COMMENT: Ukraine - the phantom of appreciation

By bne IntelliNews March 5, 2008

Oleksandr Zholud of the International Centre for Policy Studies -

The undervaluation of the hryvnia continues to be Ukraine's competitive advantage, just like the undervalued currencies of other dynamically developing countries, from Russia to China and Brazil. As the appreciation carried out in 2005 showed, the strengthening of the hryvnia does not stop inflation: from April to August 2005, inflation just steamed ahead, writes International Centre for Policy Studies' economist Oleksandr Zholud in an article for Ekonomichna Pravda, an online publication.

Conditions for hryvnia strengthening

Unlike his European and American counterparts, Governor of the National Bank of Ukraine (NBU) Volodymyr Stelmakh rarely makes public speeches. This is why people listen very carefully to each of his statements, looking for hints about the NBU's plans.

On February 18, Stelmakh stated that the pre-conditions for strengthening the hryvnia were now in place. Many people interpreted this as the National Bank intending to let the hryvnia appreciate against the US dollar in the immediate future. However, no appreciation happened after a similar statement last year. A year ago, Stelmakh said that there were economic grounds for letting the hryvnia strengthen, but it was necessary to see how this would affect different sectors of the economy.

According to analysts, the fundamental reasons that are creating pressure for the hryvnia to appreciate, first of all, include the significant inflow of foreign currency to the country. Indeed, despite the negative balance of foreign trade that raises the need for foreign currency to cover this deficit, the NBU increased its reserves by $10.2bn in 2007.

However, this year, the situation is somewhat different: in January, NBU reserves shrank $668m. According to preliminary data for February, the NBU sold foreign currency on the interbank foreign exchange market at least three times. This means that there is no immediate pressure on the hryvnia.

The official hryvnia/dollar rate unchanged in three years

Ukraine and Turkmenistan are two CIS countries that have not revised their official exchange rate against the dollar in the last three years. The majority of other CIS countries have revalued their currencies during this time. A similar situation has emerged in Central and Eastern Europe over the last few years. The Czech Republic, Poland and Hungary all revalued their currencies against the dollar and the euro. This, along with the fact that the hryvnia is one of the most undervalued currencies in the world, is an additional incentive to strengthen the currency.

Although the official hryvnia/dollar exchange rate has remained absolutely unchanged since August 2005, inflation has had its effect. Both the dollar and the hryvnia have less purchasing power in Ukraine than a year or two ago. After the appreciation of spring 2005, the real effective exchange rate - that is, the nominal exchange rates against the currencies of Ukraine's trading partners, taking into account inflation in these countries and in Ukraine - has been almost unaltered.

The fall of the dollar against the ruble and the euro (Russia and the EU are Ukraine's key trading partners) has been compensated for by faster growth in prices in this country. That is, the situation with the exchange rate is similar to what could be seen after appreciation in 2005. The foreign trade balance is putting pressure more towards depreciation, while the flow of capital from abroad remains under question because of the global financial crisis.

Last year, large volumes of foreign currency flowed to Ukraine due to overall optimism regarding the world economy as a whole and developing markets in particular. This attitude shifted considerably after a mortgage crisis that began in August in the US, has not been eliminated yet, and will continue to make itself felt this year.

Earlier, domestic banks actively borrowed abroad. Although this crisis did not have a direct impact on Ukraine, it forced Ukrainian banks to look for sources of financing as an alternative to international borrowings. For instance, in the second half of 2007, it became more difficult for domestic banks to issue Eurobonds. In the third quarter, banks still continued to issue Eurobonds, based on loan agreements concluded before the crisis. By the fourth quarter, Ukrainian banks stopped issuing Eurobonds altogether. As a result, Ukraine's banks began to borrow actively on the domestic market, significantly increasing the volume of loans compared to the previous year.

As fluctuations among global stock indices over January-February showed, the 2007 financial crisis has not gone away yet. This means that, most likely, investors will be more cautious, even about lending money to new economies, including to Ukraine.

An undervalued hryvnia is to Ukraine's advantage

There is also the psychological factor. In seven years of relatively strictly pegging of the hryvnia to the dollar, Ukrainians have grown accustomed to a stable exchange rate. Nobody can definitely tell how economic agents - businesses, households and investors - will behave if the hryvnia is allowed to appreciate. In such a situation, it makes sense to liberalize the hryvnia exchange rate very carefully, over a long period of time, rather than instantly. This is why Ukraine will most likely not see any changes in the official hryvnia-dollar exchange rate anytime soon.

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