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Financial deepening for economic growth.

The level of development of lending in Ukraine is extremely low, and credit levers for financing businesses and individuals are insufficient. However, the implementation of monetary policy adequate to the current conditions and overcoming the disintegration of the real and financial sectors could become powerful drivers of Ukraine’s economic recovery.

The comparison of credit and debt indicators of Ukraine with indicators of other countries signals a low level of lending to the national economy and a deficit of domestic credit levers to the private sector. At the end of 2020 global debt amounted to USD 277 trillion, or 365% of global GDP (see Figure 1). In Ukraine, the total debt of all sectors of the economy was slightly less than 100% of GDP, lagging behind 2.5 times the average in emerging market economies and 3.7 times the global level.

Figure 1. Global debt in relative and absolute terms in 2011-2020

 Source: Compiled by the authors using the data from the Institute for International Finance

At the end of the third quarter of 2020, the non-financial sector accumulated the largest debt liabilities in the world – 104.8% of global GDP. The second largest was the general government sector with the debt of 103% of GDP. The debt of the financial sector constituted 90.2% of GDP, and of the household – 65.3% of GDP (see Fig. 2). Over the past year, general government debt  and non-financial corporate debt grew most rapidly (by USD 8.5 trillion, or 12.3% and by USD 5.9 trillion, or 8% respectively).

Figure 2. The global debt by sectors as of end of September 2020

Source: Compiled by the authors using the data from the Institute for International Finance

The comparison of the relative indicators of received loans and accumulated debts in Ukraine with sectoral indicators of global debt leads to the following conclusions:

• the debt of non-financial corporations in Ukraine (20.1% of GDP) are five times behind the average level in emerging market economies (104.1%) and advanced countries (102.3% of GDP);

• the relative debt of the financial sector in Ukraine (9.9% of GDP) is four times lower than in emerging market economies (40%) and 12 times lower than in advanced countries (120.3% of GDP);

• the debt of the household sector in Ukraine (5.3% of GDP) is substantially different from the indicator of advanced countries and the global one (65.3% of GDP);

• the volume of public debt in Ukraine (61.8% of GDP) is almost in line with the average for emerging market economies

As noted, in Ukraine at the end of the third quarter of 2020, the total debt of all sectors of the economy was slightly less than 100% of GDP, lagging behind 2.5 times the average in emerging market economies. On the contrary, Ukraine’s gross external debt at 73.4% of GDP was three times higher than the average for low- and middle-income countries.

Existing distortions in favor of external financing raise the foreign exchange risks of accumulated debts. And the low level of lending to the national economy indicates the sluggish nature of the domestic lending process in the business. The reasons for this are, firstly, inadequate monetary policy (which until 2020 was the tightest among the countries of Central and Eastern Europe) and, secondly, lack of effective institutions to secure the fulfillment of contractual obligations related to credit relations.

As the accumulated debts in the sectors of financial, non-financial corporations and households in Ukraine are modest, the debt risks for them are minimal. The comparison of the debt of the main sectors of the Ukraine’s economy with the similar indicators in Poland, the United States and China again reveals that the national credit system is underdeveloped. For instance, in Ukraine, the debt of non-financial corporations is 20.1% of GDP, and in Poland it is 44.8%, in the USA – 88.2%, in China – 166.3% of GDP. Household debt in Ukraine barely exceeds 5% of GDP, and in Poland this figure is 35%, in the United States – 81.2%, in China – 59.8% of GDP (see Table).

Table. Accumulated Debt by Sectors and Countries (their groups) as a % of GDP at the end of 3rd quarter of 2020  

Public Sector DebtDebt of Non-Financial CorporationsDebt of the Financial SectorDebt of the Household SectorTotal Debt
Advanced Economies131.4102.3120.378.0432.0
United States127.
Euro Area115.1114126.260.5415.8
Emerging Market Economies60.3104.140.044.0248.0

Source: Institute for International Finance. Global Debt Monitor. November 18, 2020

New lending to corporations and households could contribute to financial deepening and accelerate economic growth in a country. J. Garrido, S. Nadeem, N.Riad argue that the impact of corporate leverage on economic growth is positive when the amount of debt is moderate, and the negative effects are manifested only in case of the accumulation of excessive debt (Tackling Private Over-Indebtedness in Asia). S.Cecchetti and others estimated a “tipping point”, or threshold of private debt, which reduces the potential rate of economic growth, at 85% of GDP for household debt and 90% of GDP for non-financial corporate debt (The Real Effects of Debt). On the other hand, IMF experts found that an increase in household debt has a positive effect on economic growth as long as the debt-to-GDP ratio is below 36-70% (Household Debt and Financial Stability).

As we can see, in Ukraine the existing debts of corporations and households do not yet reach the thresholds. However, the level of Ukraine’s external debt burden is quite high. The ratio of gross external debt to exports of goods and services in Ukraine overran the average level of low- and middle-income countries in 2 times, and the ratio of external debt to gross national income is 3.5 times.

Ukraine’s high level of gross external debt increases the vulnerability of the national economy to external shocks – lower prices for exported goods, falling economic growth in partner countries, rising interest rates in international markets etc. Given the significant need for debt refinancing, a sharp rise in interest rates could close Ukrainian borrowers’ access to new financing.

In the context of global debt problems, currently non-financial corporate debt and the general government debt are the most risky. The high dynamics of increase in these debts exposes borrowers to the debt refinancing risks, raises the sensitivity of their financial states to the fluctuations in interest rates and exchange rates. The IMF estimates that large corporations with constant access to finance are more likely to maintain their solvency and avoid default. However, most small firms operating in the sectors affected by the pandemic will face narrow market and low liquidity problems, which will increase the risk of default.

In the global financial sector, the situation is more favorable. At the beginning of the pandemic, financial institutions had significantly stronger capital and liquidity buffers than before the 2008-2009 crises. This situation, against the background of expansionary monetary policy, made it possible to continue lending to the economy even in the event of an economic crisis. The forward-looking analysis of banks solvency in 29 countries showed that under the baseline scenario, most banks would be able to absorb losses and continue to operate normally in 2020–2021.

The large-scale fiscal and monetary stimuli became levers of debt expansion of governments and non-financial corporations in 2020–2021. The annual growth of assets of the ECB, the US Federal Reserve and the Bank of Japan was 52%, which means an increase in uncovered money supply all over the world. According to many experts, in the realities of the post-pandemic era, combinations of high public debts and fiat monetary systems will contribute to the rapid transmissions of financial shocks and more frequent financial crises.

In the aftermath of the COVID-19 pandemic, many emerging markets are likely to face the challenge of reducing foreign long-term capital inflows from the shock of global demand, breaking global value chains, increasing sovereign credit risks, and so on. This will bring about difficult access to external financing for Ukrainian corporations.

In such conditions, the tasks of development of the domestic credit system of Ukraine become especially relevant. On the capital supply side, the devaluation of dollar savings of Ukrainian households and businesses will encourage them to seek alternative ways to hold savings, including securities of the national capital market. On the capital demand side, entrepreneurs’ needs to attract borrowed and share capital to finance potentially profitable investment projects will increase. That is, the tasks of development of the national capital market in Ukraine are becoming a priority, and their solution is impossible without modernizing the market infrastructure, expanding financial instruments and improving regulatory system.

In addition, the outlined global processes will increase the demand for real assets and the attractiveness of investments into the real economy. In such conditions, the key areas of activity of the National Bank of Ukraine should be:

  • conduct of loose monetary policy and keeping the key policy rate close to zero in real terms;
  • implementation of programs for long-term refinancing by the central bank of the bank loans issued to the real sector of the economy;
  • easing of standards for banks to reserves provisioning related to the credit risks (NBU Board Resolution No.351).

Overcoming credit and debt distortions in Ukraine is impossible without pursuing a prudent state debt policy. D. Gross rightly points out that the growth of economic and financial uncertainty during the pandemic and after its end means that a prudent state policy should be aimed at maintaining an acceptable level of public debt.

Hypothetically, countries have the following set of tools to address the high debt burden:

• stimulating economic growth (which will reduce the relative size of debt);

• budget consolidation or reduction of the budget deficit;

• eroding the real value of debt due to high inflation (inflationary debt depreciation);

• beginning of financial repression to suppress interest rates and maintaining a moderate cost of debt service;

• attracting cheap official financing from international financial organizations.

It is important that each of these tools has its spillovers and limited scope. Therefore, the following prediction seems logical: in the future, a comprehensive approach will be applied, which will be based on a different set of tools in different countries.

In Ukraine, the urgent task of fiscal policy in this context is a departure from fiscal stimulus for the economy from 2022 and a gradual reduction in the relative size of public debt in the medium term.

At the same time, the government should use the fiscal instruments that are favorable for economic growth in the long run. Among such instruments, the most important role after 2021 should be played by:

• increased taxes on property, wealth and capital gains;

• improving the administration of corporate profit tax, eliminating “loopholes” for minimization of tax liabilities;

• higher environmental taxes and rent payments;

• reduction of budget expenditures on state administration, security and judiciary.

Pursuing a prudent macroeconomic policy and strengthening the core market institutions should help overcoming the credit and debt distortions in Ukraine and setting up a sound financial basis for the development of the national economy

Scientific Director at the Growford Institute, Dr. habil. Tetiana Bogdan for Dzerkalo Tyzhnia Week.