Outlook on the Exchange Rate and Financial Stabilization in Ukraine

November 25, 2014  

Professor Alexander Savchenko

By now it is clear that Ukraine’s economy is entrenched in a deep economic crisis, and the current state of affairs of Ukraine’s banking and financial system is moving toward a collapse. Over the past year the value of the hryvnia fell twofold, while more than 25 percent of the banks went bankrupt. In my assessment, Ukraine’s GDP in 2014 will decrease by 6% and inflation will increase to 22%. As to a forecast for 2015, I will consider three possible scenarios for the development of events.

The first scenario is optimistic, and I believe there is a 10% chance of it occurring. The new pro-European coalition will for the first time in Ukrainian history form a professional Cabinet of Ministers and specialized management of the National Bank of Ukraine. Under this scenario, reforms must start tomorrow in parallel with anticorruption measures, while the GDP in 2015 will grow by 2%, inflation will increase to 10% and the exchange rate will stabilize at the level of 14-16 hryvnias to the US Dollar with a tendency toward strengthening.

The second scenario is pessimistic and I estimate there is a 40% chance of it occurring. The government and the National Bank’s management will form a crony party system and reforms will not commence. The budget deficit will be financed, as in 2014, at the expense of issuances (unsecured printing of cash) and international loans. The GDP under this scenario will decrease by 7-8% and inflation will remain at the level of 25-40%, while the exchange rate will reach 25-30 hryvnias to the US Dollar. Ukraine’s default under its external obligations in the second quarter of 2015 will be unavoidable. This scenario plays a significant role in Vladimir Putin’s plan and will be his triumph. Ukraine’s bankruptcy under this scenario will reveal that Ukraine cannot exist in Western Civilization (the EU) and that its place is within the Muscovite-Orthodox Civilization under the patronage of Russia.

The third scenario is realistic, and I believe there is a 50% chance of it occurring. The government and the management of the National Bank will form a crony party system but, under pressure from Maidan, some of the positions in the government will be occupied by professionals and honest politicians. Reforms will take place but they will not be comprehensive and consistent. Under this scenario, the EU, the International Monetary Fund and other international financial organizations will extend credit, experts and consultants who will finally adopt if not key, then extremely vital decisions regarding the monetary and economic policies of Ukraine. Under this scenario, the GDP of Ukraine in 2015 will show zero growth, inflation will remain at the level of 20-25%, and the exchange rate will fluctuate around 20 hryvnias to the US Dollar with a tendency toward stabilization. Gradual pressure from the EU will increase, and within 4-5 years Ukraine will become a normal country.

However, there is one fundamental question: in order for Ukraine to have a chance of success in 2015, what should the government begin with?

Firstly, the GDP (which is redistributed through the state budget and social insurance funds) should be radically decreased. Right now, more than 50% of GDP is redistributed through the state budget and social insurance funds, but this should be no more than 33% of GDP. This step would significantly increase the cash flow of business and income of Ukrainians, which will create an additional demand for GDP growth and ensure the corresponding financial resources for such growth. This is the mysterious reform is surrounded by lots of discussion, but very little action and comprehension of its essence.

The second step of budgetary policy reform involves the redistribution of income in favor of the youth, who create national wealth. The success of this step depends on whether it will lead to a Ukrainian society where fairness prevails and not the social populism that the Ukrainian “elite” is accustomed to. After two revolutions on the Maidan, Ukrainians simply have a “gut feeling” about social injustice. I am certain, for example, that they support pension reforms, including an increase of the pension age, provided that there will be a fair differentiation – an increase of the minimum pension amount at the expense of limiting the maximum pension payments. Rational pension reform must also create stimulation for lengthy and rigorous labor for Ukrainians and legal means of income. In addition, reform must pave the way for the accumulation of financial resources for long-term investments into the economy of Ukraine.

The third step should be the redistribution of income in favor of local budgets from 43% today to 60% in 2015. This will be the financial foundation for the decentralization of power.

These first steps will lead to a significant decrease of taxes by practically reducing budget expenses across the board, except expenses on defense (2.5% of GDP in times of peace) and culture (1% of GDP, but now 0!). Moreover, this will end the monetary financing of the budget by the National Bank of Ukraine, which will have a positive influence on the exchange rate of the hryvnia. A catastrophe is unavoidable without budgetary and pension system reforms.

Please note that the above-mentioned steps will only create pre-conditions for economic growth. Namely, growth will be possible when the mechanisms of a market economy start to work and, in the first place, crediting and investment mechanisms.

Presently, central banks, and not governments, play the main role in the creation of conditions for economic growth. Therefore, the principal function of the National Bank of Ukraine today should be to support such growth under conditions of financial and pricing stability. The National Bank, with the support of the government, must ensure an annual real growth of crediting on the level of 15-25% as normal rates for business and individuals (inflation plus 4- 6%). Normal inflation for 2015 will be 10% and for 2016 - 5%.

If reforms are undertaken as set forth above, then the first, optimistic scenario may become a reality.


Frishberg & Partners 2012