Relying on western financial support must not lead to the atrophy of the Ukrainian economy.
The Russo-Ukrainian war continues to transform into a competition of exhaustion not only on the front lines in the war itself but also on the socio-economic and political front. The first country which will not be able to withstand such pressures will have to find a non-military way out of the conflict, at the price of more concessions from its side. The Ukrainian Week has outlined that it is the first time in Ukrainian history that Ukraine has the opportunity of vast support from abroad, which neutralises Russia’s resource superiority. However, it is important that this will not lead to economic atrophy and financial stability, as this may lead to long-lasting negative consequences.
Becoming a state that functions in war and is reliant on external donations, is perhaps a heroic prospect but nevertheless, dangerous for our future. Afghanistan is an example – a country that could not be conquered for half a century, and despite the colossal investments into Afghanistan, this country remained poor and dysfunctional even compared to its neighbours. It is therefore important that our national priority would be not only the restarting of our economy but also the rapid revitalisation of productivity during this war. Foreign aid must be supportive of this and not a replacement.
Stopping future pressurisation
In a recent interview to the Economist, Ukrainian minister of finance Serhiy Marchenko declared that if the war continues for longer than the end of summer, then there would be no choice but to implement ‘painful measures’, some of which would entail the increase of taxation rates and the reduction of state expenditures (for non-military expenses). This is despite the fact that the head of the parliamentary committee of financial matters, taxation and custom affairs, Danylo Hetmantsev claimed that the April budget goal was exceeded by 2.5 billion UAH, or 6% more than 2021 (which had a 23% increase that year). Nevertheless, the increase of military expenditures while other expenditures were cut (such as customs revenues) ultimately led to an increase of the cumulative deficit from 80.6 billion UAH in March to 89.7 billion in April.
At the start of the war, the parliament added a few changes to an existing set of laws, which previously banned the national bank from providing credits to the government, while the national bank approved the purchase of domestic wartime government bonds. Nevertheless, the demand for more financial resources grew. If the first month and a half of the war had moderate financial emission rate (by mid-April, the national bank bought up around 40 billion UAH worth of domestic bonds), in more recent times, this has drastically increased. Only from the 20th of April until the 9th of May, the national bank bought 60 billion UAH worth of domestic bonds. On the 9th of May alone, this was 30 billion UAH. Henceforth, even before May, the national bank’s stake in domestic bonds was above 50% and continues to grow rapidly. A very rapid quantitative easing policy by the national bank also directly affected consumer prices which continue to grow, as well as the depreciation of the national currency which is needed for the purchasing of vast quantities of military resources, but also consumer goods. Despite the official exchange rate having 1 USD at 29 UAH, the real exchange rate on the black market is estimated to be around 20% greater for the US dollar. And this is not the limit here.
In the first weeks after the Russian invasion of Ukraine, the national bank mostly bought the remainder of the national currency which was somewhere around a few hundred million US dollars. In fact, there was still an inflow of money due to pre-war exports, while critical imports which were allowed to enter the country were becoming severely limited. Nevertheless, the situation started to change due to logistic problems of exporters, the increasing need of specific imports for military purposes, as well as the internal consumer market which was recovering after the shock of the war in the first few weeks. Nevertheless, more refugees in EU countries created a higher demand for foreign currencies, as those who moved out, operated from their UAH accounts in a foreign exchange market.
The national bank adapted its strategy, a strategy that would be effective for a short term disbalance of demand versus supply availability, however this strategy would be bad for a long-term regime of economic pressure. The currency reserves that were sold by the national bank of Ukraine grew from 1.8 billion USD in March to 2.2 billion in April. Just in the second half of April, this figure was more than 1.3 billion (within 2 weeks to be precise). This allowed it to stop and even temporarily delay the path towards the real exchange rate that was seen on the black market in March (around 35 UAH per USD). However, the rate at which the reserves were being used up, which continued even in early May, threatened their complete yet pointless annihilation. Therefore, the earlier it was to mid-May, the national bank proceeded to cut down its scaling and interventions despite the tendency of the national currency to plummet (35 UAH for 1 USD and more). During the second week of May, the drop was 40% from the week before, however, the expenditures were a sky-rocketing 0.35 billion USD.
Despite the fact that the national bank, in wartime, proceeds to emit the national currency to cover the deficit of the national budget, its leaders continue to insist on increasing borrowing in the domestic market at the expense of funds accumulated by the banking system. As an argument, it is often used that by the 9th of May, the liquidity of banks in the national currency was around 227 billion UAH, 183 billion of which were holdings in deposit certificates, 44 billion of which were costs of banks in corresponding accounts. Foreign currency reserves were approximately 7.3 billion USD. Despite this, banks will be more proactive in buying state obligations only if interest rates rise, which in fact, currently remain well below the inflation rate. This will mean not only increase the loan expenditures of the government but will also lead to a significant demotivation for banks to to credit the maintenance or other forms of revitalisation of economic activity in the country. Moreover, that would only cement the vicious cycle.
In the meantime, the very revitalisation of economic activity is the most important task for the gradual reduction of reliability on foreign financial aid to cover the current budget deficits, which would be needed to return the country to an independently sustainable form in the future. For example, the EBRD has updated its forecast for Ukrainian GDP growth to about minus 30% due to the war. Despite this, most of the country is able to revitalise its economy. More citizens are returning back to central Ukraine, and many to eastern regions such as Kharkiv. And if in March, 11 regions were directly affected by military operations taking place there (they accounted for a total of 55% of Ukrainian GDP), now it is only 6 regions, which account for around 20% of the GDp. A lot of the GDP in these regions were also situated in regional centres like Kharkiv and Zaporizhzhia.
According to data of the national bank, the reduction of economic activity in relatively untouched regions can be explained by the disruption in production chains and deliveries, as well as the increase in risk brought by the departure of a significant part of the workforce abroad, or in other regions, domestically. The amount of companies that completely stopped functioning has been estimated to decrease by half (in April) when compared to the initial shock at the start of the war (from 32% total to 17%). Another matter is that 60% are operating with less capacity or productivity than before the invasion, moreover, for 23%, the output has fallen more than half of the norm. Despite this, most of the negative factors in regions not affected directly by the war, can be offset by state policies such as recruiting domestic migrants to work in these industries as well as those who have been returning from abroad. It is crucial to support the activity of small and medium businesses, as according to the EBA, the quantity of dysfunctional businesses is 26% made up of small and medium businesses (formerly 42% during the initial shock of the war). Only 20% are operating under normal capacity.
The right priorities
The priority of economic and tax policy for the near future (if not before the end of the war, then at least towards its positional phase) should be based on the support, revitalisation and development of economic activity. Taxation, especially in its direct form, and the use of tax revenues to pay wages must not be a current priority as this will hinder economic recovery. Taxation priorities must shift towards indirect taxes and the taxation of luxury industries.
Nevertheless, it is important to count on the budget deficit on the account of foreign financial aid. Moreover, various statements by western officials, including the ministers of finances in powerful western countries show that their high-level understanding of Ukraine’s needs in a long-lasting financial source of aid for the support of critical functions in wartime.
Furthermore, the latest statements by the same officials show that it is possible to initiate talks of the transfer of frozen Russian assets to the needs of Ukraine and simultaneously, the writing off of a significant chunk of Ukrainian foreign debt.
This was done in the case of Poland after its communist regime had fallen. Poland was left in a state that was much better than that of Ukraine currently, however. What stands in the way of a repeat of such a move for Ukraine? Currently, such a move would allow the use of vast financial resources for real purposes instead of simply repaying foreign debt. It would also minimise the negative consequences of Ukraine’s currency depreciation to a more balanced level, which would not require artificial support through the mindless consumption of billions USD of Ukraine’s monetary reserves.
Ukraine still has the international financial reputation to convince its partners and donors to not only support the minimum functions of its state mechanism and defence expenditures, but also the most vital economic activities on non-occupied territories. The latter is impossible without the preservation and partial indexation of key social and budget expenditures which ensure the trickle-down effect of economics. The idea is that it will lower the demand of western financial support, and will lower the exhaustion of Ukrainian society from the negative socio-economic consequences of the war, and will ultimately bring Ukraine to long-term financial and economic stability.
