Ukraine received some good news in the middle of August, receiving the backing of private sector bondholders to give Ukraine a 24-month debt service freeze.
The Paris Club agreed a similar initiative on Ukraine’s sovereign bonds until the end of 2023, with an option for a further 1-year extension. Potentially this saves Ukraine around $12.5bn in external debt service payments.
But agreement with foreign creditors for a debt service freeze does not hide the reality that Ukraine has not been receiving Western financing flows in sufficient scale and in a timely enough manner. The result has been sub-optimal policy decisions.
In particular, much has been made of the fact that Ukraine has been running a budget deficit of $4-5bn a month since the war began, which compares with a pretty balanced budget position before the Russian invasion. The cost of the war to Ukraine is thus of the order of $4-5bn per month. This is what Ukraine needs to fund this war.
According to Ukrainian Ministry of Finance (MOF) data, since the war began Ukraine's financing needs have been just short of $27bn, which tallies quite closely to the $4-5bn figure given above. But of this number, only around half has been met through Western financing, and of the latter there is a 40:60 split in grants to loans.
This raises multiple issues: First, the high share of loans means that Ukraine is being charged for fighting this (our) war. And as a result, when the war ends, Ukraine will be saddled with a weight of debt, and the risks there is then of a further need for debt restructuring which will delay/complicate market access when Ukraine's reconstruction needs will likely be enormous.
Second, the shortfall in financing has meant that the MOF has had to fall back on central bank financing of the deficit, to the tune of around $8bn. This is never a good scenario, it leads to fiscal dominance issues and I think we are already seeing the effects of this in terms of undermining central bank independence.
Additional monetary emission to fund the deficit puts added pressure on the exchange rate. Initially the NBU tried to counter this by maintaining a peg, but lost around $7bn defending the exchange rate. It has since re-pegged the exchange rate at a 25% weaker level, which cut weekly FX sales by around half to around $500m, but pressure is again building. But we all know that CB financing of the budget deficit leads to higher inflation, pressure on the exchange rate, reserve loss and the risk of an inflation-devaluation spiral.
But let’s be clear here that this is a case of "needs must" from the Ukrainian authorities; they are only going down this route because Western financing is coming too slowly and being caught up in bureaucratic idiocy – the EU pledged €9bn, mostly in debt, but only €1bn has been released thus far, months after the initial pledge. At least the US approved another $4bn disbursement this week.
Third, it's fine making short-term anti-crisis decision, like the NBU financing the deficit, but the danger is that all this becomes the norm – again the risk is of an inflation-devaluation spiral taking hold.
It’s a shame, as this would risk one remarkable plus so far from the conflict, that macro-financial stability has generally been maintained, and banks have functioned and there have not been any bank runs. The reason the latter has not occurred is because of the real reforms rolled out at the NBU, around MOF financing and in the banking sector since 2015. The introduction of a floating exchange rate, inflation targeting and restrictions on NBU financing of the deficit yielded strong underlying confidence in the system, which has held firm throughout the past six months of the conflict.
But we are now seeing backtracking, with a pegged exchange rate in effect, a move away from inflation targeting (or weakening of monetary transmission mechanism) and now the rise of fiscal dominance because the West is not pulling its finger out with adequate and timely financing of Ukraine.
For Ukraine to win this war, it’s not all going to be about guns, but about keeping the economy, its banks and financial system working. So far, the Ukrainians have done a remarkable job in incredibly difficult circumstances, but the West is at risk of failing them unless it fast-tracks disbursements to help fund the Ukrainian state. And now.
Timothy Ash is the senior sovereign strategist at BlueBay Asset Management in London. This note first appeared in an email to clients.