Ukraine's Monetary Policy Is Shockingly Incompetent

Op-ed in the Kyiv Post, originally published in Russian by Forbes Ukraine magazine

January 10, 2013

Most of the time, the policy of the National Bank of Ukraine (NBU) has not been very beneficial for the nation and its economy, but the present policy represents a low-water mark.

A central bank is supposed to pursue monetary policy with two primary goals: price stability and economic growth. There are additional subordinate aims, such as a sound financial system, the stability of the banking system, the convertibility of bank deposits, the convertibility of the currency, a predictable exchange rate, and the predominance of the domestic currency.

Of all these objectives, the NBU has achieved one—low inflation. Arguably, it is the most important objective, but the current zero inflation suggests it has been overdone at the expense of everything else. The list of failures is disturbing.

The Ukrainian banking system is going from bad to disastrous. At present, Ukraine is unique with its extremely high interest rates of 25 to 28 percent a year. The interest rates are so high because otherwise capital would quickly leave the country, since nobody believes that the effectively fixed exchange rate is sustainable. The consensus view is that it has to be devalued by at least 10 percent because of the large and rising current account deficit. The prices of and demand for steel are falling and steel continues to dominate Ukraine's exports.

With such high interest rates, many borrowers cannot service their debts, and the non-performing loan ratio is astoundingly high at 40 percent of all loans, and rising. This kills the banking system. Most of the large private domestically owned banks went under in the midst of the financial crisis of 2008–09. The Western banks held out during the crisis but now they are fleeing the country. State banks, a couple of oligarchic banks and Russian banks persist, but they are not filling the void.

Absurdly, in the midst of this calamity, the NBU is boasting about the sharp fall in the foreign indebtedness of Ukrainian banks, but that only means that the Western banks are withdrawing their funds from Ukraine, realizing that the country is no longer open for banking business. Furthermore, many Ukrainian-owned banks can no longer obtain foreign credits.

In practice, small and medium-size enterprises in Ukraine have minimal access to bank financing. As a consequence of the weakness of the steel industry and the near absence of financing for small and medium-sized enterprises, output contracted during the second half of 2012. Even Prime Minister Mykola Azarov no longer expects growth in 2013.

Virtually all professional economists urge the NBU to let the exchange rate float more or less freely. Small, diversified and very open economies may peg their exchange rates, but larger economies dominated by cyclical commodity exports, such as Ukraine, need let their exchange rates float.

Rather than accepting the need for a floating exchange rate, the NBU is fighting ever more desperately against devaluation. It has seized monopoly on all payments, possibly eliminating foreign credit cards, such as Visa and Mastercard, and is finally killing off the long-suffering Ukrainian stock exchange, which seems to be about to record another year of a 40 percent plunge.

Another old-style measure has been to demand that half of export revenues get exchanged into hryvnia. That will certainly aggravate the prevalent transfer pricing and connected capital flight to Cyprus.

A truly desperate draft law of an exchange tax of originally 15 percent and now 10 percent on all exchange of currency is being pushed through parliament. This is complete Soviet thinking. Who would transfer any money to Ukraine if this absurd law were passed? Needless to say, all these three legislative novelties are likely to block any financing from the International Monetary Fund.

It is no surprise that the two rating agencies, Moody's and Standard & Poor's, downgraded Ukraine even deeper into junk bond territory in early December. Moody's judgment was devastating. Its key explanation was "a deterioration in the country's institutional strength, against the backdrop of poor policy predictability as well as reduced data transparency."

It complained about "Ukraine's weak track record in carrying out reforms stipulated in the current as well as past IMF programs... ad-hoc administrative measures, in particular on the foreign-exchange market." Specifically, the NBU stopped publishing quarterly updates on external debt redemptions in January 2012.

Is there any silver lining? On a visit to Kyiv after the elections, I asked a couple of wealthy Ukrainian friends what they made money on. They told me that it was all about bonds. They purchased high-quality corporate bonds and had reached returns of up to 40 percent in the last year. Their stories reminded me of Russia in 1997–98 with a pegged exchange rate and enormous bond yields. We all remember how that ended in a devaluation of 75 percent, default on domestic treasury bonds, and a collapse of the bank system.

Ukraine is not in such a bad situation. The state finances are far better and the public debt is much smaller. Yet, the NBU keeps digging a dangerous hole, although it is obvious to all that the current exchange rate is untenable. Ukraine's international currency reserves have shrunk in less than a year from $38 billion to $25 billion, and the capital outflow is accelerating.

At present, the expectation is still a devaluation of 10 to 20 percent, but as the domestic interest rates are currently skyrocketing, the devaluation expectations may do the same. The more the NBU is reinforcing its draconian currency regulations, the sharper the fall of the hryvnia will be when it comes, and it will inevitably come soon. The devaluation may swiftly rise from 10 to 50 percent, because the NBU has minimized the attraction of the hryvnia.

What should be done? First, let the hryvnia exchange rate float. Second, tighten the budget in order to reduce the devaluation. Third, liberalize currency exchange so that people want to hold hryvnia voluntarily. Fourth, clean up the ever-worse banking sector. Finally, this outstandingly incompetent central bank management should be sacked.