Geoffrey Smith of Renaissance Capital -

In mid-May, we warned that the Ukrainian authorities needed to put the interests of their country above their personal political dispute and give a clear, comprehensive and coordinated response to the threat of inflation, or risk the development of a wage-price spiral.

A week later, we received a policy response that was partial, unclear and incomplete. The government failed again to present a budget for 2008, partly because the president won't allow it to raise revenue as desired - through privatisation. The National Bank of Ukraine, stung by international criticism and apparently growing tired of waiting for a political response, was forced to act independently and allowed the official hyrvnia exchange rate to rise to 4.85 against the dollar, from 5.05. It then intervened on May 22 and 23 at 4.80 to indicate where it thought the short-term equilibrium rate should be.

The news is supportive for any business obtaining its revenues from Ukraine and its funding (or raw materials) from abroad: hence, this is good for real estate and bank stocks, and especially good for holders of the debt of gas firm Naftogaz. The benefits to utilities and refiners, while real, are mitigated by other aspects of the regulatory regime. The news is a short-term negative for export-oriented sectors - steel, machinery, agriculture and fertilisers, although in the case of fertilisers it is mitigated by the restraining effect on the price of natural gas.

Visibly, very few things transfer national income from one sector of the economy to another faster than this, so very few things are quite as politically electrifying. As long as the hyrvnia rate was stable, the opposition Party of the Regions (PR) could quietly enjoy the spectacle of the president and prime minister beating each other up and deadlocking parliament. With the new hyrvnia rate eating into the profit margins of the steel and machinery sectors, they have been galvanised into action. PR leaders from Viktor Yanukovych down attacked the move aggressively in the press, before the NBU's supervisory council - with four PR members directly appointed from the Rada - took the unprecedented step of vetoing it.

The NBU council is not dominated by the PR: of its 14 members, only six are appointed by the Rada (the two non-PR ones are from the Socialist Party and council chairman Petro Poroshenko, is a Yushchenko confidante). The other seven - mainly academics - were directly appointed by Yushchenko, mostly at the outset of his presidency. It is hard to avoid the suspicion that the aim of the council was, at least in part, to put pressure back on Prime Minister Yulia Tymoshenko and her government. That in itself is not a bad aim, in our view. The main source of Ukraine's inflation is indeed fiscal, not monetary. Moreover, it is nearly June and there is no budget in place for the year.

Unfortunately, the council could not have chosen a worse tactic. Monetary policy, the world over, can be too tight or too loose; but it must always be communicated clearly and with conviction. Anything else will undermine the currency, cause higher inflation, lower investment and political instability: a high price to pay for making a political point.

Muddying the waters

One of the Ukrainian investment climate's saving graces for the last few years has been the relative clarity of monetary policy, compared with the rest of the political spectrum. Presidents, prime ministers, prosecutors and constitutional court judges have come and gone, but the central bank has consistently safeguarded the stability of the currency, at least in external terms. That consistency has encouraged Ukrainians to have more trust in their own currency. In 2002, long-term hyrvnia savings accounts in Ukrainian banks totalled only UAH585m (€78m). At the end of last year, they stood at UAH81.6bn - a substantial pool of savings with which to fund corporate and public investment.

Thus, when the evidence of the dollar's weakness became obvious even to the average citizen of Rivne and Luhansk, they changed their savings not into euros, but hryvnia. In 2007, the share of hryvnia in total long-term deposits rose by nearly 9 percentage points, to 62.9% of the total, after staying largely stable for the previous decade.

People are not by nature currency speculators. No normal person wants to go to bed unsure of how much their savings will buy when they get up the next day. Unfortunately, Ukrainians faced exactly that concern for much of the 1990s - at least until hyperinflation meant that they had no savings to worry about any more. They learned to think first and foremost of "stability" as defined by how many hryvnia would buy a dollar. Over time, that way of thinking recedes, as a responsible monetary authority ensures that the new currency gains first domestic, then international, trust. At this point, it becomes imperative to focus on internal, rather than external, stability, and for the authorities to target a low consumer inflation rate, rather than a stable exchange rate.

Arguably, Ukraine has not reached that point yet: although the domestic economy has grown rapidly over the last five years, external trade is still equivalent to over 70% of GDP. Little economic activity goes on, at least in the private sector, that isn't affected pretty directly by the dollar price paid for energy imports, or by the dollar price received for exported steel or agricultural products. In this respect, the NBU's supervisory council, through which the constitution forces the bean-counters to hear - if not obey - the voice of the people's representatives, had a legitimate gripe against the revaluation.

A very different case is the comments of the presidential staff on May 23 concentrating on the grievous harm done by the NBU to people whose savings are in dollars, and once again proclaiming the dollar peg as the "anchor" of stability. To the best of our knowledge, the world's sailors, over the years, have had little use for anchors made of jelly. If the economic might of the US and the combined intellectual brilliance and wisdom of its government are not enough to keep the dollar stable, then there is not much sense in expecting Volodymyr Stelmakh to do it on his own.

Ukraine needs the extra flexibility in its monetary regime that Stelmakh tried to introduce mid-May. More importantly, it needs to trust in the one institution that has demonstrated regularly its ability to defend the national interest in a competent and politically neutral manner. We expect the revaluation to stay in force, but note that extra flexibility means a greater readiness to let it depreciate if economic fundamentals dictate.

Geoffrey Smith is head of research at Renaissance Capital in Kyiv

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