Ukraine should let currency float, impose capital controls - experts

MOSCOW. July 14 (Interfax) - Ukraine should stop fixing its exchange rate, work harder on raising more revenue and controlling expenditures, reprofile payment schedules on bonds, think about capital controls and double efforts to attract more resources on a bilateral basis, said Oleg Churiy, a former National Bank of Ukraine deputy governor, and Yuriy Gorodnichenko, professor at the University of California, Berkeley.

"If the current policy is continued, the NBU can run out of reserves and may resort to rationing of the foreign exchange and limiting its use only to purchases of weapons or other critical supplies," Ukrainian media quoted the experts as saying in an article for VoxUkraine.

Initial policies after February 24 were adequate, "however the landscape is changing, and macroeconomic policies should be adjusted," they said.

They said Ukraine's allies provide some support on a bilateral basis but this assistance is not enough so far: on average it is about $2.7 billion per month, while $5 billion is needed. The National Bank has to print money - UAH 225 billion since February 24 - to support the government.

"This situation is not sustainable. Although the NBU can provide direct support to the government, this comes at a cost of burning foreign exchange reserves at a fast pace. In June alone, the central bank sold approximately $4 billion of its reserves to support the hryvnia," Churiy and Gorodnichenko said.

"With limited resources and instruments, the central bank has to deal with conflicting objectives. It cannot simultaneously defend the exchange rate, print money to cover fiscal deficits, and support stability of the financial system," they said.

"Projected funding from the international community for the second half of 2022 is about $18 billion. With monthly foreign exchange interventions of about $4 billion and external debt payments, principal and interest, of $3 billion in the rest of 2022, foreign exchange reserves might decline to a dangerously low level of $12-15 billion. The reserves may be depleted further by potential demands from Naftogaz to pay for energy during the heating season, which might stand at $2-4 billion during the second half of 2022," the article says.

"Fixing the exchange rate was the right policy in the early months [of the crisis] when the economy was hit particularly hard and it was critical to control expectations and to avoid panic. However, with every additional day [...] the exchange rate is increasingly disconnected with the fundamentals in the economy thus creating further imbalances. The NBU can either devalue the currently or let it float freely. Each of these options has pros and cons but either of them should be implemented," it says.

With inflation rate in Ukraine well above global levels, the hryvnia has appreciated significantly in real terms which may be a drag on the economy, it says.

A devaluation today can provide a temporary relief, but it also creates expectations of future devaluations which can raise inflation expectations and reduce incentives of exporters to bring in hard currency.

"Free floating allows the market to absorb shocks [...]. One may be also concerned that with a floating exchange rate it is hard to have a nominal anchor in current conditions - another option is to control prices directly, which is a bad idea, or to focus on inflation targeting, which is hard to achieve when monetary transmission is so uncertain," the experts say.

As in April, the experts talk about the need to reprofile Eurobonds. "Payments on privately held sovereign debt amount to $1.7 billion in the second half of 2022 and $2.8 billion in 2023. At minimum, the government should reprofile payment schedules into a more distant future - at least three years - and this reprofiling should apply not only to bonds that mature in 2022-2023 but also to bonds that mature in later years," they say.

Capital controls may be justified in a critical situation. "One has to create a new, much more restrictive list, or raise tariffs - impose additional tariffs of 10-15% - to limit imports. There are many other tools one can use to limit outflow of capital from Ukraine. For example, the NBU can ban import prepayment, perhaps with some exceptions; curb potential foreign exchange demand from banks due to loan loss provisions; and impose tighter limits on payment card transactions by individuals."

As for attracting more resources on a bilateral basis, the experts say the NBU could work on establishing swap lines with other central banks - it has such a line with the Polish central bank.

The NBU fixed the exchange rate at UAH 29.25/$1 after February 24, however this has fallen in the money market from UAH 35.2-35.3/$1 to UAH 37.4-37.65/$1 in the past week alone.