Floating the Hryvnia Arms the National Bank to Fight Inflation Now
by Anders Aslund, Peterson Institute for International Economics
Op-ed in the Kyiv Post
April 3, 2008
© Kyiv Post
Ukraine's inflation has got out of control. In February, it surged to no less than 22 percent over February 2007, doubling from 11.6 percent in 2006. This inflation crisis is Ukraine's most urgent economic problem. Unlike in the 1990s, the problem is not the budget, which is close to balance. Instead, the main culprit is the inept exchange rate policy.
Most of the inflation can be explained by the dollar falling in relation to the euro by 12 percent in this period, and the euro is much more important than the dollar in Ukraine's foreign trade. Ukraine imports the inflation of rising international food and energy prices through its dollar peg. The hryvnia rate has been pegged to the dollar since 2000, at a fixed 5.05 hryvnia per one dollar since 2005. The inflation will continue to rise if the dollar plummets.
Strangely, many Ukrainian industrialists claim to be happy with Ukraine's exchange rate policy. These businessmen harbor the dangerous illusion that this is good for Ukraine's competitiveness and exports to maintain a low exchange rate. In reality, this exchange rate policy harms Ukraine's competitiveness and must be abandoned.
Such reasoning confuses the nominal exchange rate, which has been fixed, and the real exchange rate that has risen sharply. For the last eight years, Ukraine has enjoyed a real economic growth of 7.4 percent a year, but the GDP measured in current dollars has risen by no less than 24 percent a year. This means a real appreciation of the hryvnia in relation to the US dollar of nearly 17 percent a year from 2000 until 2007, because the real appreciation is the sum of nominal appreciation (which has been zero) and inflation.
The dollar peg does not only make Ukraine import inflation but also breeds additional inflation, which undermines the country's competitiveness. The dollar peg forces the National Bank of Ukraine (NBU) to maintain a negative real interest rate and pursue an extremely loose monetary policy, because Ukraine's current discount rate is a paltry 10 percent a year.
With inflation of 22 percent per year, a normal interest rate yielding a real interest rate of 3 percent per year would be 25 percent per year. But such a high nominal interest rate in dollar terms is neither desirable nor feasible with a dollar peg, because it would lead to a huge, short—term, speculative inflow, which would flow out after an inevitable appreciation.
Because of its sharply falling real interest rates, Ukraine's money supply (M3), which increased by 35 percent in 2006 exploded by 52 percent in 2007. After the financial crises of the 1990s, such increases were permissible, as the Ukrainian economy was undergoing a fast remonetization, but today the result is massive inflation. Ukraine needs to approximately halve its monetary expansion. Otherwise inflation might rise toward 30 percent for no good reason. Such high inflation will render economic calculation highly unpredictable, disorganize the economy, and dampen growth.
Admittedly, many transition countries have had double-digit inflation for years without apparent negative effects, because while converging with the European economies, their price levels are also converging, but no inflation over 10 percent a year is permissible.
Ukraine's government and National Bank need to focus on getting inflation under control. First of all, the exchange rate policy must be changed to allow the hryvnia to appreciate. The standard advice is to broaden the currency band. Officially, the NBU has set it at 4.95–5.25 hryvnia per dollar, but until mid-March it intervened and bought dollar when the hryvnia tended to appreciate. The simplest policy change is to broaden the band further and let the hryvnia rise.
Then, Ukrainians will quickly learn that it is uneconomical and insecure to hold dollars, and they will exchange their dollars for hryvnia or euro. As a result, the far-reaching dollarization of the Ukrainian economy will ease, reducing the currency risk, to which many Ukrainian enterprises and individuals are exposed. After some time of controlled hryvnia appreciation, the NBU can move on to a floating exchange rate, which presumably will rise substantially because of the substantial capital inflows.
An alternative approach would be to follow Russia's example, by relating the exchange rate to a basket of euro and dollar, which allowed for an effective ruble appreciation of 7 percent in each of the last two years. Considering how far the dollar has already fallen, however, and how high Ukraine's inflation has soared, this step would be belated and insufficient. Although its inflation stays at a more moderate 13 percent, Russia is on its way toward free float. Ukraine needs faster improvement.
When Ukraine has adopted a floating exchange rate for the hryvnia, the NBU can finally raise its interest rates, so that real interest rates become positive without nominal rates skyrocketing. The NBU can restrain the monetary expansion and contain inflation.
The International Monetary Fund, the Organization for Economic Cooperation and Development (OECD), and a range of international economists have long urged Ukraine to alter its exchange rate policy in such a fashion. Poland and the Czech Republic have long pursued such a policy of inflation targeting, which has led to low and predictable inflation.
Until recently, the cost of Ukraine's inappropriate exchange rate policy was limited. But at least three things have changed with the current financial crisis: the dollar is slumping, and the hryvnia with it; international food and energy prices are soaring; and domestic inflation has doubled. Therefore, Ukraine can no longer afford to pursue an exchange rate policy that lacks intellectual underpinning.
Let the hryvnia exchange rate appreciate to contain Ukraine's inflation!