Tuesday, September 2, 2014
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Ukraine’s Dollar Addiction

KYIV – Inflation in Ukraine is skyrocketing. By March, it reached 26% per year and continues to rise. Although prices are increasing around the world, Ukraine’s inflation is extreme, twice as much as in neighboring Russia. Amazingly, instead of dampening inflation, Ukraine’s central bank is stoking it.

Ukraine’s prices started spiraling out of control around the time when Yuliya Tymoshenko returned as prime minister last December. Malicious observers suggest that she is to blame for pursuing populist social expenditures. But this is false. Her government actually tightened the budget just before New Year. Indeed, Finance Minister Viktor Pynzenyk reports that the state recorded a budget surplus of 0.6% of GDP during the first quarter of 2008.

This is not surprising, because state revenues expand with rising prices, while expenditures are largely fixed. But Tymoshenko’s government has, in reality, done a solid fiscal job. State finances are generally in good shape, with public debt at just 11% of GDP. According to the National Bank of Ukraine (NBU), international reserves have grown steadily and now stand at $33 billion.

The real cause of Ukraine’s inflation is that its currency, the hryvnia, remains pegged to the US dollar. When the dollar falls in value, as it has, Ukraine’s very open economy imports inflation. In the last year, the dollar’s value dropped by 12% against the euro, which is a more important currency than the dollar in Ukraine’s foreign trade.

The International Monetary Fund has persistently warned Ukraine that its dollar peg could cause a financial crisis because of over- or undervaluation, and for years has called on Ukraine to free its exchange rate. But the NBU refused to do so – making Ukraine the last country in Central and Eastern Europe to tie its currency to the dollar.

Ukraine’s powerful industrialists praised the NBU’s low exchange-rate policy, believing it makes the country more competitive. They ignore the fact that the NBU can control only the nominal appreciation of the hryvnia. But costs are determined by the real revaluation, which is the sum of exchange-rate changes and inflation.

The dollar peg has also forced the NBU to pursue a loose monetary policy. Ukraine’s current refinance rate is 16% a year, 10% less than inflation, which means that Ukraine has a negative real interest rate of 10% a year. As a result, Ukraine’s money supply, M3, exploded by no less than 52% in the last year, which points to inflation hitting 30% soon.

The NBU’s leadership understands that it must act to contain inflation, but its insistence on the dollar peg ties their hands, because it prevents them from raising interest rates sufficiently. Instead, they have reverted to strict reserve requirements, effectively rationing credit and thereby causing a domestic credit squeeze in the midst of the current international financial crisis, which is likely to force some medium-sized banks into bankruptcy because of liquidity problems. Rationing is always worse than a market.

Why does the NBU persist with this harmful policy? Incompetence is one reason, but politics is probably the decisive cause. The NBU is subordinate to President Viktor Yushchenko, who, despite naming Tymoshenko as prime minister, seems more interested in harming her politically than in capping inflation.

The flaws in the NBU’s policy are so obvious it will be forced to free the exchange rate, but it might act too late. Even now, in the midst of an inflationary crisis, the NBU wants to move in small steps, evidently failing to grasp the severity of the crisis. The NBU needs to announce that it no longer has an exchange-rate target and that it will stop intervening by ending its purchases of dollars on the currency market.

If the NBU lets the exchange rate float, Ukrainians are likely to exchange billions of dollars into hryvnia, driving up the hryvnia exchange rate. That would contain Ukraine’s inflation, as the NBU could restrict the money supply through high interest rates rather than rationing.

Time is short. The great economist Rudi Dornbusch used to say that a financial crisis usually starts much later than anyone expects, but then develops faster than anyone can imagine. Ukraine is on the financial precipice.

Yushchenko and the NBU can still act, but if they do not do so immediately, a costly and unnecessary financial crisis might ensue. As prime minister, Yushchenko saved his country from financial default in early 2000. Ukraine’s well-being must not be sacrificed to his political ambitions.

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