Ben Aris in Moscow -

Surrounded by booming economies, Belarus is finding that a market economy is seeping into the country despite the best efforts of "the last dictator in Europe."

There is a strong argument for making the transition to a market economy slowly. At this year's EBRD annual meeting, Joseph Stiglitz said: "Looking back, it is now clear that the IMF advice to proceed with transition quickly was a mistake. Our data shows that the countries that moved more slowly have done better."

Belarus President Alexander Lukashenko has taken this go-slow approach to an extreme, but there have been some benefits. While young Belarussians flee the country at the first opportunity, the old are the only pensioners in Eastern Europe to have largely escaped the pain of transformation. This has gifted the autocratic leader with a strong political base.

Despite Lukashenko's idiosyncratic approach to economics, Belarus has been attracting rising amounts of foreign investment – much of it from Russia – as one of the last untouched markets in Eastern Europe.

The most recent sign of this was the announcement on October 23 by South Korea's Samsung Electronics that it is considering building an assembly plant for audio and video appliances in Belarus.

Yet this was only the latest of a string of deals to be announced over the past 18 months – contacts with the outside world that are causing market mechanisms to percolate through the economy.

Refining Russian oil and transporting Russian gas remain the biggest businesses in the country and provide the government with a huge subsidy to keep the show running. However, Russian businessmen have been targeting telecommunications, retail and banking in the past year as the economy continues to improve and average incomes rise at a steady, if unspectacular, pace.

For most of the last decade the Kremlin has been content to ignore its crass cousin and only rolls out the prospect of uniting the two countries ahead of every election, which plays well with the voters.

But things changed this year and the Kremlin is now forcing change on the small republic to its west.

Moscow has announced it will increase gas prices for Minsk in line with price hikes to all the former Soviet vassal states as Gazprom effectively ends the Soviet energy subsidies and tries to impose market conditions on its neighbours. While the decision to cut off gas to Ukraine last winter after it refused to accept a doubling of prices made headlines around the world, the Belarusian price hike went largely unreported. Currently the republic enjoys the lowest prices in the CIS, paying a mere $47 per 1,000 cubic meters, but Gazprom officials are now demanding $146. The only reason why the price has not been raised so far is that the Russian gas monopolist is negotiating to take over the Belarusian gas pipeline company Beltransgaz in lieu of the price hike.

The next blow came in May when President Vladimir Putin announced that Russia was cutting off all economic aid to Minsk. Putin ordered a halt to, "all subsidies to Belarus, direct or indirect, and all forms of re-export or contraband in Russian goods."

Banking on change

The Kremlin is certainly turning the screws, but it is unclear if this is simply part of the general attempt by Moscow to move from Soviet-era economic relations to market-based ones, or if it is actively applying pressure to open the Belarusian economy to Russian business.

Although the republic is a European pariah, it is also the fastest growing economy in the region, albeit from a very low base. Gross domestic product was officially $30bn in 2005, compared with Russia's expected $1 trillion this year, and the country put in 9.2% growth in 2005 and 10.1% on year between January and June this year.

While industry, and particularly machine building, remains the mainstay of the economy, the new consumer-related sectors are playing an increasingly important role: consumer goods production was up by about 9% at the end of 2005 year-on-year and foodstuff production was up 13.2% over the same period. And retail turnover was up a whopping 19% over the first quarter of this year.

The growth is reflected in the growing strength of the Belarusian banking sector. This summer, Fitch ratings agency confirmed the 'B-minus' rating of the republic's biggest bank Belarusbank (BBK), which is 73.2% owned by the Ministry of Economy and 26.5% owned by executive committees of Minsk and the six local regions, saying it can now stand on its own feet and its rating no longer relies on the state's backing.

"BBK's improved stand-alone financial strength reflects the bank's strengthening franchise, extended track record of sound asset quality and greater funding diversification. The stable funding base is also a rating positive for the bank. At the same time, the ratings also reflect the bank's challenging operating environment, including the high level of actual and potential government influence on its operations, modest profitability and capitalization and the low loan-loss reserves," Fitch said in its statement.

A month later, Belpromstroibank, originally a construction bank that has a diverse corporate client base and a rapidly expanding retail business, was also upgraded by Fitch to 'D/E' from 'E'. The agency cited the bank's "strengthened franchise, continued track record of sound asset quality, improved earnings performance and greater funding diversification" as reasons for the upgrade.

The country already boasts one foreign bank, Priorbank, which was set up as a joint venture with Raiffeisen International in 1989. The Austrians own 61.3% of the bank, the EBRD holds a 13.5% stake and the remaining 25.2% is owned by private individuals connected to Lukashenko.

Now the big guns are moving in as the bank sector gathers momentum. In the same month as Putin said he was cutting off Belarus' subsides, Andrei Kostin, the CEO of Vneshtorgbank (VTB), was in Minsk to announce a deal to buy additional shares in Belarus' Slavneftebank.

"We're interested in such a large bank as Vneshtorgbank coming to Belarus. We're also interested in its investment projects," Lukashenko said at a meeting with Kostin. "Foreign bankers want to work in Belarus a lot, but we want to cooperate with our own folk."

VTB increased its stake in Slavneftebank to over 50% and plans to develop the oil refining specialist into a universal bank investing in Belarus' banking, oil processing, electric power, real estate and agriculture sectors.

Politics played a big role in this deal, as Slavneftebank is also partly owned by the Belarus state oil company Belneftekhim, the Belarusian refinery Mozyr and the Russian oil company Slavneft with 9%.

After the fall of the Soviet Union in 1991, among the assets that the new republic found itself in possession of were two of the most modern refineries in the bloc: the Mozyr and Naftan refineries. Russian oil companies fight over the chance to process their crude in Belarus because it is both efficient and highly profitable.

However, banking is attractive in its own right. In June, the CEO of Russia's biggest bank Sberbank, Andrei Kazmin, said he was also considering investing in Belarus. "We have received proposals from several Belarusian banks and are considering them now," he said.

Several commercial banks have also made the move. Russia's biggest privately owned retail bank Rosbank raised its stake in Belrosbank to 99.9% from 76.9% in September. The Russian bank has been increasing its share of the Belarusian bank steadily all year from a starting point of 57%.

Belrosbank was registered in 2003 and has an authorized capital of BYR18bn (€6.7m). The Bank specializes in loaning to enterprises in the manufacturing and energy sectors, including Belarusian power plants. Power Machines OJSC and SP IPK Yarovit (Belarus) were the co-founders of Belrosbank.

Power Machines is partly owned by Rosbank's parent Interros and has been using Belarus as a base of operations. In addition, the heavy engineering company has won some attractive orders from the government, the most recent of which was to build an additional turbine for the Lukomi thermal power plant in October.

And Kazakhstan's top-three bank and the 10th largest bank in the CIS, Bank TuranAlem (BTA), is also in the process of increasing its 49% stake in Belarusian bank AstanaEximBank as part of its strategy to build a pan-regional banking giant.

Industrial investment

Clearly Russian interest in Belarus' banking sector is linked to both politics and industrial ties left over from the Soviet era. Politics of a different kind have driven the biggest investment, which is in the automotive sector.

In August, an automotive assembly plant set up as a joint venture between Belarusian auto producer Yunison and Iranian auto producer Iran Khodro Industrial Group went into operation. It will assemble Iran's Samand cars in Belarus. The initial production run will be 800 cars this year, rising to 6,000 next year and eventually to 60,000 by 2014, according to Alexei Vaganov, the joint venture's general director. The plant will provide cars for the domestic market, but eventually the plan is to export to other countries in the CIS.

The country's other automotive producers are also doing well, thanks to Belarus' gradual integration into the regional market. The output of Belarusian state-owned tractor manufacturer Minsk Tractor Works, or MTZ, rose 15.5% year-on-year to 36,908 units between January and September and exports last year were up 13% to 35,000 units.

And the bus maker MAZ has seen production soar in the last year after its output almost doubled to 689 units between January and May. The company hopes to almost double its product again over the rest of the year to 2,500 units, exporting most of the increase to the Russian market.

With raw materials, politics counts for little and here is where Belarus has cast its net widest. In August, Russian oil companies Russneft and state-controlled oil major Rosneft said they may finance the upgrade of the Krichevtsementnoshifer cement plant, which needs a new oven worth $35m. But the biggest deal so far was one signed between the Belarus Potash Company (BPC) and China for 1.7m tonnes of fertilisers worth an estimated $1.1bn.

BPC is a 50-50 joint venture between Belaruskali, the world's second largest producer of potash fertiliser, and Russia's Ukralai, the world's biggest fertiliser company. BPC is also setting its sights on taking over Russia's second largest potash fertilizer producer Silvinit by the end of 2006 or in early 2007, according to Vladimir Semashko, first deputy prime minister of Belarus.

Shopping for business

The last frontier is that associated most closely with the West and includes the retail, media and telecom sectors.

In the telecom sector, MTS, Russia's leading mobile phone operator, was an early arrival and operates in a joint venture with the Belarusian telecom ministry. The franchise already had 2.5m users as of June and MTS would like to expand, but the government turned down an offer of $1bn for its 51% stake last year.

For years the only nod to bourgeois consumerism was the sole McDonalds restaurant on Nezavisimaya Prospekt; Belarus was the 100th country to be blessed with the golden arches. But in the last few years it has been joined by the enormously popular Patio Pizza, a Russian chain owned by Rosintern, as well as a few of their other chains like El Rincon Espanol.

Now the Russians are also moving into the shopping sector. In July, Alexander Zaribko, a shareholder of Russian retail discount store network Victoria Group, bought Belarusian retail chain Rublyovsky, which consists of 15 supermarkets, in a deal worth an estimated $5m.

Cyprus-based Detroit Investments, the former owner of Russian brewery Pivovarni Ivana Taranova (PIT), plans to establish a chain of 20-30 discount stores in Belarus under a new brand jointly with the International Finance Corporation (IFC) and Lithuanian company Palink, which owns the Iki retail chain.

In August, one of Russia's leading supermarket chains Seventh Continent bought half of Belarus' Prostoremarket retail company for $5m, a month after the company opened the Prostore hypermarket in Minsk.

Perhaps the most ambitious project is the plan of Renova Media Enterprises, the media arm of Russian tycoon Viktor Vekselberg, to bring cable TV to the Belarusian capital.

Vekselberg bought a 100% stake in the holding that controls half of Belarus' cable operator Kosmos-TV from a group of private investors. The remaining 50% belongs to the state-owned Belarus Radio and TV Broadcasting Center. Kosmos-TV has more than 75,000 users.

With deal valuations on the order of $5m, Minsk is not going to be become a magnate for high-rolling investment bankers anytime soon and no one is expecting the country to boom just because there is some investment trickling in. However, by letting in the businessmen, Lukashenko has begun the process of creating a middle class that will eventually form the grassroots of a political movement and likely start to hold the government more to account. This process can, and will, take years if not a decade, but the investments of the last 18 months have at least begun to prise open the door to prosperity and perhaps even eventually democracy.

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