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Friday, May 23, 2008

Monetary Chaos Breaks Out at the Ukraine Central Bank

by Edward Hugh: Barcelona

Does anyone happen to know offhand the "official" dollar rate of the Ukrainian currency, the Hryvnia? I am asking this question since clearly over at the central bank they are having difficulty deciding at the moment, since - like the legendary character Hydra - they seem to be speaking with two "heads" at the same time, and the only question I can ask is: would the real representative of the Ukraine central bank please stand up!

This issue unfortunately is neither a small nor a comic one, since Ukraine is currently running a 30% plus annual inflation rate, and letting the currency rise against the dollar is one of the few serious anti inflation policies anyone has on the table at the present time.

Essentially the story to date is that the Ukraine central bank had been keeping the "official rate" for the national currency - the Hryvnia - at 5.05 to the dollar (within a broader target band of 4.95-5.25) since August 2005 - although traders have generally been saying that the bank effectively stopped intervening around February-March. However during the last 24 hours the "official rate" has become a highly contested issue, with one part of the bank's monetary policy structure suggesting that the official rate has now been revalued to 4.85 to the dollar, while another part is denying this and maintains the rate is still 5.05. Basically one part of the structure is challenging the right of another to take decisions.

Of course the reaction of the financial markets to this state of affairs is not that hard to predict (at least in the immediate term), and Ukraine's hryvnia fell the most against the dollar in a single day in over eight years yesterday, falling 4.01 percent on the day to trade as low as 4.7875 per dollar by 6:04 p.m. in Kiev, down from 4.5550 late Wednesday, making it the worst performer among the 178 global currencies being tracked by Bloomberg yesterday.

The fall at this point may, however, be more part of the internal tussle which is taking place in the bank itself than any knee-jerk financial markets reaction (although that could well be to come as central bank credibility at this point must be tending towards zero), and a according to Agata Urbanska, an emerging-markets currency strategist in London at ING Bank "They (the central bank, or part of it) are back in the market................This is all about the central bank weakening the currency.''

The latest incident is only one more episode in a long term tug-of-war which has been going on inside the central bank (and of course, inside the Ulraine parliament itself, since, it will be remembered, President Viktor Yushchenko was recently physically prevented from giving his state-of-the-nation address before parliament by legislators loyal to Prime Minister Yulia Tymoshenko who blocked access to the speaker's chair). The immediate problem started on Wednesday when Ukraine`s central bank board (note here the key term board) announced that it had decided to strengthen the official rate of the hryvnia to 4.85 to the dollar from the previous level of 5.05.

This move was not entirely unexpected since the bank has been under constant pressure to revalue or liberalise the hryvnia since inflation began rising dramatically in the autumn of last year, and Central Bank Governor Volodymyr Stelmakh had announced back in late April that there would soon be a "move" on the exchange rate front. However in a statement which now assumes rather more significance than it did at the time, the bank`s council (yes, note the COUNCIL - not the board - since the council is the other main player in this game) explicitly repudiated Stelmakh and rejected the idea of broadening the band on the very same day. From that moment on it should have been clear that monetary policy at the Ukraine National Bank was in for a bumpy ride, and so it has been.

Not to be upstaged by the decisions of the Board, Ukraine's central bank council itself met yesterday and formally rejected the hryvnia revaluation which had been decided on by the bank's board only one day earlier, and issued a press release stating that the official rate still stood at 5.05 to the dollar. This was the first example of one body vetoing another since the bank was founded when Ukraine became independent in 1991.

The bank council has 14 members, including the governor, parliamentary speaker Arseniy Yatsenyuk, and a number of parliamentary deputies. Stelmakh himself abstained at yesterday's vote while the other members all backed the veto of the board's decision.

"Today, the action of the board of raising the official rate to 4.85 was rescinded. Therefore, the official rate stands at 5.05/$," Petro Poroshenko, the council's head, told a news conference after a council meeting. He also advised the bank's board to re-examine the issue on Friday and suggested the board could only overturn the council's decision with a two-thirds majority.

Now for those of you who are - like me - a little bit confused by this somewhat Byzantine institutional structure, perhaps I should make plain that the board is effectively the bank's executive, while the council is a body created to formulate a framework for ongoing monetary policy. But now we find the board hold that the hryvnia is valued at 4.85 to the dollar, while the council maintain that the "official" value is still 5.05. So which is it? Well at this point your guess is as good as mine - and this is certainly "pluralist" monetary policy in action - but the board do seem to want to insist that they are going to have the last word, since late last night Reuters reported that the board had decided to overturn the councils veto and had issued a statement saying the hryvnia's rate on Friday would stand at 4.85 to the dollar -- unchanged from the rate it had set for Thursday, revalued from 5.05, before the council imposed its veto.

The Ukraine parliament - the Verkhovna Rada - have however voted to summon central bank of head Volodymyr Stelmakh to give an explanation of his actions (by 382 votes out of a possible total of 447) following a proposal put forward by the parliamentary groups of the Party of Regions, the Block of Lytvyn, BYuT, and CPU.

Anyway, I do know how many of you are able to follow all of this? Personally my head is already whirling. And the whole situation became even more bizarre late last night when central bank officials declined to comment on whether the board had in fact overturned the earlier council veto decision, effectively sidestepping the problem posed by head of the council Petro Poroshenko earlier in the day when he stated only a two-thirds vote on the board could do this.

Basically the background to all of this is that until recently, the central bank had been intervening regularly, buying and selling currency to maintain the hryvnia within a prescribed tight-corridor of 5.0-5.06. As a rseult the hryvnia had been hovering around 4.7-4.8 since the central bank stopped intervening in February-March, but in recent days it had begun to soar, touching at one point 4.6 to the dollar, following comments from various central bank officials indicating a revaluation was coming soon, and pressure from credit ratings agencies and multilateral bodies like the IMF to allow the currency to rise in an attempt to soak up some of the globally imported inflation.

Earlier this week a rapid (and possibly speculative) surge in demand took the market rate to 4.6 leaving a gap of about nine percent between the interbank and the official rates, leading the bank`s deputy chairman, Oleksander Savchenko, to state on Monday that decisions would be taken "in the next few days" to tackle the hryvnia`s "highly volatile rate". Effectively it was the developing gap between the official and the interbank rates which precipitated the move on the part of the bank BOARD.

So the problem here is inflation and what to do about it. Ukraine's inflation rate was once more up sharply in April - passing the threshold of the 30% annual rate - as the bickering continued between Prime Minister Yulia Tymoshenko's government and the office of President Viktor Yushchenko over economic policy and how to handle the problem. Inflation was up 3.1 percent month on month (running at an incredible 37.2 annualised rate), and although this was lower than the 3.8 percent monthly increase registered in March (which was a 9-year record) it was still far higher than most analysts were expecting.

Annually, inflation reached a huge 30.2 percent - aided by an almost 50 percent jump in food prices - and the cumulative price rise for the first four months of this year was 13.1 percent, a 'mere' 3.5 percentage points above the government's whole year 2008 target of 9.6% which the government has yet to revise.

The Ukraine central bank has been trying to soak up hryvnia liquidity since the start of the year, twice raising the refinancing rate (which is now at 12 percent, up from 8 percent at the end of last year) and issuing a large amount of depository certificates.

The bank has also repeatedly said that it sees a strengthening of the hryvnia as a means to combat inflation. And of course the bank has been under continuing pressure to revalue or liberalise the hryvnia after inflation began to accelerate in the middle of last year.

When the decision to change the official rate was announced by the board on Wednesday the ratings agency Standard and Poor`s immediately called the move a step towards curbing price rises.

"Liberalising the exchange rate regime should help to curb inflation of tradeables, and in particular commodities such as gas and food, which are priced in dollars," the agency said in a statement. It has currently a rating of BB- for Ukraine.

However ones the smoke finally clears on all this we will be left with a number of outstanding questions. Not least of these is whether in the mid term the hryvnia is not more likely to move DOWN than up. Certaily Ukraine's economic problems are now substantial ones. This was explicitly recognised by Standard and Poor's in its comments following the decision by the bank`s move board, and they painted a bleak picture for Ukraine, saying inflation was boosted by non-monetary factors and that a stronger hryvnia would ultimately harm exporters, raising the current account deficit.

"In the first quarter of 2008, nominal government expenditures increased just under 50 percent, pushing up public sector wages and sending a highly inflationary signal to the private sector," it said. "Loose income policy continues to affect goods prices via second-round effects."

The agency also lambasted the government of Prime Minister Yulia Tymoshenko in January, calling its fiscal policies "populist" after it began paying compensation to people who`s Soviet-era savings were wiped out by hyperinflation during the 1990s.

Tymoshenko has repeatedly promised that the government would be able to bring inflation under control in just a few months, and some officials had even predicted deflation during the summer months due to bumper food harvests (which are more than possible, the harvests, not the deflation, and this may mean in the short term that economic growth and inflation only accelerate).

Meantime Ukraine is currently running a current-account deficit, a deficit which has widened to $4 billion since the beginning of the year, and many analysts estimate it may exceed $15 billion by year-end. In fact the IMF estimate that it will reach 7.6% of GDP this year.


By way of conclusion I would like to make three simple points about this strange affair. The first of these is that the situation in the Ukraine to some extent parallels the situation in Russia, since both countries are facing a major inflation problem, and both are under pressure to allow the currency to rise to soak up some of the inflation. The political battle in Ukraine also mirrors the one in Russia in this sense, since the Putin/Medvedev group have been making it quite clear that they favour going for growth over the need to tackle inflation, and thus will resist currency revaluation pressures, even though the inflation itself will at some point almost inevitably undo all this solid growth performance due to the instability which will eventually follow, as I attempt to explain in this post.

The second point would be that the ability of simple currency appreciation alone to handle the kind of overheating Ukraine is experiencing is in fact rather questionable. Basically letting the currency appreciate can soak up some of the global dimension in Ukraine inflation, but it will not in and of itself resolve the internal overheating dimension. Ukraine, like Russia, has a declining population and a declining working age population. Unlike Russia Ukraine has out-migration and not inward migration. This means that the labour shortage issue in Ukraine is expecially acute when growth is in the 5 to 7% pa range. Basically Ukraine does not have the human capital resources to grow this quickly, and having a steady stream of remittances from those working abroad fueling consumption and construction only adds to (and does nothing to help resolve) these underlying problems.

Lastly, it is clear that Ukraine is now locked in to some sort of "boom-bust" cycle, but the bust may well not be imminent: that is to say we may well go up further before we finally fall back to earth. The reason for this is the current high in wheat prices, and the fact that Ukraine may well have a bumper harvest this year.

Economic analysts (and CEE specialists) 4Cast are predicting a significant recovery in agricultural performance across the entire East European region this year, driven by a massive rise in crop yields and farming output. They say weather conditions seem favourable in many countries in the region. Gábor Ambrus, analyst at 4Cast in London. believes the effect will be most visible where the share of farming is high, i.e.: Ukraine and Romania, while Poland, for example, may not benefit especially as it was spared from much of the regional draught in 2007.

Ambrus sees Romania and Ukraine as particularly likely to benefit from an agricurally driven boost to headline GDP effect. (The share of Romanian agriculture in GDP is 7-8%, so even a 30% increase in farming output may boost GDP by 2pp above expectations.) The effect on Ukraine is even larger with agriculture having something like a 17-18% share in GDP. The crop estimates being offered by UkrAgroConsult indicate a 35% increase in crops, and this could boost GDP by as much as 6pp over 2008, offsetting much of the slowdown coming from other sources, Ambrus argues. Of course this estimate may well be on the high side, but nonetheless Ukraine should get a substantial GDP boost, which means we should watch out, since this train may well now be about to accelerate before coming to what looks like it will inevitably be a "sudden stop".

Anyone interested in a rather fuller explanation of the underlying human capital resource problem could do worse than read this post I wrote some months ago on the topic.


Well it is less than an hour since I put the post up, and already I am updating. I suspect this may happen more than once in the coming days. The latest news is that - unsurprisingly - Ukraine`s central bank chairman Volodymyr Stelmakh publicly confirmed this morning the bank's change in the official hryvnia rate to 4.85 per dollar from 5.05. The show goes on.

“The bank’s board made decision to confirm the change of the rate. We are confident that we do everything right, and we will defend our position”, V.Stelmakh said. According to him, the bank`s council had no right to decide on economic or legal issues and he saw the bank`s change of the official rate as merely eliminating imbalances in the market, and based on economic factors, rather than a "revaluation".