Ukraine The Inflation Challenge

1
Ukraine The Inflation Challenge
Dr. Edilberto Segura Chief Economist SigmaBleyzer,
The Bleyzer Foundation May 15, 2008
v6
2
Ukraine- Economic Performance has been Good

• Between 2001 and 2006, Ukraine showed excellent
  performance, with high GDP growth, low fiscal
  deficits, moderate inflation rates, fairly stable
  foreign exchange rates, good current account
  situation, high international reserves, and low
  ratio of external public debt to GDP.
• But 2007 showed signals of economic
  disequilibria, with high rates of inflation
  (16.6) and larger current account deficits (4.2
  of GDP).

Source State Statistics Committee of Ukraine,
National Bank of Ukraine, Ministry of Finance of
Ukraine, The Bleyzer Foundation
3
Comparative Economic Performance

• Over the last five years, the Ukrainian economy
  grew by 7.9 per annum, becoming one of the
  fastest growing economies in the region.

4
But Inflation is also high

• But in 2007, Ukraine also had the highest
  inflation rates in the region and even in the
  world.

20
18.8
16
16.6
13.4
12
12.1
11.9
11.6
8
6.6
6.7
6.3
6.3
4
4.8
4.1
4.0
3.0
3.1
2.5
0
USA
world
CEE
Asia
EU-15
Moldova
Poland
Ukraine
Russia
Bulgaria
Belarus
Canada
Australia
Romania
Kazahstan
Latin America
5
Monetary Performance Accelerating Inflation

• In 2004-2006, inflation was already high at 12
  pa, driven by food utility prices.
• Acceleration of food prices led to inflation of
  16.6 in 2007 and 30 yoy in April 2008.
• Increases of food prices were due both to supply
  and demand factors.
• On the supply side, food prices were affected by
  bad weather (with agricultural value-added
  declining by 5 in 2007), higher input prices,
  pass-through of energy price increases to
  agriculture and higher global food prices.
• On the demand side, loose monetary and fiscal
  policies also contributed to increased inflation
  following NBUs large purchases of foreign
  exchange, rapid growth of bank credit and large
  social fiscal expenditures.

6
Origin of Loose Monetary Policies

• The NBU policy of fixing the exchange rate to
  the dollar reduced inflation in the 1990s.
• But with large trade surpluses and/or capital
  inflows, in order to maintain the exchange rate,
  the NBU had to purchase large sums of foreign
  exchange and supply billions of Hryvnias to the
  market.
• The side chart shows that the purchases of
  foreign exchange by the NBU (red line) almost
  entirely absorbed the net inflows of foreign
  exchange, thereby maintaining the peg.

Ukraines External Sector and NBU Interventions
on Forex Market ( billion, quarterly)
7
Sources of Foreign Capital Inflows
Foreign Capital Inflow ( billion)

• The side charts show the composition of foreign
  capital inflows.
• Over the last two years, foreign direct
  investments contributed 25 of capital inflows.
• The major capital inflows came from increases in
  commercial bank borrowings (45 of the total) and
  other borrowings (particularly corporate
  long-term debt).

External Debt by Sectors ( billion)
8
NBU Interventions and Money Supply Increases

• The chart shows that the volume of NBU
  interventions and the growth of the monetary base
  were very close.
• These purchases of foreign exchange inflows by
  the NBU led to a 40 pa growth of the monetary
  base in 2004-07.
• Increases in the monetary base, together with
  bank deposits originating from income, wages,
  pension payments -- and the effects of the money
  multiplier -- led to growth rates of broad money
  supply (M3) of 47 pa during the last three
  years.
• These increases in money supply and bank foreign
  borrowings in turn led to rapid increases in bank
  credit (which increased by about 70 pa over the
  last three years).

NBU forex operations and Monetary base, UAH
billion
9
Role of Fiscal Policies

• The chart shows that in the last five years,
  fiscal deficits have not been excessive,
  averaging 1.0 of GDP.
• These small deficits occurred even when fiscal
  expenditures were growing at a real rate of 30
  pa.
• These expenditures were financed by higher taxes
  and the elimination of exemptions and privileges,
  enjoyed mainly by the corporate sector.
• But these policies led to large transfers of
  resources from the corporate sector to
  households.
• Although this may have been socially desirable,
  this extra purchasing power in the hands of poor
  households led to increases in consumption,
  aggregate demand and inflation.

10
Contributors to the Increases in Money Supply
Contributions to money supply growth by selected
components and counterparts (Percentage points)

• The side chart shows that the major contributor
  to the increases of narrow money (M1 currency
  plus demand deposits) has been the accumulation
  of foreign exchange by the NBU.
• The need to finance fiscal deficits has had a
  negligible effect on increases in money supply
  in Ukraine.
• This contrast with the experience of Latin
  America and Asia where the financing of fiscal
  deficits were the main sources of money supply
  increases and of inflation.

11
Effect of Money Supply Increases on Inflation

• The side chart shows that money velocity (the
  inverse of money demand) declined from 1998 to
  2005, reaching a plateau in 2005.
• Therefore, up to 2005, money supply increases had
  not resulted in high inflation thanks to a growth
  in money demand that accompanied high rates of
  GDP growth.
• During this period, the NBUs policy of
  purchasing FX and monetizing the economy was
  reasonable.
• But after 2005, the net increases in money
  supply/credit, together with supply shocks, have
  been leading to higher inflation.
• In the future, there is little room for increases
  in money supply to outpace money demand without
  inflation.

12
Measures to Control Inflation

• Controlling inflation requires credible
  measures to reduce the gap between aggregate
  demand and aggregate supply.
• Increasing aggregate supply is a painless measure
  as it reduces inflation while supporting GDP
  growth. This strategy should be strongly
  pursued. However, a supply response takes time
  to emerge.
• In the short term, the only available option to
  control inflation is to contain aggregate demand.
  
• This requires controlling the expansion of money
  supply and the growth of fiscal expenditures.
• As noted, in many countries, inflation has been
  caused by increases in money supply arising from
  the need to finance very high fiscal deficits in
  excess of 5 of GDP. This is not the situation
  in Ukraine.
• The main task to reduce money supply increases in
  Ukraine is to reduce or sterilize the purchases
  of capital inflows by the NBU arising from
  external commercial bank and corporate borrowings
  and to control the rise in fiscal expenditures.

13
Inflation Government Actions

• The NBU/Government has taken a number of measures
  to tame inflation
• The NBU has reduced its purchases of foreign
  exchange, allowing the FX rate to go below the
  official FX band (to UAH/ 4.95-5.25).
• The NBU carried out sizable sterilization
  operations, absorbing more than 12 billion of
  excess liquidity since November 2007.
• The NBU has tightened reserve requirements on
  foreign capital borrowed from abroad and
  tightened capital adequacy norms.
• The NBU has raised its discount rate by 400 basis
  points to 12.
• The government plans to reduce its 2008 fiscal
  budget deficit to 1.2-1.5 of GDP (down from
  previously targeted 2.1 of GDP).
• The government has postponed the issuance of
  Eurobonds and relies on domestic debt.
• From May 2008, it will pass-through increases of
  natural gas prices to households, gradually
  raising tariffs by 19 - 49.

14
Further Recommended Action

• The Government program may succeed but even if
  money supply and fiscal expenditures were to be
  controlled, inflation inertia may continue.
• Inflation is positively related to increases in
  money supply, and is negatively related to
  increases in money demand and real income.
• But many studies show that expectations about
  future inflation are key.
• This means that the credibility of the
  government measures to control inflation may
  determine their success or failure.
• International experience with disinflation
  programs shows that their success depends on
  whether (a) they can cool off aggregate demand
  or increase supply, and (b) they are credible to
  the public.
• Experiences in other countries suggest that a
  credible anti-inflation program should include
  the following
• (1) The real causes of inflation and the
  concrete anti-inflationary measures should be
  carefully explained to the public in a
  coordinated way by all agencies and based on
  concrete measures -- just a list of proposed or
  intended broad measures will not be credible

15
..Further Recommended Action

• (2) The policies should represent a Big Bang
  approach including strong fiscal, monetary and
  supply measures, since gradual measures will not
  bring credibility. This requires that all
  government agencies should present a
  comprehensive program that would include the
  following
• The NBU should state and adopt a more flexible
  exchange rate regime allowing money supply to
  increase at a rate close to the desired inflation
  rate.
• An over-adjustment of fiscal tightening should be
  adopted to support credibility of this policy
  transformation and anchor expectations. The
  fiscal budget for 2008 should be balanced and a
  credible cap on government expenditures should be
  implemented.
• The above demand side policies should be
  accompanied by the implementation of stronger
  measures to increase aggregate supply by
  improving the countrys investment climate,
  including public governance, legal and judiciary
  matters, regulatory quality, corporate
  governance, pension reform, banking supervision,
  energy efficiency and similar measures. Strong
  measures to improve the supply of agricultural
  products should be implemented.

16
..Further Recommended Action

• The NBU should have as its policy objective the
  control of inflation and not attempt others, such
  as foreign exchange stability or economic growth.
  Furthermore, the NBU should have sufficient
  independence to enable it to be responsible and
  accountable for inflation control.
• If the FX anchor is phased out, the NBU has two
  inflation anchoring options One is to target
  monetary aggregates the other is to target
  inflation.
• The international experience is that monetary
  targeting is unfeasible when the relationship
  between the money and inflation is unstable,
  which is true for Ukraine. This undermines the
  credibility to monetary policy, which is crucial
  in managing inflation expectations. Moreover,
  there are very few countries where monetary
  targeting proved to be successful.
• On the other hand, the experience of inflation
  targeting in a number of countries shows that it
  can be quite successful in reducing inflation
  rate, even in the periods of adverse supply side
  shocks.
• Inflation targeting involves defining a monetary
  policy instrument, such as a key interest rate
  of the NBU, making an accurate forecast of
  inflation, developing a good understanding of the
  lags and the transmission mechanisms through
  which the monetary policy instrument affects the
  real economy (aggregate demand, aggregate supply
  and exchange rates) and eventually the rate of
  inflation.

17
Comparing Ukraine with Kazakhstan
Ukraine
Kazakhstan