The price of war: monetary dimension | UA2DAY


Chairman of the National Bank of Ukraine

As a solution, the NBU will help reduce inflation, maintain stability in the foreign exchange market, and move to easing restrictions in 2023.

Despite the brutality of the blows that the economy and the financial system, together with the whole country, are currently experiencing, with joint efforts we manage to keep inflation under control and stability in the currency market. The banking system also remains stable – banks continue to work, issue and accept deposits, make payments, and there have been no high-profile bankruptcies. For this, decisive, sometimes extraordinary, and often harsh measures have to be taken.

The war continues, so threats to the economy remain. Understanding this, the National Bank comprehensively weighs and thoroughly substantiates each decision. Their logic is subordinated not only to the needs of “quick response”, but also to the strategic priorities of the NBU to meet the needs of the wartime economy and the need for its rapid recovery.

In this column, I will briefly answer the key “Why?” and as?”

Why does the NBU keep the discount rate high?

The decision to increase the discount rate from 10% to 25% in June 2022 was not easy, but necessary. Without the corresponding changes, last year’s price growth would have been, according to the NBU, 6.4 percentage points higher (that is, it would have risen to 33%). Although the increase in the value of hryvnia resources means an additional burden for some economic entities, it compensates for it many times over, protecting the hryvnia from depreciation.

According to the results of 2022, consumer prices in Ukraine increased by 26.6%. The indicator is high, but not a record. In the current emergency conditions, it is acceptable. For comparison, last year inflation broke long-term records even in developed countries. For example, in the USA, the indicator reached the highest values ​​in the last 40 years. That is, this phenomenon was not purely Ukrainian.

This year, the National Bank predicts a slowdown in inflation in Ukraine to 18.7%. And this is possible only if tight monetary conditions are maintained.

How will we act?

Our updated forecast assumes that the discount rate will remain at the level of 25% at least until the end of the first quarter of next year. I would like to note that the forecast is not an obligation of the NBU. The final dynamics of our key rate will be determined by the speed of reaction of banks, the situation in the economy and financial markets.

This year, the NBU predicts a slowdown in inflation in Ukraine to 18.7%

However, it must be stated that the effectiveness of the response of banks’ interest rates to the increase in the discount rate, which met the needs of peacetime, turned out to be insufficient in the conditions of martial law. This mechanism works, but it is weakening due to the colossal surplus of liquidity in the banking system. Therefore, the effectiveness of this mechanism should be strengthened. As? About this in the answers to the following two questions.

Why should the cost of domestic borrowing be high if it increases the debt burden of the state budget?

Placement of government bonds on market terms, even if they are unfavorable, is dictated by the need to avoid direct financing of the budget deficit by the NBU. Last year, the latter reached more than 27% of GDP (combined budget, excluding grants).

In 2022, the NBU was forced to “print” UAH 400 billion to cover part of the government’s military expenses. This led to the accumulation of a significant amount of free money in the banking system. Their impact on inflation was largely offset by the sale of currency by the National Bank to support the fixed exchange rate. However, future recurrences of uncovered emission of similar scales may cause irreparable damage and, most importantly, hinder the economic recovery stage.

How will we act?

In order to avoid emission financing of the budget deficit, the National Bank and the Ministry of Finance establish effective cooperation. The NBU allowed banks to cover half of the required reserves at the expense of domestic government bonds. It is also worth giving credit to the Ministry of Finance – the yield on its debt obligations has increased over the past four months. As a result, the domestic debt market revived — in January, the demand for hryvnia government bonds on the primary market rose to a record since the beginning of the war of UAH 91.5 billion.

The NBU will continue to avoid the direct purchase of government bonds, instead encouraging banks to participate more actively in the auctions of the Ministry of Finance. After all, when OVDP are bought by commercial financial institutions, there is a redistribution of already existing funds in the banking system. Consequently, the risks to macro-financial stability are not increasing.

Why are mandatory reservation standards being increased?

The week before last, the NBU decided to additionally increase banks’ required reserves for current accounts and demand funds after their increase in January. The goal is to further increase rates on hryvnia deposits and increase the share of time deposits in the banking system.

We see that deposit rates have been rising since June 2022, when the NBU raised the discount rate to 25%. Small banks react most actively, while the largest banks “graze the rear”. Therefore, the increase in rates in the system is not transformed into an increase in the volume of term loans.

To understand how it works, I suggest you answer a few simple questions to yourself. If so, why do you keep the funds in a checking account instead of opening a deposit? Do not trust your bank or the fact that it offers you a deposit with a rate of 10% per annum, or even less? Would you agree to transfer your savings to a deposit if the bank offered you a rate of 20%?

If the deposit income offered by the bank were more adequate, you would have motivation and a choice.

The inactive reaction of the largest banks can be explained by the increase in funds on their accounts and the growth of the client base. At the same time, there is a simple explanation for this – it is through them that payments related to the war are made: social and military salaries. And the fact that banks receive significant resources in this way, in my opinion, should, on the contrary, encourage them to offer citizens adequate deposit rates to protect savings. Banks at the level of management and supervisory boards must realize their role in preserving trust in the hryvnia and preserving citizens’ funds in the conditions of martial law.

Insufficient maturity of funds in the banking system creates risks for macro-financial stability. So, for example, if there were no administrative restrictions, if certain risks were realized, the funds that citizens keep in current accounts would instantly end up on the foreign exchange market with corresponding consequences. Therefore, we urgently need to minimize the risks of the above-mentioned “money canopy”, and for this – to solve the problem of short-term involvement of banks, which is fundamental for the stability of the entire system.

How will we act?

Our verbal signals to the banks were transformed into a significant increase in required reserves for current accounts. If until January 11, the norms of mandatory reservation by banks for funds in citizens’ current accounts in hryvnia were 0%, then from March 11 they will increase to 20%. Is such an increase significant? So. But is it unfair? No.

There will no longer be a situation where banks made high profits thanks to leveraged funds, while not offering customers sufficient rates to protect their savings. If necessary, the NBU is ready to take additional measures.

We expect that the potential loss of income (due to the increase in required reserves) will stimulate banks to more actively raise rates on hryvnia deposits. When the largest banks raise deposit rates, Ukrainians will have more incentives to open deposits. Better maturity of funds in the banking system will make it possible not only to maintain stability in the foreign exchange market, but also to create prerequisites for the gradual removal of currency and capital restrictions.

Why does the NBU keep the exchange rate fixed?

Abandoning the floating exchange rate policy and introducing strict restrictions on the foreign exchange market were among the first decisions the NBU made in the first hours of the war to protect the financial system. According to our estimates, without the exchange rate fixation, last year’s inflation would have been higher by at least 8 percentage points (that is, it would have been about 34% instead of 26.6%).

Now the situation is stable and under control. In the conditions of the loss of 30% of GDP and the lion’s share of the export potential, the National Bank balances the demand for currency at the expense of its interventions. Thanks to a balanced policy and the help of external partners, the NBU managed to maintain an acceptable level of international reserves, which reached $28.5 billion last year, exceeding pre-war indicators.

How will we act?

Maintaining exchange rate stability while gradually removing administrative restrictions is another strategic priority of the NBU for 2023 and subsequent years.Administrative restrictions on foreign exchange transactions, which came into effect in 2022, are now, in our opinion, the most painful factors for business activity. By eliminating (to the extent possible) obstacles to full-fledged business activity, we will create prerequisites for restoring normal operation and the financial system.

Instead, the regime of the fixed exchange rate currently remains stable and its abandonment is possible only if the role of the National Bank in balancing the market is reduced and the ability of inflation to be a nominal anchor for expectations is returned. Therefore, the process will not be determined by time limits, but by the presence of the necessary macroeconomic conditions. Until they appear, the official exchange rate will remain fixed.

Why are the NBU’s latest decisions worth special attention?

The main difference is that together with decision on the discount rate The National Bank announced the quintessence of its strategy for 2023: avoiding issue financing, increasing the attractiveness of hryvnia assets, strengthening the stability of the foreign exchange market, and creating appropriate conditions for easing administrative restrictions.

The emergency situation in which our financial system is under martial law is much more complex than the known analogues from any methodology or textbook. Simple or universal solutions do not exist today. Each of these decisions has its own price, which everyone has to pay – the state, entrepreneurs and bankers, the whole society. The contributions of each of the parties must be comparable. This is a fundamental condition for ensuring trust, which means the success of both individual measures and the entire policy of the National Bank.

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