Ukraine should adopt an ‘Export Price Norm’

It has not be a great year for Emerging Markets and the next Emerging Markets country to worry about could very well be Ukraine.

This is what my Danske Bank colleague Sanna Kurronen has to say about Ukraine:

We have been expecting a soft devaluation of the Ukrainian hryvnia for some time, as the artificially strong exchange rate is creating severe imbalances in the economy. Currently, we see it as a likely scenario that Ukraine will allow soft devaluation in accordance with the IMF, which would lead to a 10% devaluation of the currency and then move to a managed float regime following the Russian example. However, as the necessary devaluation has been continuously postponed, it is beginning to seem more likely that the devaluation will be more dramatic.

GDP has been contracting for a year now in Ukraine as domestic production has been declining significantly. Yet, retail sales growth was still 6.7% year-on-year in August, supported by low inflation and rapid wage growth. A large current account deficit has been putting a pressure on the hryvnia, which has led to a rapid deterioration in Ukrainian foreign exchange reserves. The reserves are already at a critical level, below three months’ worth of imports. As market sentiment remains vulnerable for emerging markets, we believe external debt issuance is now very difficult for Ukraine and that significant debt redemptions are ahead.

A little more than a third of outstanding loans to both households and firms in Ukraine are still foreign-currency denominated. This makes devaluation politically very difficult. Nevertheless, we believe it is a good time for Ukraine to close a deal with the IMF, hike domestic gas tariffs and allow devaluation of the currency. Co-operation with the IMF would of course reduce the country’s independence, but only temporarily. The other alternative would be closer co-operation with Russia, which might have less predictable consequences. A hike in gas tariffs would speed up inflation, but the CPI is now around 0%, so there is room for tariff increases. The presidential election is still some time away (in March 2015), which allows the economy to grow while the election draws nearer. By postponing a necessary devaluation of the currency, Ukraine risks a severe collapse in its currency, whereas the IMF could provide the tools for a more restrained devaluation.

This is very much a story of fear-of-floating (due to significant foreign currency lending) and regime uncertainty (the political situation is nearly by definition always extremely uncertain).

Ukraine’s fundamental problem is an extremely dysfunctional political system and all other problems seems to smaller or large extent to be a function of the fundamental “regime uncertainty” in the country. However, purely looking at the monetary side of things it is clear that Ukraine should move towards a much more “floating” exchange rate or alternatively introduce a variation of what I have termed an Export-Price-Norm (EPN).

Ukraine could introduce an Export Price Norm by pegging the hryvnia to a basket of US dollars and the price of the country’s main export products – steel and agricultural products. That I believe would do a great deal to stabilize aggregate demand growth in the Ukrainian economy and at the same time introduce a lot more rule-based monetary policy in Ukraine. Something badly needed in a country known for extremely low levels of transparency in economic policy making.

If the hryvina was pegged to a basket of the dollar and the price of the main export goods then the hryvina would automatically weaken if the price of for example steel or agricultural products drop. That would lead to an significant stabilization of export prices (measured in hryvina), which on its own would do a great deal to stabilize overall aggregate demand in the economy. It would not be perfect, but it certainly be much better than the present quasi-pegged exchange rate regime and would likely also work better than a freely floating currency.

If you want to read more on why I think an Export Price Norm would work well for Emerging Markets commodity exporters see more here in the case of Angola, Russia, VenezuelaMalaysia and South Sudan.

Ukraine NGDP steel

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  1. Egor Duda

     /  September 24, 2013

    “A little more than a third of outstanding loans to both households and firms in Ukraine are still foreign-currency denominated.”

    Lars, is it safe to assume that large part of this foreign-currency-denominated debts are going to be in default if Ukrainian Central Bank is to follow AD stabilization policy, such as EPN? Are you aware of any research regarding supply-side effects of such massive defaults? I’d grant that many of those loans are “bad” anyway, but is it possible that Ukrainian CB may want to “steer” the economy somewhat between risks of massive defaults and risk of insufficient AD?

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