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2 June, 2012  ▪  Volodymyr Lanovyi

The Illusion of Macroeconomic Stability

Economic growth is impossible without macroeconomic stability. The latter is understood as the stability of financial-monetary parameters of a national economy in time.

History knows no examples of countries experiencing dynamic development while their currency was a monetary surrogate without popular trust. With any proportions and stimuli for macroeconomic redistribution, the instability of money and prices erodes value, rendering economic activity unreliable and expected profits illusionary. Conversely, there are countries with extremely successful economic dynamics which became possible when their currency had stable purchasing power. The exchange rate of the Hong Kong dollar has remained the same for six decades now, and the economic successes of this Asian tiger are well-documented. Germany experienced rapid growth exactly when its mark had a fixed exchange rate: in the 1950s and 1960s and then in the 1980s. But in the 1920s, when Deutsch-marks devalued almost on an daily basis, Germany’s economy collapsed.

We have had our own experience of industrial output being dependent on the stability of the Ukrainian currency. Ukraine's unsatisfactory growth is largely caused by the financial-monetary turmoil it has experienced. In the years of hyperinflation (1992-96), Ukraine's economy plummeted so low that we have not been able, in all this time, to bring it back to its 1990 level. The 2008 drop in the GDP was also caused by a sharp decline in the hryvnia’s value compared to world currencies.

Stability can be defined as long-term macroeconomic balance. In other words, it is attained by an economy that remains balanced over time. Stability can be revealed using several overall indices. The key indiced are inflation and the GDP deflator, changes in the currency exchange rate and bank interest on loans. There is a strong correlation between these indicators: interest cannot be low when the currency exchange rate is plunging down or price are skyrocketing. Thus, the financial-monetary stability, or its opposite, manifests itself through all these indices at the same time.

Once applied to Ukraine, these indices reveal our instability. In the first half of 2011, we had super-high inflation – about 12 per cent in annual figures. In the second half, the prices of consumer goods and services formally stayed put. (On a side note, this claim does not have much credibility, because reports of the State Statistics Service are clearly manipulated to suit the interests of the government.) The bank interest rate shot up to 30 per cent or more, a level we have not seen in recent years. Loan issuance to enterprises essentially halted for 4-5 months. Only government contractors were able to obtain large loans through state-owned banks, which used centralised resources from the Cabinet of Ministers and the national bank of Ukraine.

Inflation was partly curbed through forceful administrative methods. First, the NBU was given a strict command to limit demand for money from enterprises and citizens. Thus, it made new hryvnia injections and extracted “extra” liquid assets owned by banks. To do so, it used its own deposit certificates which were placed with financial institutions that had a surplus of money. In this way, UAH 116.8 billion was extracted within one year from banks on varying terms. To compare, all bank deposits grew by less than UAH 73 billion in the past year. Moreover, commercial financial institutions spent UAH 53.5 billion to purchase internal government bonds. This experiment led to a crisis of the payment system – the treasury did not have enough money on its accounts to make mandatory government payments in late September 2011. It also caused interest on economic loans to skyrocket. They became a rarity. This was vulgar monetarism in action, which only hurts the economy, causing it to spiral down. The situation persisted until November after which the NBU loosened the screws by discontinuing its deposit certificates scheme and issuing direct loans to banks to the tune of UAH 18.6 billion, while they received half of the sum (UAH 9.2 billion) in the previous 10 months.

Second, the Ukrainian government targeted inflation as the main enemy of its financial policy and began banning price hikes in 2011 in all sectors in which prices are established administratively. This includes tariffs on services in natural and organisational monopolies: communications, railroad, energy, housing and utilities, municipal transport, etc. At the same time, the Minister of Infrastructure recently made a statement that sounded ridiculous: he said that the ministry would not be charging more for second-class seats in passenger carriages. So does this mean they will raise them for sleeping and third-class carriages?

Inflation does not end simply by suppressing the objective movement of prices. Instead, it becomes latent. The unnatural dynamics of prices makes people anxious and causes them to expect more rapid inflation in the future. Indeed, the suppressed spring of inflation will eventually be released, causing hyperinflation. Ukraine already has this kind of experience. Strangely, the current government is disregarding this and trying to restore the economy to the price regimen of the Soviet and early post-Soviet era. Why was the State Committee for Pricing revived? In order to again set prices centrally? Are we also to expect the revival of the State Planning Committee and ratio cards for people to buy “social” products? All of this points to helplessness and ignorance, even though we cannot rule out a conscious effort to restore centralised planning.

In conditions like these, monetary stability is out of the question. It is secured only when a balance between demand and supply is achieved in markets, including goods and monetary markets. The goods markets in Ukraine can hardly be called balanced. There is no freedom of entrepreneurship, equality of participants’ rights, free pricing, competition, and so on. The balance of demand and supply must be attained also in all segments of the monetary markets: interbank, economic loans, personal loans, government bonds, deposits, corporate stock and foreign currency. However, government bodies do not see the need to fulfil this task. On the contrary, through centralised interference in the redistribution of financial resources and establishing interest rates, they only move the economy further away from the state of monetary balance and hence monetary stability.

Instability makes the accumulation of finances dangerous to their owners. But without surplus finances it is impossible to invest in production. Thus, the volatility of monetary value hampers the growth of capital assets, forcing the economy to tread water. The reader will remember that total investments in capital assets in Ukraine have not exceeded UAH 155 billion for three years now. Meanwhile, Ukraine's GDP grew by 46.3 per cent, from UAH 913.3 billion to UAH 1.335 trillion, in 2010-2011. But this nominal growth was due largely to price increases (the deflator index was 33.4 per cent for two years) rather than to real GDP growth, which was at 9.7 per cent. Thus, stability is a rosy dream at present.

Mykola Azarov’s appeal to the newly appointed Finance Minister Yuriy Kolobov is alarming: work with banks so they will find money to finance the bottomless deficit of the government budget. It follows that this “scared cow” will continue to devour monetary resources of the banking and credit system in view of the reigning monetary drought and distrust for the hryvnia. The threat of instability is constant as long as this government is in office, because its actions are aimed at treating merely the symptoms, rather than the causes, of the malady and the causes behind Ukraine's economic instability today are plenty.

For example, there are several key causes behind the inflation rate, which is one of the factors of stability. For one, goods markets have been totally monopolised, and this has only been exacerbated in the past two years, while pricing abuses have become even more brazen. Prices and tariffs on products made by state- and municipally-owned enterprises have been fixed administratively. (The government made sure to secure their profitability by annual increases in price levels.) Prices for imported goods, including energy, have gone up. Permanent increases in Russian gas and fuel material prices have had the largest impact here, and this process will continue in 2012.

The NBU is artificially increasing bank liquidity in hryvnias (even though such regulations alternate with their opposites) and money supply. (It issues, and will continue to issue, targeted loans to refinance particular banks beyond any reasonable limits and without any real grounds.) The government has taken out excessive foreign loans not intended for making international payments. These arrive on the internal currency market, causing a surplus of dollar supply. To maintain a stable currency exchange rate, the National Bank buys this surplus, thus unjustifiably increasing the hryvnia supply on the market.

Is this current government capable of preventing these trends from driving up price inflation? It seems that only the source of foreign investments to finance the budget deficit has been exhausted, and the government cannot simply satisfy its appetite for foreign currency. The government will try to transform part of the price inflation into a hidden form, such as by freezing housing and utility tariffs. As well, the government may again choose to cut bank liquidity in an administrative way and curtail demand for monetary resources. Thus, a more lively loans market is not to be expected. Of course, this will jeopardise production growth and will make it doubtful. However, the government can also be expected to take the exact opposite steps, particularly artificially cranking up inflation in order to fill its empty coffers.

Another factor of instability is the high interest on bank loans, which are inaccessible to most Ukrainians. The key and constant causes of the state of affairs are well-known: high inflation, which necessitates adequate compensation (amortisation) for financial assets which lose value over time. (In 2012, interest rates will also be fuelled by inflation expectations of Ukrainians.) Second, loans are highly risky. The likelihood that bank loans will be paid off remains low. The situation is further complicated by a poor business climate and administrative market regulation, which erodes the credibility of bank evaluations of projects and marketing. Monetary-credit resources will be a rarity on the market due to the fact that the government takes out excessive loans and is inclined to issue emission-based loans to state-owned financial institutions. In 2012, these distorting trends will be more marked.

Another reason is that separate monetary markets are isolated with no self-regulation of inter-market flow. Different banks have unequal rights in the markets in which they are allowed or forced to operate. And these markets differ in their interest rates (the rates on retail credits are 2-3 times higher than those on internal government bonds), the availability of resources and creditors, etc.

Unfortunately, reducing market interest rates is not a priority for the current government. Therefore, crediting the national economy is not going to improve any time soon.

Panic on monetary markets also erupts when the national currency exchange rate plummets abruptly or in an avalanche-like fashion. This is the third key factor of monetary instability. Such falls occur in Ukraine much more often and with an incomparably larger amplitude than any other country. Why did the 2008 financial crisis hit the currency exchange rate in Ukraine more than any other country of the world? This vulnerability is a consequence of Ukraine being financially closed, which essentially means it is isolated from the world monetary market.

Ukrainesuffers from overregulation, and the government and the National Bank are to blame. This overregulation includes mandatory things like permits for banks to open foreign currency accounts, carry out international foreign currency transfers and loan and stock transactions, issue foreign currency loans and convert hryvnias in other currencies. International credit, insurance, investment and other companies must be licensed to operate in Ukraine. All of these and countless other administrative regulations and limitations that run against EU norms and standards set up barriers to the free movement of international capital and discriminate the operation of foreign financial operators, stripping the currency market of its convertibility, its guarantees and predictability.

Above all, this enhances the risks of foreign currency transactions for foreign investors, forcing them to eschew long-term contracts and raising the cost of foreign loans. The difference between interest rates in Ukraine and in the eurozone is not shrinking: our rates are three or even four times higher. Ukrainian territory remains unattractive to international financial mediators who prefer other economies of Central and Eastern Europe. Foreign capital flow has almost stopped, and we have to earn foreign currency with our own efforts. No special progress has been made in this area, as is known. The foreign currency reserves in the banking sector are close to a critical low point, so there will be no remedial means available if foreign currency circulation is disrupted.

In light of all of the above, a shock on world financial markets, such as those in 1997-98 and 2008, would lead to the following: international loan capital and portfolio investments would stop flowing to Ukraine’s economy, while short-term investments would be urgently withdrawn and returned to international donor banks. In the second half of 2008, the net outflow of bank and economic credits from Ukraine exceeded $8 billion (over seven per cent of the GDP) of which $4.5 billion was short-term loans. In parallel, periodic reductions in the foreign currency supply occur on the internal market due to more dollars being bought by citizens from banks through the retail network. For example, this amount was more than $6.5 billion in 2008 with October and November accounting for half of the total. A lack of foreign currency was catastrophic in these conditions, and the internal market exploded.

Thus, the key causes behind avalanche-like periodical devaluations of the hryvnia are as follows: a permanent foreign trade deficit, which necessitates additional foreign currency injections to pay for imports; the high cost and limited volume of international credits issued to Ukraine’s economy due to its financial impenetrability and isolation and the extra-high risks associated with foreign investments here. Furthermore, international credit-and-investment agreements are signed for the short term, allowing foreign operators to reduce financial risks and quickly repatriate financial resources in shock periods. Direct foreign investments are limited as a result of an unfavourable business climate.

Ukrainian citizens did not have confidence in the hryvnia's stability and expected it to lose value due to negative trends in the dynamics of payment balances across the economy, which generates additional household demand for foreign currency for saving purposes. The country does not have enough foreign currency reserves, which is especially true of banks and the government. Ukraine also continues to pursue an archaic policy of pushing the dollar out of the markets of credits, investments, deposits and savings by way of bans, unfairly high reserve requirements set to banks, etc. Nearly all of these components precipitate another fall of the hryvnia's exchange rate, which appears to be unavoidable. Only a miracle, such as a gift from the IMF or a rouble shower from Moscow, can delay it until 2013, but then the fall will be even steeper, similar to what happened in 2008.

Therefore, all indices point to the fact that monetary stability in Ukraine is not to be expected in the near future. The year 2012 is likely to be critical. The government of Ukraine is concerned exclusively with its own fiscal, budgetary and loan priorities. Meanwhile, government officials themselves are undermining the foundations of macroeconomic stability. The government is counteracting private market processes, unions, self-regulation and balance on monetary markets, as well as more intensive competition on goods markets. It is passive with regard to the growing foreign trade and payment deficit and accruing debts. No steps are being taken to increase financial openness and harmonise our system with the European one, which means that Ukraine will not be saturated, as it needs to be, with capital on the level of highly developed countries. It should also be kept in mind that the financial crisis will peak in the European Union this year.

Instability of finances and prices will hamper savings and accumulation of capital. People are unlikely to have confidence in hryvnia bank deposits. It is easy to see that private investments will not increase, either. Government and municipal spending may be greatly curtailed, because 2012-13 will be time to spend budget money to pay the interest on and the body of previously obtained credits. It is absolutely clear that production growth will falter. The first quarter of 2012 confirmed these simple truths: even official statistics record a reduced growth rate in all sectors of the economy as industrial production slowed down.

So what should the government do in order to break out of this vicious circle and secure macroeconomic stability? Above all, goods markets need to achieve their full operational potential through competition among suppliers; the removal of monopolistic abuses; equality of the rights of purchasers and suppliers; self-regulation of demand and supply and non-interference of administrative bodies in pricing; elasticity of the market supply of goods; value equivalence of exchange, etc. Market relations need to be secured in international trade; external and internal gas markets need to be united and a direct connection has to be established between them. External energy sources need to be diversified. The government must encourage and support Ukrainian exports with the goal of having a constant surplus of Ukraine's trade balance and accumulating international currency reserves.

A balanced market monetary-credit system needs to be formed in which artificial administrative increases or decreases of bank liquidity would be impossible, just like NBU loans to specially chosen, mostly state-owned, banks. Discrepancies between monetary markets need to be removed, and an equilibrium should be secured among them. The risks associated with credit and deposit transactions need to go down. The country has to switch to non-deficit budget financing and reduce the proportion of spending on centralised purchases and investments, as well as limit government international loans exclusively to the needs of importing high technology and servicing external debts. An open financial model of Ukraine's economy needs to be introduced which would abandon orders, permits and prohibitions regarding the international movement of capital, international financial mediation, hryvnia conversion on bank accounts, issuing foreign currency credits, making foreign-currency investments in the country, etc. The state needs to foster foreign investments; secure freedom in investment activity, the openness of stock investments and liberal currency exchange; do away with limitations and regulations regarding private businesses. It also needs to battle the currently high cost of Ukraine’s international bonds and the short-term nature of foreign loans given to the government and economic entities of Ukraine. This can be done, among other things, by cutting foreign debt, balancing state finances, reducing interest rates on interbank credits, securing transparency and openness of Ukraine's financial system, hedging currency risks, setting non-compensated reserve requirements to banks that sign short-term loan agreements.

Unfortunately, Ukraine is now moving in the exact opposite direction, away from economic stability.


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