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A hot spring in Ukraine
Kiev is greeting the EBRD Annual Meeting in all its spring beauty. The city is buzzing with activity from the mayoral election. Flag-waiving campaign workers operating out of makeshift tents accost passers-by with prepared speeches promoting the particular faction they support. Competing stages have been erected for the rock bands enlisted by the different candidates. While the leaders lending their names to these campaigns are not always the best symbols of democracy, their grassroots are. The economy is also brimming with activity. Growth is broad in terms of both regions and sectors. Domestic consumption is expanding rapidly, and favourable commodity prices are fueling exports. But clouds are gathering. Inflation soared to 30 per cent in April, the highest levels in our region. Increasing prices of food and energy are mainly to blame, but rapidly expanding credit and an expansionary fiscal policy have contributed. The global credit squeeze is adding to the complexity of the economic situation. In many ways Ukraine is representative of what is going on in the EBRD region as a whole. Like most of our countries of operation Ukraine has weathered the financial crisis and rising energy prices well so far, but investors are more cautious, taking a second look at risks. The Ukraine premium has come up compared to its low-point a year ago. The fact that Ukrainian and Russian sovereign risks were judged to be about the same, despite the huge difference in reserves, is an indication of how reckless markets had become. The key explanation for why Ukraine has done well is the same as for the rest of the region - the strong fundamentals. In the Ukrainian case the favourable prices on steel and other metals it is exporting have been particularly beneficial. But the economy has also been helped through the global liquidity squeeze by the dramatic transformation of the country’s financial system. The rapid penetration of foreign banks, with four out of the five top banks now in foreign hands, has helped ensure rapid growth in credit to the corporate as well as to households. But the combination of the credit squeeze and rising inflation now puts the National Bank of Ukraine in a very difficult situation with a limited set of instruments at its disposal. Through its peg to the dollar the country is importing the monetary policy of the United States which has been focusing on easing the liquidity situation at the expense of inflation. With 30 per cent inflation, reinforced by the decline in the dollar relative to the euro, Ukraine needs to go in the opposite direction. A couple of weeks ago the central bank raised interest rates dramatically, but its influence is limited. The provision of liquidity is now to a considerable extent in the hands of the foreign parents of the local banks. Even though exports are doing very well at the moment, the economy needs to manage a “soft landing”, akin to what the Baltic economies have tried to achieve. The central bank must focus on inflation, and it is making steps in that direction. It is also showing greater flexibility in managing the exchange rate allowing the currency to appreciate, as you can see from the prices quoted in the exchange booths all around the city. The government needs to restrain fiscal expansion and make sure that one-time privatisation revenues do not lock the country into unsustainable social programmes. Some of the large privatisations also look less likely to happen anytime soon. But as in the Baltic states there is also a need to coordinate with the foreign banks active in the country. The problem in Ukraine is that the number of banks is larger and, unlike the Baltics, they are not under the same regulator. Needless to say, the banks in Ukraine are fighting aggressively for market shares. At the same time local banks without international parents and specialized institutions relying on external funding models are struggling to cope with the liquidity squeeze. To manage through this rough patch will take extraordinary focus and determination. Macroeconomic management is not the business of the EBRD, but we have a responsibility to support the efforts of the responsible authorities. We must use the increasing demands on the Bank to help banks adjust to the new reality of more difficult funding conditions for banks and soaring inflation. Reigning in consumer credit expansion, reducing foreign exchange exposures and improving capitalization and risk management are all part of this adjustment. There are signs that banks are reducing their growth targets and this should help slow down consumption growth. This is critical because inflation undermines financial development as households are less likely to leave their money with the banks. Moreover, developing Ukraine’s fledgling local currency markets will prove even more challenging. Rising food prices fuel inflation One important reason for the higher inflation is the recent increase in food prices, food accounts for 56 per cent of the consumption basket. For Ukraine with its vast arable land this should be a boon, but years of neglect of investment have meant that the short-term response capacity of the country’s agricultural sector is modest. Property rights are still unclear, and the infrastructure for transporting and warehousing foodstuffs is in poor shape. A recent conference we organized in London demonstrated the need for much more dialogue between the private sector and the government. The Bank can play an important role in coordinating this dialogue and promoting specific projects along the agribusiness value chain. If successful, Ukraine can make a major contribution to solving the global food crisis. The changing global environment with higher premium on risk and reduced capacity of banks to lend will particularly hit the more risky small and medium-sized firms. Often these firms also have less capacity to hedge themselves against increasing foreign exchange risk. Again, the EBRD must maintain its support for this sector so important for the Ukrainian economy. The strong economic growth has taken place against a background of infighting and indecision within the Ukrainian political elite. Some observers suggest that this shows that politics really does not matter for economic growth, or more strongly that impotent politicians are actually good for growth. Both these views are fundamentally flawed. Perhaps for the short-term challenges facing the country at the moment may not require the immediate involvement of parliament and perhaps not even the government, as long as the central bank functions properly. But for the longer term Ukraine must implement a large number of important reforms, including a new code, the joint stock company law, and the energy law. Efforts are also needed to reform the opaque gas monopoly, the unsustainable pension system, and the poorly functioning domestic capital markets. Taking its place in the world economy Yet the political activists pushing their mayoral candidates are an encouraging sign. For all the bickering and gridlock within the political class Ukrainian democracy is now firmly established. Elections are routinely conducted in a fair and transparent fashion. Unlike most of the countries in the CIS the country’s democratic system has even survived a political backlash without dramatic disruption. Of course, the perennial question of Ukraine’s international orientation stemming from its history, geographical location and ethnic composition has not been resolved. But probably the most promising avenue at the moment is for Ukraine not to choose between Russia and Europe but focus on its integration into the world economy. The recent membership in the WTO is an important step in this direction. In the longer term this will undoubtedly bring Ukraine, and hopefully Russia, closer to Europe.
17 May 2008 |
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