Commerzbank Ukraine: The exchange rate problem

The cost of defending currency stability in Ukraine is rising. Monetary policy is tight, interest rates show excessive volatility, while real sector activity has been slowing sharply. Ukraine’s external deficit has been widening on the back of its energy trade.

The government plans to cut Russian supply to a minimum and increase domestic and other sources, but over the medium term the energy deficit is likely to remain high. As global steel demand has weakened, so have Ukraine’s terms of trade. In our view, for any measure of stability Ukraine will have to restore its IMF program, which will require increased exchange rate flexibility. Ukraine’s dollar peg is inefficient in European trade and in light of the country’s heavily cyclical commodity revenues. Increased currency
flexibility will in our view involve devaluation in the course of the coming months.

Ukraine has been fighting devaluation expectations for a year. The low credibility of the currency peg is due to the country’s increased foreign borrowing requirement (see below) that it has difficulty to cover in all states of the world. The authorities maintain that there is no reason for a devaluation as Ukraine will have managed to balance its foreign payments. However, foreign financing is intermittent and signs of external imbalance are evident. The Central Bank has been defending the peg at rising costs; the monetary stance is tight despite sharply slowing real sector activity, international reserves are down c. $10bn in a year. The government has also increased the number of verbal interventions and claims to ‘demonstrate steady control of the situation’.
We looked into a number of underlying factors to assess Ukraine’s most likely policy choice after the elections. Historically, the trigger for exchange rate adjustments in Ukraine has been terms of trade shocks or slumps in global steel demand, given the two-thirds commodity content of the country’s exports. In fact, we see considerable risk of this playing out in the last quarter of the year (see more below) and further widening of the trade deficit, which may increase precautionary demand for dollars in the economy.
From a more structural point, there is no agreement on whether devaluation makes economic sense given Ukraine’s relatively high external debt, banking sector weaknesses and an ongoing ‘offshoring’ and dollarisation of activities arising from institutional weaknesses locally. More importantly, however, Ukraine’s trade balance deteriorated with its energy deficit as Russia withdrew its gas subsidies. With a similar industry structure, built originally on subsidised gas from Russia, Belarus experienced a balance of payment crisis last year1. In contrast to Belarus, Ukraine has managed to maintain a non-energy trade surplus so far (1.6% of GDP year-to-date). Nevertheless, the energy trade may leave Ukraine no choice.
For any measure of stability we believe Ukraine will need to resume its IMF program. This will require increasing the degree of flexibility of the exchange rate. Switching the dollar peg to a euro-dollar basket could serve as a transitory phase toward greater flexibility (similarly to Russia), or it could be done vs. the dollar, but flexibility will, in our view, include an upfront or crawling devaluation.

Devaluation: the case for and against
Ukraine’s 60% currency devaluation in 2008 occurred against an overheated economy and heavy import demand. This was aggravated by a sharp terms-of-trade shock (decline in steel prices), which eliminated the country’s surplus on its non-energy trade. Although the current account deficit has reached nearly the same critical level (see chart 2), currently it is clear that Ukraine is suffering primarily under the terms of its energy imports. The rising energy deficit goes back to the 2009 gas contract with Russia that phased out subsidies. According to Prime Minister Azarov (and based on a year-long futile bargaining), Russia is not willing to revisit the 2009 ten-year gas agreement; including the price of gas, transit and supply – which increased Ukraine’s overall external balance by c. 6% of GDP in the last three years (chart 4). Russia also insists on the take-or-pay clause, which means that Ukraine will need to take at least 80% of the 52bcm contract volume or a minimum of 41.6bcm this year. While 55% of the contract volume is outstanding – that is a c. $17bn energy bill for the remaining part of the year, the government expects that it can cut
volume without penalty to 28bcm1. As steel exports are falling, Ukraine’s trade deficit is likely to widen further in the fourth quarter (the average monthly trade deficit could double if the minimum contract volume is taken).
This is a risky terms-of-trade combination at present. However, Ukraine’s non-energy balance has been positive so far but has shrunk this year. There is no clear case on Ukraine’s competitiveness (or lack of it) – as was the case in 2008 and in Belarus last year (chart 5).

The hryvnia’s real effective rate has also been in line with trade partners, and favourable against the ruble. However, there is some concern that Ukraine’s industry has not been fully able to cope with the increased energy price since Russia withdrew the subsidies. The government’s appeal to the WTO for maximum tariffs on a broad range of goods, and Ukraine’s efforts to diversify energy imports are proving the case.
The question remains the future of energy trade. Ukraine has rejected Russia’s offer for Ukraine to join its customs union, in return for restoring the gas discount as for Belarus (60% in price, to $160/bcm). Instead, the National Energy Strategy envisages cutting gas imports from 40bcm to 5bcm by 2030, while more than doubling gas extraction to 44bcm. Domestic production is projected to be relevant only after 2020. Ukraine therefore will have to rely on imports, and while the government intends to keep cutting the Russian supply to a minimum and diversify the sources (Qatari gas through Poland, from RWE in Germany), it may reduce the cost on about one-third of its supply by c. 10%-15% in the near term, which is roughly 1% of GDP versus its energy deficit of 15% of GDP.

Transition to flexibility
The hryvnia’s dollar peg might be under review. The country’s trade is dominated by commodities and base metals, and its terms of trade as well as net trade position are highly cyclical. It has proven costly for the country to hold a fixed exchange rate against a strongly fluctuating net trade position. The dollar peg is favourable when the dollar is weak, but when the dollar strengthens Ukraine’s competitiveness deteriorates in European trade, and also in the CIS, where currencies trade to a dollar-euro basket. This issue raised the problem of the dollar peg last year.

Regarding Ukraine’s trade by geography, a role for the euro would be justified (chart 7). At the same time, the currency composition of settlements in the current account is heavily dominated by the dollar, (75%) due to the dominance of commodity trade. The role of the euro for settlement is c. 12% and that of the ruble 13%. Foreign liabilities are similarly dominated by the dollar, as well as household savings. These alone would suggest a currency basket of c. 75% dollar and 25% euro, and is likely to match the currency composition of Ukraine’s reserves. It would, however, introduce relatively low degree of flexibility compared to the current. As the country remains in favour of a European free trade agreement, choosing a larger share for the euro in the basket than currently represented by transactions would be sensible, and allow the role of euro to gain in transactions.
Ukraine’s safest choice at this point would be to return to the IMF after the October elections. This would require some degree of exchange rate flexibility and the basket could be used for the transition phase. Alternatively, the NBU could continue to work with a ‘crawling peg’ versus the dollar. The UAH has been allowed to depreciate nearly 2% in such a way this year. Any scenario of increased exchange rate flexibility, however, would initially involve devaluation in our view, as excess dollar demand prevails. Capital-intensive commodity exporters tend to lose the initial gains earned from devaluation as the cost of capital responds to the crisis/devaluation. In Ukraine’s case, however, the weak credibility of the peg and the cost of maintaining it are already showing strains on the economy.