No fear of floating for the hryvnia

To prevent the panic, the National Bank of Ukraine (NBU) fixed the exchange on the first day of the full-scale war. It largely worked: the public regained confidence in the Ukrainian economy. However, this policy worked only for some time. In July 2022, the NBU had to devalue the hryvnia by roughly 25% to relieve pressure on foreign exchange reserves, restore the external competitiveness of Ukraine, raise more fiscal revenue, and align the official and cash-based (“black market”) exchange rates. By the nature of the fixed exchange rate, as time goes on, potential mis-pricings and imbalances accumulate and one reaches a critical point when another adjustment is necessary. So another correction of the exchange rate in a long war is a near certainty.

We already see how vulnerabilities are building up. First, the real exchange rate (that is, the nominal rate adjusted for differences in the price levels across countries) is appreciating because Ukraine’s inflation (≈ 30% per year) is much faster than the inflation rate of its trading partners (≈ 10% per year). This makes Ukrainian exporters less competitive and depletes NBU’s foreign exchange reserves. For example, just before the July devaluation, the NBU was burning reserves at the rate of $4 billion per month. The devaluation helped to reduce the outflow to roughly $ 2 billion per month. However, this reprieve was temporary and the outflow accelerated to approximately $3 billion in October. This is potentially dangerous if foreign aid to Ukraine is delayed or withdrawn. Second, the gap between the official and cash-based exchange rates creates distortions for the economy and opportunities for abuse and corruption. Third, although the NBU fixes the hryvnia to the US dollar, the main trading partner for Ukraine is the European Union and the euro depreciated against the dollar which further hurts Ukrainian exporters. Fourth, given the current environment, a correction of the exchange rate becomes a highly politicized event which likely postpones the necessary adjustments and hence results in worse economic outcomes. Obviously, the best policy is to try to nip these problems in the bud but what is the right way to do it?

The wartime experience of other countries may help see the range of the options. For example, Israel and South Korea, two countries with perennial security challenges, have not been using the fixed exchange rate over the last 30 or so years. Although they experimented with crawling pegs, managed floats and other hybrid regimes, the general idea is to allow the exchange rate to adjust in response to market forces. Famously, the U.S. abandoned the gold standard because it was unsustainable due to highly expansionary monetary and fiscal policies during the Vietnam war. Many countries during World War I suspended the conversion of their currencies into gold. On the other hand, Iraq after the 2003 war had a fixed exchange rate with occasional adjustments. In short, there is a variety of regimes adopted by countries during wars and one has to consider specific conditions to make a recommendation.    

Given the high sensitivity of inflation expectations to the exchange rate in Ukraine, a free float can generate excessive macroeconomic volatility. Indeed, the hryvnia gyrated violently during the 2014-2015 after the first Russian invasion. Hence, the solution has to be an intermediate option.

Crawling peg, one of these intermediate options, publishes a schedule (usually a year) of future exchange rates. As a result, it provides some flexibility and limits volatility but there are nuances. First, only market forces can find the point where demand meets supply and hence a crawling peg can be mispriced. Second, if the central bank publishes a schedule with the local currency gradually depreciating, such a schedule will worsen inflation expectations which can destabilize the regime. Third, just like with the fixed exchange rate, unexpected shocks may call for changes in the trajectory of the peg which can undermine the credibility of the central bank. Hence, the NBU should focus on policies with fairly short horizons.

Another intermediate option is to limit daily fluctuations in the exchange rate to a narrow band. For example, the exchange rate cannot depreciate or appreciate by more than 0.1% on any given day. In this case, the direction of adjustment is determined by market forces but the speed of adjustment is controlled by the central bank. Note that this regime does not promise to devalue the hryvnia: the exchange rate can appreciate or depreciate depending on the situation. The experience of the hryvnia during the COVID-19 crisis underscores how useful this feature is for Ukraine: after the hryvnia weakened in the early days of the crisis, eventually the hryvnia got stronger because demand for Ukraine’s output remained strong. As a result of this flexibility, the Ukrainian economy faired relatively well in 2020-2021. If the number of trading days in a year is set to 250, the hryvnia depreciates by at most 28 % ( = (1.001^250-1)*100) in the worst case scenario which is large enough to accommodate the current 20% differential in inflation rates (30% for Ukraine minus 10% for the euro). But this adjustment will be gradual thus giving ample time for the economy to adapt. In short, this regime, which has been tried before, strikes a balance between allowing market forces to speak (and thus help the economy adjust) and containing fluctuations.

There are other potential benefits from this policy. First, this regime will give operational freedom to the central bank. Specifically, the NBU will not have to consult with politicians about possible tweaks in the exchange rate. This is good not only for enabling the central bank to respond to macroeconomic developments quickly but also for building institutional independence of the central bank.

Second, after the war is over, Ukraine’s economy will transition to reconstruction. At that stage, it will be important to avoid sharp macroeconomic adjustments and shocks that often happen after long wars. For example, the US government heavily regulated prices during World War II. After liberalization of prices inflation peaked at 20% between 1945 and 1948. By allowing the economy to adjust in small increments now, one can minimize post-war fluctuations. Indeed, Ukraine will have to return to inflation targeting and a flexible exchange rate and one should lay the groundwork for that regime now.  Specifically, by letting the exchange rate respond to market forces, the NBU will start rebuilding the monetary transmission mechanism.    

Third, the NBU used the introduction of the hryvnia in 1996 to signal that it is serious about price stability and thus could break the inflationary mindset developed for the kupon, the hryvnia’s predecessor. In a similar spirit, this new regime offers a natural opportunity to switch the mindset of the public. Specifically, given Ukraine’s objective to join the European Union (EU), one should expect that the euro will play a much greater role in the future. (To be clear, the dollar will continue to be important because Ukraine’s exports will be heavy on commodities.) This was the path of Czechia, Poland, and other Eastern European countries that joined the EU. Consistent with this experience, the share of the euro in current account transactions for Ukraine has been steadily growing and accounts for over 40% of transactions. To facilitate this transition, the NBU can start managing the float of the euro-hryvnia exchange rate rather than dollar-hryvnia as it does now (the NBU will have to do interventions in the euro rather than the dollar).

In summary, the right economic policies will not only help Ukraine to win the war but also pave the way for a successful post-war reconstruction. Given the tradeoffs faced by Ukraine now, we propose a managed float with limited short-term fluctuations. Obviously, this policy alone cannot resolve all problems (e.g., the broken monetary transmission mechanism) and it will have to be complemented by other measures (capital controls, alignment of interest rates on NBU deposit certification and the government bonds, etc.) to deliver the desired results. One brick is not enough to build a house, but one has to lay the first brick in the right place. This policy can become a cornerstone for Ukraine’s success today and in the future.