’s policy trajectory has increasingly been to position itself opportunistically between West and East with respect to trade and foreign affairs, and has little incentive to stop.

The Russian economy is currently showing little dynamism, weighed down by stagnation and isolation. Minsk is clearly determined to chart its own political and economic course, having adopted stability-oriented economic policies, as well as some liberalisation measures, limiting the risk that it would require large-scale assistance from Russia. Nonetheless, Minsk is confident that it still enjoys an effectively explicit Russian guarantee to extend support if needed.

This confidence is reflected by leading ratings agencies and current market pricing, which show that Belarus is regarded more as a Russian risk rather than an economically unstable country on the verge of bankruptcy (such as Ukraine, Egypt or Pakistan). Indeed, although leading rating agencies rate Belarus and Ukraine almost equally, longer-term Ukrainian dollar-bonds currently yield about 9%, while Belarusian bonds yield about 6-7%. Russia, in comparison, ‘only’ has to offer a yield of 4-5%. There would need to be considerably greater economic upside before Minsk agreed to a full-scale economic integration or common currency with Russia, or other such strategic convergences.

All in all, the coming 2-3 years will be crucial to gauge whether unification could become more realistic at a later stage – most likely before the 2024 Russian election, when Vladimir Putin may seek a way to bypass presidential term limits.

However, we assess that the political will for “unification” only exists insofar that it allows both sides to engage in geostrategic hedging. It is noteworthy that a full “political merger” is not on the table; the Treaty on the Union invoked by Moscow only envisions steps towards a single currency and common tax, customs and courts.

Even this is fanciful: integration is expensive, especially if it entails fiscal transfers, as the reunification of Germany demonstrated – and unlike West Germany, Russia is not in an economic position to finance a state-building project. As was the case with the GDR, ‘official’ data, self-delusion and propaganda might be concealing the true economic picture in Belarus.

Moreover, unlike in Germany, popular support for unification in Russia and Belarus is simply lacking. Indeed, civil unrest risks would likely increase in Belarus. Putin could surely identify less politically and financially costly ways to stand for re-election. After all, the Russian president in particular is more than aware of the economic, social and political aspects that continue to divide former West and East Germany today.

A more likely scenario is that Moscow will entertain piecemeal initiatives in order to shield its remaining economic influence in Belarus, mindful of its loss to China and the EU in Central Asia and Ukraine, respectively. Minsk will resist anything beyond this: why an authoritarian leader such as Lukashenko would consent to relinquishing any significant powers to a supranational body is unclear. Moreover, with a “political merger” Lukashenko would expose himself to the “Putin Succession Conundrum” that Russia will face sooner or later.

Risk outlook

We assess that investment risk is unlikely to be significantly impacted by the most realistic scenario with respect to (no) unification; namely, technical preparations for deeper integration in some areas. At the current stage, we do not expect that this will extend beyond closer cooperation in customs in order to better control, for example, re-exports of sanctioned EU products to Russia via Belarus.

The establishment of a supranational court would coordinate their legal and regulatory systems but it is not clear that this would necessarily lead to deterioration in investment risks in Belarus.

The imposition of a single currency could have some long-term benefits for Belarus, but is highly unlikely as long as Russia and Russian markets are targeted by Western/US sanctions and Belarus continues to pursue stability-oriented economic policies. 

More generally, Minsk is highly unlikely to agree to any unification measures that somehow subordinates Belarus to Russia in practical terms. There would have to be very significant incentive, which Moscow is not in a position to provide. The status quo in relations - interdependency with opportunistic geostrategic diversification by Belarus in certain areas - is likely to persist.

Negotiations, with occasional theatrical flourishes, will persist in the 2-3 year outlook, especially given that Belarus is due to hold presidential and parliamentary elections in 2020. If significant steps are taken towards unification, political instability and civil unrest risks would likely rise in Belarus.