"CONFRONT INFLATION NOW TO AVOID REGRETS LATER"
OP-ED: By Balazs Horvath, Resident Representative in Ukraine,
International Monetary Fund (IMF) and by
Martin Raiser, Economic Advisor, Poverty Reduction and Economic
Management, Europe and Central Asia Region, The World Bank
Economic News (in Russian), Kyiv, Ukraine, Friday, May 16, 2008

Article re-published in English by the U.S.-Ukraine Business Council
Kyiv, Ukraine, Friday, May 16, 2008 with permission of the authors

1. Surging inflation in Ukraine has become a major concern. Twelve-month
CPI inflation in April exceeded 30 percent, among the highest rates in
emerging markets. This makes fighting inflation a top political priority.

This is not a time for political point scoring. Successfully reducing
inflation will require all major political forces to work together: the
Government, the President, the National Bank of Ukraine and the Verkhovna
Rada.

2. The underlying cause of the rise in inflation is that domestic demand
exceeds supply by a significant margin.

This overheating reflects years of:

a. real wages rising faster than productivity;
b. social transfers, including pensions, rising at an unsustainable pace;
c. an explosive growth in money supply and credit fueled by large
    capital inflows under the de facto exchange rate peg; and the
d. effects of improving terms of trade on national income and domestic
    demand.

Exogenous price shocks for food, energy and other commodities have
played a notable additional role.

3. High inflation causes severe harm. Over longer periods, countries with
inflation above single-digit levels have grown substantially slower on
average than those with low inflation.

High inflation markedly lowers economic efficiency by confounding price
signals. It gives rise to a price-wage spiral and undermines
competitiveness.

It also weakens trust in the national currency, often stimulating capital
flight and diverting domestic savings from investments in productive
capacities.

Finally, inflation hurts the poor in particular, since they are much less
able to protect themselves against the erosion of their savings and incomes.
The public and politicians are right therefore to worry about inflation.

4. Now is the time to act in concert to curb inflation. If macroeconomic
policies are appropriately tight, inflation could decline substantially in
the second half of the year as growth slows to a more sustainable pace and
the new harvest-most likely better than last year's-helps lower food price
pressures.

The IMF and the World Bank believe that inflation could return to the low
teens in 2009 and to single digits by 2010. This would be in line with the
experience of countries that adopted an appropriately flexible and tight
macroeconomic policy mix, allowing them to contain inflation and weather
shocks well.

But without appropriate policies, inflation expectations are likely to drift
further upwards, giving price increases momentum that would be increasingly
hard to break.

5. Addressing high inflation is primarily a matter of controlling demand and
costs. Structural reforms that raise the supply of goods and services are
critical and should be implemented without delay, but their effect on supply
and inflation will only materialize in the medium-term.

Thus, near-term actions to lower inflation should focus on macroeconomic
policies managing domestic demand:

a. Fiscal policy should be tightened including by saving, rather than
spending, budgetary revenue overperformance and any excess privatization
receipts.

b. Social transfers should be contained through improved targeting, while
retaining budgetary support to the most vulnerable parts of the population.

c. To break the incipient wage-price spiral, minimum and public wage
increases should be kept at a level consistent with single-digit inflation.

d. At the same time, the scope for monetary policy tightening should be
increased by gradually moving away from the exchange rate peg in the
context of adopting inflation targeting as the monetary policy framework.

6. The authorities' initial policy response does not have consistent
political support and has failed so far to stabilize inflation expectations.

The budget was kept in broad balance to date, and the NBU has taken
several measures to tighten monetary conditions.

These steps, presented in the Government's anti-inflation program of March
2008, go in the right direction. But they are already under attack.

To raise the effectiveness of anti-inflation measures, the authorities
should stay the course and clearly explain that the hryvnia will be allowed
to fluctuate within a wider band to allow for more active monetary policy,
and that further increases in public spending and the minimum wage will be
delayed until demand pressures ease.

By contrast, planned administrative interventions in supply and price
formation would fail to sustainably raise supply or lower demand, and would
exacerbate the inconsistency of the policy mix, thereby simply accumulating
even greater problems for the future.

7. Ukraine is at a cross-roads and inaction could be very costly. Today, the
issue is no longer whether some slowdown in growth is a price worth paying
for lower inflation-some slowdown is inevitable and indeed desirable to
bring demand back into balance with supply.

By acting now to consistently tighten macroeconomic policies Ukraine will
be able to limit the costs of lowering inflation and inflation will come
down markedly starting this summer.

Conversely, delaying such policy action could push Ukraine towards a
prolonged period of high inflation, volatile and potentially negative
economic growth, and raise the risk of a sudden breakdown in investor
confidence. Such a scenario would primarily hurt the poor and the middle
class, at whom recent spending increases have been targeted.

8. Political backing is critical at this juncture. Sustained rapid growth is
well within reach given Ukraine's recent growth momentum and excellent
potential stemming from top-notch human capital, considerable comparative
advantage in several key sectors, favorable geographical location, and
promise of convergence toward the EU's level of productivity.

Political backing of near-term demand containment is key for ensuring the
credibility of the necessary inflation-fighting package, and hence, its
success.

Ukraine's politicians have joined forces in the past around issues that
mattered critically for the country's future, such as WTO accession.
Inflation-especially given its link to sustained growth-is clearly such a
critical issue today.

Politicians should act now on the basis of shared long-term interests and
back a coherent inflation-fighting policy package as well as a minimum
critical mass of structural reforms.

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LINK: http://eizvestia.com/fin/full/35554