Exchange rate correction: adapting the Ukrainian economy to the realities of war

The sharp devaluation of the official hryvnia exchange rate by the National Bank of Ukraine (NBU) on July 21 was both a long-awaited and surprising event.

The national exchange rate has been fixed since the invasion of Russia on February 24. Meanwhile, the national economy contracted by 35-50% in the first months of the war and is expected to fall by a third in 2022 on an annual basis. In addition to the contraction of the economy, the budget quickly accumulated the budget deficit: for the first half of the year it amounted to 405 billion hryvnias (13.8 billion dollars, according to the rate fixed since Vladimir Putin ordered the Russian armed forces to invade Ukraine).

The NBU actively monetized the deficit by buying government bonds. The war stimulated the non-monetary drivers of inflation; a market deficit for certain products, much higher transport logistics costs, great uncertainty and poor market expectations. As a result, the consumer price index reached 21.5% in June, on an annual basis, twice as much as for the whole of 2021.

The certain recovery of economic activity since April, as well as the additional need to import military equipment, caused the acceleration of imports which rapidly depleted foreign exchange reserves. Balancing the foreign exchange market with a fixed exchange rate, the NBU lost $4.8 billion in international reserves during the four months of the war, or 17% of its size at the end of February. In total, the NBU sold $11.4 billion for the period.

Therefore, the NBU tried to deal with macroeconomic imbalances by raising the discount rate to 25% on June 3. However, it did not reverse the flow in favor of hryvnia assets as believed by the banking authorities, with whom they used to justify their decision. . As a result, the exchange rate correction has become inevitable. The only concern has been the timing and magnitude of this change.

On the other hand, the depth of the official devaluation was surprisingly high – the hryvnia/dollar rate rose overnight from 29.25 to 36.57, and the economy lost one of its main points of devaluation. anchoring of inflation, which can further deteriorate inflationary expectations.

The market has since begun to probe the buying capacity margins, which will define the extent of acceptable price corrections. Speculative runs have already started at street counters, where the hryvnia/dollar rate for a week after the devaluation soared, reaching 41₴/$1, and even more, at one point.

A certain optimism, concerning the limited influence of devaluation on the rate of inflation, may follow a sharp fall in the incomes of consumers who have been affected by the war. Additionally, “speculative money” was restricted during the hype mentioned above. However, the general shift in the price list cannot be avoided due to the correction of costs involving imported components.

The positive effects of devaluation predominate

The latter resolutely discharged the maintenance of the fixed exchange rate. In July, the NBU was able to purchase foreign currency to fill its reserves to the tune of $900 million. The budget will benefit from import taxation (import VAT and import duties were reinstated on July 7 after being suspended at the start of the war).

International aid received by Ukraine is becoming much larger in its hryvnia equivalent and exporters now have a chance to improve their financial situation as the NBU has most likely coordinated its movements to coincide with the release of grain exports from Ukrainian Black Sea ports. Domestic producers should benefit from less pressure from imports, which means that more resources can be targeted towards local manufacturing.

The headquarters of the National Bank of Ukraine in Kyiv.

Losing price competitiveness in the market for finished products exported to Ukraine, foreign partners could benefit from growing demand for equipment, processing of agricultural products, locally supplied utilities – water, energy supply and heating – as well as other goods and services that will be needed once the territories occupied by Russia in the east and south of Ukraine have been liberated.

While developing its policy, the Ukrainian government should mitigate potential devaluation risks and accelerate its expected positive impact on short-term growth and local incomes. Its main priorities should be: the promotion of exports, cooperation with its European partners to solve transport problems and bottlenecks at borders; the forced resumption of domestic production (this may include the resumption of foreign direct investment inflows into relatively safe regions that are covered by appropriate international insurance instruments); efficient allocation of increased budget revenues for proper service of social payments and salaries in the budget sector; domestic sales support; and investments in the recovery of damaged assets.

Recent measures taken by the NBU, including sharp increases in discount and exchange rates, facilitate the task of institutionally improving Ukraine’s monetary policy. By relying on rational reactions common to quantitative monetary regulations in times of war, the bank risks more unexpected hyperreactions from economic agents, which can aggravate macroeconomic imbalances.

The NBU should be more predictable at a time when the country faces the largest and bloodiest invasion from Europe since World War II. Its communication with the government must allow for consolidated complementary policies instead of consecutive ad hoc reflexive reactions.

Christi C. Elwood