UKRAINE: "FLOATING THE HRYVNIA ARMS THE
NATIONAL BANK TO FIGHT INFLATION NOW"
Ukraine's inflation has got out of control. This inflation
crisis is Ukraine's most urgent economic problem.

OP-ED: By Anders Aslund, Senior Fellow of the Peterson
Institute for International Economics, Washington, D.C.
Kyiv Post, Kyiv, Ukraine, Thursday, April 03 2008

Let the hryvnia exchange rate appreciate to contain Ukraine's inflation.

Ukraine's inflation has got out of control. In February, it surged to no
less than 22 percent over February 2007, doubling from 11.6 percent in 2006.

This inflation crisis is Ukraine's most urgent economic problem. Unlike in
the 1990s, the problem is not the budget, which is close to balance.
Instead, the main culprit is the inept exchange rate policy.

Most of the inflation can be explained by the dollar falling in relation to
the euro by 12 percent in this period, and the euro is much more important
than the dollar in Ukraine's foreign trade. Ukraine imports the inflation of
rising international food and energy prices through its dollar peg.

The hryvnia rate has been pegged to the dollar since 2000, at a fixed 5.05
hryvnia per one dollar since 2005. The inflation will continue to rise if
the dollar plummets.

Strangely, many Ukrainian industrialists claim to be happy with Ukraine's
exchange rate policy. These businessmen harbor the dangerous illusion that
this is good for Ukraine's competitiveness and exports to maintain a low
exchange rate. In reality, this exchange rate policy harms Ukraine's
competitiveness and must be abandoned.

Such reasoning confuses the nominal exchange rate, which has been fixed,
and the real exchange rate that has risen sharply. For the last eight years,
Ukraine has enjoyed a real economic growth of 7.4 percent a year, but the
GDP measured in current dollars has risen by no less than 24 percent a year.

This means a real appreciation of the hryvnia in relation to the US dollar
of nearly 17 percent a year from 2000 until 2007, because the real
appreciation is the sum of nominal appreciation (which has been zero) and
inflation.

The dollar peg does not only make Ukraine import inflation, it also breeds
additional inflation, which undermines the country's competitiveness. The
dollar peg forces the National Bank of Ukraine (NBU) to maintain a negative
real interest rate and pursue an extremely loose monetary policy, because
Ukraine's current discount rate is a paltry 10 percent a year.

With inflation of 22 percent per year, a normal interest rate yielding a
real interest rate of 3 percent per year would be 25 percent per year. But
such a high nominal interest rate in dollar terms is neither desirable nor
feasible with a dollar peg, because it would lead to a huge, short-term,
speculative inflow, which would flow out after an inevitable appreciation.

Because of its sharply falling real interest rates, Ukraine's money supply
(M3), which increased by 35 percent in 2006 exploded by 52 percent in 2007.
After the financial crises of the 1990s, such increases were permissible, as
the Ukrainian economy was undergoing a fast demonetization, but today the
result is massive inflation.

Ukraine needs to approximately halve its monetary expansion. Otherwise
inflation might rise toward 30 percent for no good reason. Such high
inflation will render economic calculation highly unpredictable, disorganize
the economy, and dampen growth.

Admittedly, many transition countries have had double-digit inflation for
years without apparent negative effects, because while converging with
European economies, their price levels are also converging, but no
inflation over 10 percent a year is permissible.

Ukraine's government and National Bank need to focus on getting inflation
under control. First of all, the exchange rate policy must be changed to
allow the hryvnia to appreciate. The standard advice is to broaden the
currency band.

Officially, the NBU has set it at 4.95­5.25 hryvnia per dollar, but until
mismatch it intervened and bought dollar when the hryvnia tended to
appreciate. The simplest policy change is to broaden the band further and
let the hryvnia rise.

Then, Ukrainians will quickly learn that it is uneconomical and insecure to
hold dollars, and they will exchange their dollars for hryvnia or euro. As a
result, the far-reaching dollarization of the Ukrainian economy will ease,
reducing the currency risk, to which many Ukrainian enterprises and
individuals are exposed.

After some time of controlled hryvnia appreciation, the NBU can move on to
a floating exchange rate, which presumably will rise substantially because
of the substantial capital inflows.

An alternative approach would be to follow Russia's example, by relating the
exchange rate to a basket of euro and dollar, which allowed for an effective
ruble appreciation of 7 percent in each of the last two years.

Considering how far the dollar has already fallen, however, and how high
Ukraine's inflation has soared, this step would be belated and insufficient.
Although its inflation stays at a more moderate 13 percent, Russia is on its
way toward free float. Ukraine needs faster improvement.

When Ukraine has adopted a floating exchange rate for the hryvnia, the
NBU can finally raise its interest rates, so that real interest rates become
positive without nominal rates skyrocketing. The NBU can restrain the
monetary expansion and contain inflation.

The International Monetary Fund, the OECD and a range of international
economists have long urged Ukraine to alter its exchange rate policy in such
a fashion. Poland and the Czech Republic have long pursued such a policy
of inflation targeting, which has led to low and predictable inflation.

Until recently, the cost of Ukraine's inappropriate exchange rate policy was
limited. But at least three things have changed with the current financial
crisis: the dollar is slumping, and the hryvnia with it; international food
and energy prices are soaring; and domestic inflation has doubled.

Therefore, Ukraine can no longer afford to pursue an exchange rate policy
that lacks intellectual underpinning.

Let the hryvnia exchange rate appreciate to contain Ukraine's inflation!

Anders Aslund, who is a senior fellow of the Peterson Institute for
International Economics, Washington, D.C., is the author of "How
Capitalism Was Built: The Transformation of Central and Eastern
Europe, Russia, and Central Asia." Aslund has served as a senior
advisor to the U.S.-Ukraine Business Council (USUBC) for several years.


LINK: http://www.kyivpost.com/opinion/oped/28759/