Financial markets in the war and beyond
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Financial markets in the war and beyond

Photo: ua.depositphotos.com / leungchopan
19 April 2022
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What economic policy is optimal during a war? Since Russia annexed the Crimea and occupied parts of the Donbas in 2014, this was not a purely academic question for the National Bank of Ukraine and the Ukrainian government. But answering this question got a new sense of urgency on February 24, 2022 when Russia invaded Ukraine. Furthermore, after more than 50 days of heroic resistance, Ukraine has to think very hard about how it can sustain its economy to endure the fight and whether initial moves to protect the economy continue to serve the country in the best possible way.  

In response to the invasion, the National Bank of Ukraine swiftly fixed the exchange rate and imposed capital controls (e.g., investment abroad is prohibited, Ukrainian businesses can’t repatriate income abroad, foreign exchange can be provided only to purchase critical imports, etc.). These decisions helped to mitigate the first shock and prevent a financial panic. To further protect the financial sector and the economy, the central bank tightened the restrictions in the following weeks (e.g., impose limits on payment cards and withdrawals). These policies are consistent with the experience of Ukraine in 2014-2015 as well as the experience of countries during World War II. Indeed, when markets are disrupted and prices likely fail to allocate resources, focus on quantities is common practice. In addition, given the sensitivity of inflation expectations and trust in the banking system to the exchange rate, a fixed exchange rate provides an important nominal anchor that likely dominates alternatives such as inflation targeting. 

Is this going to be enough? It is increasingly clear that the war can last for a while and so it is critical to have “durable” policies that support a resilient war economy. To this end, we would like to offer two key recommendations. 

First, the war puts the exchange rate under enormous stress. With the blockade of ports, Ukraine has limited capacity to export. On the other hand, Ukraine has to import a number of essential goods to keep the economy and army running. The resulting current account deficit erodes the foreign exchange reserves and thus undermines the fixed exchange rate. In these conditions, it is vital to limit imports to critical goods. Unfortunately, the list of critical goods keeps growing and now includes such “critically” important items as bananas or yogurt. In fact, the current list covers 89% of all imported goods. This is a gross mistake that must be corrected immediately. The list should include only truly critical goods. To further protect the foreign exchange reserves, the central bank should tighten capital controls even more. For example, the additional controls could cover a ban on repatriation of non-resident loans by banks, a ban on conversion corporate clients foreign-currency loans into the hryvnia, a limit on foreign exchange net purchases by banks into open currency position, a ban on non-essential payments such as cryptocurrencies, bookmaker’s services, etc.

Second, the war imposes a very high burden on government finances and management of government debt. After the initial shock, the economy is gradually recovering but the tax revenue is significantly below pre-war levels while government spending has soared. If raising taxes is not an option, the fiscal deficit can be covered only with printing money (given the current trends, this source might cover roughly 10-20% of the estimated need), loans from other governments or international financial institutions (approximately 20-25% of the estimated need), and internal borrowing (mainly domestic banks). Each of these sources has a limit. 

Because victory depends on the ability of the government to pay for the war effort, it is critical to set clear priorities for different types of public spending. Apart from outright cutbacks of government programs, anything that allows the government to reschedule payments from the present to the future frees up resources to pay for the war now. For example, development projects funded by the government (planting trees, census, etc.) can be put on hold. In the same spirit, the price of Ukraine’s public external debt (eurobonds) is about 40 cents on a dollar. This low price signals that investors do not expect to be paid in full and some form of debt restructuring is already priced in. The government can probe a targeted restructuring or reprofiling of sovereign eurobonds without risking a major upheaval for the domestic economy since the Ukrainian banking system has little exposure to sovereign eurobonds. This will not only lessen the strain on the fiscal position but also minimize eating away foreign reserves. Obviously, the war leaves few easy solutions in this environment and yet tough choices must be made. 

These policies have a clear element of firefighting but they can also lay foundations for a post-war recovery. For example, lowering debt burden now is essential for paving the way to more government spending to rebuild infrastructure. Capital controls and foreign exchange interventions can help align the economy with the growth trajectory in the future. For example, on its path to become a member of the European Union, Ukraine will need to shift its focus from the dollar-hryvnia exchange rate to the euro-hryvnia exchange rate. Indeed, trade with the European Union will play an increasingly important role, remittances mainly come from European countries, and funding for reconstruction will likely come from the European Union. This transition to the euro-based regime may be accelerated by the central bank doing interventions in euros rather than dollars while capital controls are still in place but also for some time after the war is over. The coordination between the central bank and fiscal authorities developed during the war can help with exiting the fixed exchange rate. For example, the ministry of finance can use its external funding to participate in the foreign exchange market via state-owned banks, providing foreign exchange supply and hence help with making a smooth transition to a floating exchange rate.

In summary, a possible war of attrition requires Ukraine to implement prudent policies right now. Foreign exchange reserves must be used frugally, fiscal resources should be focused on funding the war effort. Although these policies necessarily aim to maximize the probability of victory, one can look beyond the horizon and use these policies to also pave the way for the economic future of the country as well.    

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