by Ralf Wiegert
In the largest single-day move of the dollar exchange rate since 1999, the National Bank of Ukraine (NBU) allowed the US currency to depreciate to accommodate sharply rising market-side pressure. As a result, the hryvnia plunged 3% from 5.19/dollar on 20 April, but stabilized a day later at 5.05/dollar as the central bank stepped in again to buy dollars. Initially, the NBU was reportedly to set the official dollar rate at 5.02 hryvnia on 22 April, but 5.05/dollar has been maintained since then; on the cash market, however, the dollar has traded below the 5.00-hryvnia threshold.
Resisting the Markets for Two Years, the NBU Finally Gives Way. Upward pressure on the Ukrainian currency has been mounting since 2003, when the export-led boom took off. It has only strengthened in recent months, and the NBU's sudden move to alter its exchange-rate strategy was likely triggered by strong inflows of short-term foreign investments, apparently betting on a hryvnia appreciation. Indeed, a treasury bill auction earlier that week raised US$425 million, with 60% of the paper reportedly snapped up by foreign investors. Of course, the exchange-rate adjustment was long overdue. The dollar rate had remained quasi-fixed from 2002 through June 2004 at 5.32–5.33 hryvnia, and had been allowed to decrease only gradually since then. But that was not enough, because Ukraine had recorded strong growth based on surging world commodities prices in 2003–04. But unlike Russia or Kazakhstan, which have allowed their currencies to appreciate against the dollar since 2002 and 2003, respectively, the hryvnia traded at a relatively stable rate even as foreign exchange reserves piled up at the NBU.
Ever since the after-effects of the 1998 financial crisis finally faded, the National Bank of Ukraine has closely guarded the exchange rate, allowing only minuscule day-to-day changes. As such, the sudden drop of the dollar marks a profound change of strategy. Although a more-flexible exchange-rate management (including hryvnia appreciation) was in the offing, the timing and sheer size of the realignment was shocking, sparking anger among financial markets, politicians, and the public. The latest move, however, was not so much a change of strategy but rather a prolongation of the current strategy at a different exchange-rate level.
Expectations of an imminent exchange-rate realignment have been building since the Yushchenko administration came to power this January. But mounting inflationary pressures made such a move even more imperative, and the new government strongly advocated a relaxation of the NBU's grip on the dollar rate, implying a follow-up appreciation of the domestic currency. Indeed, in early April, the government persuaded the central bank to scrap mandatory foreign currency sales for export earnings—a serious blow to the NBU's power to safeguard day-to-day exchange-rate adjustments.
A major hryvnia appreciation could thus have been anticipated, but its timing and scope have been surprising. The rate adjustment caused much anger among private households, because a large chunk of private savings is held in dollars. These savings have now been devalued in hryvnia terms. Panic sales are unlikely, as the government had been communicating an imminent exchange-rate adjustment for some time already, but the dollar might still come under increased pressure if private savings are converted to hryvnia or euros at a faster pace. Ironically, many Ukrainians have been turning their backs on the domestic currency and were desperately trying to buy dollars only four months ago, when the election crisis was unfolding and annual inflation had surged into double digits.
Hryvnia Remains Set for Appreciation. The suddenness and scope of the exchange-rate adjustment are both unwelcome and worrying, since they add uncertainty to Ukraine's financial markets and population alike. While the recent appreciation is a dramatic sign of the hryvnia's current strength, significant macroeconomic problems underscore the notion that exchange-rate risks—upside as well as downside—cannot be neglected. At present, there are no indications that the hryvnia's appreciation path will end anytime soon. Moreover, the International Monetary Fund (IMF) had, quite correctly, argued that the hryvnia's exchange rate was undervalued, probably by as much as 30%. But inflation remains quite high and government finances are only partially recovered from the latest fiscal spending boom. If annual GDP growth falls short of its projected 8% rate, the situation could worsen considerably. On the other hand, the hryvnia appreciation will surely dampen import prices and hence inflation. In addition, the devaluation of dollar savings will also lessen the demand-side pressure on goods markets.
A careful relaxation of the exchange rate, alongside a gradual decline of the dollar rate, might have been highly desirable, although probably impossible as foreign investment poured in. Indeed, action would have been required back in 2004. Unfortunately, the NBU has apparently not yet decided on its future strategy, and remains ill-prepared to manage the monetary environment of a financial system set to open up to international capital markets. If the central bank continues to uphold a quasi-peg to the dollar at the new rate, it will likely get trapped again. Without doubt, foreign investors will jump at the chance to bet on a hryvnia appreciation, pouring hot money into the country’s financial markets. Hopefully, both the central bank and the government will learn their lesson from this rather bumpy start and be more careful over the next several years. Barring a major worsening in Ukrainian finances and inflation, the hryvnia remains almost a sure bet in the short term, the recent appreciation notwithstanding, and we expect the dollar rate to decrease further, albeit much more gradually.
