On October 2nd, the NBU announced a return to a flexible exchange rate regime, citing this change as a means to strengthen economic stability. The decision was not sudden. Several months ago, the NBU mentioned the need for greater exchange rate flexibility and a return to inflation targeting in its strategy to ease currency restrictions. We present an overview of a conversation with Viktor Koziuk, the head of the Department of Economics and Economic Theory at the West Ukrainian National University and a longstanding member of the National Bank of Ukraine’s Council, discussing why the fixed exchange rate was canceled precisely now and what lies ahead.
You can listen to the full conversation at the following link
What is managed floating?
“Manage floating” is a term used in English-language literature to refer to a system where the exchange rate fluctuates within a range managed by the central bank. This exchange rate regime allows the central bank to intervene in the foreign exchange market and is common in countries with low to middle incomes. It represents a step towards higher levels of flexibility, i.e., the floating exchange rate regime Ukraine had before the onset of the full-scale war.
Why did the NBU make this decision?
Firstly, the National Bank, in its communications, has repeatedly mentioned that the economy can adapt relatively quickly to wartime conditions, and it is essential for it to operate on market principles because this ensures its stability and flexibility.
Prices, export and import operations, and other business decisions have long since shifted to a so-called wartime mode. In other words, while the Ukrainian state bravely fights for its independence and right to exist, businesses have adjusted and adapted, moving away from the initial shock.
The exchange rate was one of the few parameters that had not yet returned to a market-based format in interaction with other macroeconomic processes. While interest rates are already approaching market conditions, the question arises as to why the exchange rate still does not reflect the macroeconomic conditions.
It takes time to transition from a fixed exchange rate to a more reasonably floating one, similar to what Ukraine had before the full-scale war. The NBU began this transition earlier to ensure it proceeds gradually, allowing markets and citizens time to adapt to the new conditions.
What affects the balance of payments?
Under normal conditions, the balance of payments is influenced by the productivity and competitiveness of the economy. Currently, Ukraine faces non-market factors that can be considered structural problems: partially blocked exports, limited capital movement, and other restrictions that affect the balance of payments.
Moreover, in dollarized economies, the exchange rate reflects not only the state of the balance of payments but also the demand and supply of foreign currency from residents. When there is an opportunity to convert national currency into foreign currency for assets or savings (i.e., when the exchange rate is influenced not only by external factors but also by the efforts of economic agents to hedge against the risk of their savings’ depreciation), the situation in the foreign exchange market becomes significantly more complex. This makes it harder, in particular, to maintain a fixed exchange rate.
Typically, capital controls in countries with middle and low incomes often remain in place for an extended period after introducing a floating exchange rate (as was the case in Ukraine from 2015 to 2019 – ed.). The liberalization of capital flows begins when financial markets mature enough to handle it. However, Ukraine had to “reverse” the liberalization that had been achieved prior to the full-scale invasion to minimize capital flight during the shock of the war’s onset. Therefore, we will have to go through the process of capital liberalization once again.
Will the devaluation of the hryvnia stimulate exports?
Correcting the exchange rate does not always boost exports. When prices are denominated in a dominant currency (typically the U.S. dollar), a depreciation in the exchange rate may affect exporters’ profit margins but not necessarily the volume of exports. Additionally, Ukraine faces significant logistical constraints on its exports, which hinder their physical growth.
On the other hand, an exchange rate correction can help curb unproductive imports and reduce the volume of payments made abroad using hryvnia cards.
However, today, we cannot assert that the exchange rate is meant to balance export earnings and import payments alone, as we receive significant amounts of donor aid, which considerably impacts the balance of payments.
If we were to look at the trade balance and, consequently, the intervention balance in the foreign exchange market formally, one might argue that the exchange rate could only move downward. However, the situation changes significantly when substantial capital inflows come in as aid or official government borrowings from abroad (e.g., from the IMF). Therefore, we cannot discuss the dynamics and factors influencing the exchange rate in purely black-and-white terms.
Is the government interested in lowering the exchange rate of the hryvnia?
This is a common challenge when the government views the exchange rate as an indicator that balances the budget items rather than as a macroeconomic variable that is difficult to predict in advance.
On one hand, the government might indeed be interested in devaluing the hryvnia. Since tariffs and certain excise taxes are denominated in foreign currency, a devaluation could increase the inflow of hryvnia revenue from these taxes, as well as the volume of foreign aid in hryvnia terms. However, the government also has foreign currency payments, particularly for arms purchases.
Furthermore, we are net importers of energy resources. Any energy resources purchased by the government or the private sector can impact the profitability of businesses, which in turn affects the magnitude of future tax revenues.
Therefore, it is always important to look at the whole picture rather than just one of its parts. While the National Bank and the government may have different perspectives, compromises can always be found. The key is timely communication because sometimes, a careless word can significantly influence the volume of interventions that the NBU is forced to carry out.
How did the National Bank operate in the foreign exchange market before?
The National Bank had a macroeconomic model for a balanced exchange rate, which it used to determine the optimal exchange rate trajectory at a given moment. This trajectory was then adjusted for specific situational factors related to export and import prices, differences in interest rates, capital flows, expectations regarding government external debt payments, and domestic demand for foreign currency. By comparing the current exchange rate deviations from the modeled equilibrium rate, the National Bank could smooth out excessive fluctuations in the exchange rate in either direction.
What challenges will the National Bank face now?
Firstly, a significant reduction in market size. Whereas NBU interventions rarely exceeded 10% of the market size in the past, today, the volume of interventions can even surpass the magnitude of market operations.
Secondly, well-known models for determining equilibrium exchange rates or established approaches to determining potential exchange rates are significantly distorted by war-related factors, uncertainty, and significant logistical complications of a non-economic nature. Therefore, the NBU cannot determine the equilibrium exchange rate with the same precision as it could in the past.
This means that the National Bank needs to take into account official aid, significant intervention volumes, and the fact that, at least in the initial stage, a flexible exchange rate will not necessarily correct the imbalances that have started to form in the economy.
What to expect from the National Bank?
Firstly, the regulator has stated that it currently does not use the flexible exchange rate to correct imbalances and does not view the exchange rate as a channel for monetary transmission. Today’s goal is to expand flexibility so that economic agents feel the foreign exchange market is returning to its normal regime. However, sooner or later, the exchange rate will need to correct economic imbalances. The question is when this transition will occur and when economic agents will feel its effects.
The second challenge concerns how the National Bank will maintain constructive ambiguity so that market participants cannot predict its actions with 100% certainty. Constructive ambiguity is necessary because if market participants know the regulator’s actions in advance, it creates opportunities for speculative profit. Therefore, all central banks try to maintain it.
Here arises a certain problem. If we build an intervention model based on data about how much foreign reserves were spent in the past, the argument that interventions are carried out under conditions or based on the principle of constructive uncertainty weakens immediately. Constructive uncertainty only works when decisions about currency interventions are made based on forecasted assessments rather than past data.
Therefore, adding an element of forecasted values, for which the National Bank has better access to information compared to market participants, is essential. This way, you can track the actions of the National Bank based on historical data but not at the moment of intervention itself.
The third challenge that arises from this is the communication issue. How to structure communication in a way that market participants are confident that the regulator is conducting currency interventions to stabilize the market and that, in the long run, both the stability of the currency market and the stability of the financial system will enhance the regulator’s ability to maintain price stability, which is its primary mandate.
Should we expect a devaluation of the hryvnia?
It is worth looking back at the events in 2014 once again. Firstly, back then, the NBU was losing reserves for an extended period until April 2015. Secondly, the imbalances in the national economy were much greater. Issues with the balance of payments and the trade balance reflected a hidden and clearly unhealthy trend of capital flight from the country. Since banking supervision and financial monitoring were essentially not functioning, the capital of banks looked good only on paper. The level of dollarization and mistrust in banks was enormous. One could say that our economy in 2014-2015 exceeded all possible vulnerability indicators.
Now, the situation is entirely different. Despite the ongoing war, the National Bank has managed to accumulate historically high levels of foreign reserves. Secondly, we receive significant official assistance. It is precisely the combination of the ability to accumulate reserves with the receipt of financial aid that allows us to say that not only the trade balance affects the situation in the foreign exchange market.
Another important aspect is the stabilization of economic agents’ expectations that the financial system has endured, is enduring, and will continue to withstand the shock.
Therefore, it cannot be said that devaluation is inevitable. It can be said that with a certain stabilization of the situation and further inflation reduction, some downward adjustment of the exchange rate would be desirable for the economy to compensate for productivity losses.
But first, it is necessary to reduce the inflation rate and ensure that re-dollarization does not occur. Then, the exchange rate will gradually adjust the economy for greater stability.
The processes of European integration will also entail changes in the structure and sources of revenue. However, in the long term, it is crucial to remember that the inflow of significant financial assistance will be a substantial safeguard against any shock scenarios related to exchange rate correction.
The authors do not work for, consult to, own shares in or receive funding from any company or organization that would benefit from this article, and have no relevant affiliations