From 2000 to 2008, the National Bank of Ukraine (NBU) pegged the Hryvnia to the US dollar. In the autumn 2008 the international financial crisis hit Ukraine and the currency was let to float, a move which implied a sizeable devaluation. During the course of 2009 the NBU allowed for some currency flexibility. However, since January 2010 the Hryvnia has been de facto fixed once again to the US dollar at a level of around 8.00 UAH/USD.
From January 2010 till mid-2011 the peg was held without significant turbulences. However, starting from mid-2011 problems appeared and from mid-2012 these problems intensified. By now, it is obvious that the peg does not represent a sustainable FX policy. Official FX reserves are dropping fast and have now reached the critical level of 3 months import coverage. But also the current account is deteriorating fast. In 2012, the current account deficit is heading towards 7.2% of GDP, at a time of relative low FDI and difficult access to international capital markets. The population reacts with heavy purchases of cash FX, thus further weakening the currency and making the situation even less sustainable.
On top, the current FX policy has a very negative impact on economic growth. In order to maintain the overvalued exchange rate, monetary policy is extremely restrictive and interest rates very high. At some stages, the benchmark 1-month Kiev prime surpassed 40%, while inflation is practically zero. High interest rates imply lower investment and are bad for short- and long-term economic growth. In short, the current FX system is not sustainable and is restricting economic growth. Thus, the question is no longer whether, but how to change the system.
Two changes need to be performed: the level of the exchange rate has to be adjusted and a new system has to be installed. Regarding the level, there is a sizeable, though not huge need for devaluation. In principle, a gradual devaluation could prevent some hardship for economic agents. However, the current low level of FX reserves does not allow for a gradual approach. Thus, the country needs a sudden devaluation. In order to ensure an orderly process and to anchor expectations for the future, the sudden devaluation needs to be accompanied by the establishment of a new system. On the one hand, the new system has to provide an anchor for monetary policy and expectations; on the other hand, it needs to secure enough flexibility for absorbing shocks.
Regarding the anchor, we propose the use of a currency basket consisting of US dollar, Euro and Russian Rouble, with each currency having the same weight (i.e. 1/3). This weighting broadly reflects Ukraine’s trade patterns and is easy to understand. A currency basket is in our view preferable to a peg to the US dollar, especially because it reduces the negative effect of cross currency volatility between the major currencies. While the choice of a currency basket already increases flexibility, there is a need to ensure additional flexibility by setting a relatively wide band.
The new exchange rate system will help to restore macroeconomic stability and economic growth. At the same time, it will pave the way for the foreseen introduction of inflation targeting in the medium term. Higher exchange rate flexibility, especially towards single currencies such as the US dollar, will contribute to the development of institutions and instruments which are necessary for implementing inflation targeting in the future.
Finally, the new transitory exchange rate system should be part of an overall adjustment of macroeconomic policy, including a clear tightening of fiscal policy. The necessary adjustment of macroeconomic policy should be implemented in the context of a new IWF program; a move that will increase credibility and the likelihood of an orderly exit out of an unsustainable macroeconomic situation.
