How Much Does the High Key Policy Rate of the National Bank of Ukraine Cost the Budget?

The increase of the key policy rate by the NBU Board from June 3 had a weak effect on the hryvnia assets attractiveness for investors, but caused huge losses of public funds – about UAH 60 billion for six months. Such profligacy during the war requires an adequate public assessment and balanced monetary policy decisions.

On June 2, 2022, the Board of the National Bank of Ukraine decided to raise the key policy rate from 10% to 25% per annum. The corresponding press release of the NBU states that making hryvnia savings more attractive as a result of the increase in the key policy rate will help decrease the demand on the foreign exchange market, will ease the pressure on Ukraine’s international reserves and will gradually resolve the issue of multiple exchange rates.

The new monetary policy design, introduced by the same decision, provided that the rates on deposit certificates of banks would be equal to the key policy rate minus 2%. That is, from June 3, the National Bank of Ukraine began to reward excess liquidity of banks at the rate of 23% per annum. For comparison: at that time, the yields on the short-term government issued bonds was 9.9% per annum, and on bank term up to 1 year deposits in hryvnia – 6.1% per annum.

Certificates of deposit actually became a highly profitable risk-free asset for banks, and the liquidity of banks kept growing affected by the inflow of monetary emission and external resources to the budget. In such conditions, NBU’s interest payments on certificates of deposit grew like an avalanche. The NBU, as a rule, uses the received revenues or monetary emission to cover its ownexpenditures. And the excess of the NBU’s revenues over expenditures is to be transferred to the budget once a year. Therefore, NBU’s interest payments on certificates of deposit, in fact, become lost budget revenues in favor of banks.

To support banks due to the NBU payment of interest on certificates of deposit was also expensive for the budget in past years. In particular, in 2020, the NBU paid UAH 10.5 billion of the interest payment on certificates of deposit, in 2021 – UAH 10.7 billion, and in just one month of 2022 (October) – UAH 5.4 billion. In total, for January-October of the current year, interest payment on certificates of deposit cost the NBU UAH 26.3 billion. According to our forecast, the continuation of this banquet for banks till the end of the year will increase the NBU’s interest expenditures to UAH 37.5 billion. If we compare this amount with the “moderate” expenses of 2021, the increase in interest payments on certificates of deposit in 2022 will amount to UAH 26.8 billion.

Unfortunately, this is not the only channel of unproductive absorption of public funds. The otherone is the Government’s interest payment to the National Bank of Ukraine on bonds purchased by the NBU during their initial issue. The width of this channel is also directly related to the key policy rate.

After the key policy rate was raised, the Cabinet of Ministers of Ukraine adopted Resolution No. 659, which abolished the fixed yield for military bonds at 11% and established a floating yields close to the key policy rate. It was to be determined on the basis of the average key policy rate for the annual period up to the first day of the month preceding the month of coupon payments. The norms of this Resolution were in effect until the end of July, and from August the NBU started to buy military bonds at the current key policy rate of 25% per annum.

Thus, the NBU receives significantly higher yields on government issued bonds than ordinary buyers on the primary market. The table shows monthly data on yields on government issued bonds purchased by the NBU and by dealers of the primary market in May-November 2022. As we can see, the difference in yields for various categories of creditors ranged from 9.1% per annum in October to 13.9 % in June.

Table. Monthly yields on government issued bonds depending on the type of creditors in 2022, % annualy

Source: compiled by the author according to the National Bank of Ukraine.

After calculating the product of the volume of military bonds sales by the Government to the National Bank of Ukraine in June-November and the difference between the actual yield and 11% (for which the bonds were purchased by the NBU until June), we will get non-productive losses of budget funds from the higher yields on military bonds. They amount to about UAH 33 billion for the sixmonths since the key policy rate was increased. If we add UAH 33 billion and UAH 26.8 billion losses from the operations with certificates of deposit, we will get almost UAH 60 billion of unjustified losses of public funds related to an excessively tight monetary policy.

This sum does not take into account additional budget costs for the increase in yields forgovernment issued bonds to commercial creditors, since the increase in yields in this market segment was moderate and did not correspond to the dynamics of the NBU key policy rate.        

When comparing UAH 60 billion of losses for the six months of the 25% key policy rate with other potentially possible areas for the use of state funds, we will have the following results. The amount of UAH 60 billion relative to the planned annual expenditures of the Consolidated Budget in 2023 is:   

more than 50% of state administration expenditures;  

almost 30% of expenditures for health care;  

almost 20% of expenditures on preschool, secondary and higher education;  

7% of defense expenditures of the country at war.  

In other words, next year, expenditures on defense could be increased by 7% or on education by 20%, or on health care by 30%, if public funds had not been thrown into the black hole of wasting resources to “fight against inflation” for the past six months. It is difficult to call such payments justified when the state needs huge expenses for the material and technical support of the Armed Forces of Ukraine, for the protection and rebuilding of critical infrastructure facilities, for the reconstruction and provision of temporary housing for the affected citizens, for the organization of evacuation and maintenance of the population from the combat zone, for the provision of high-quality medical care to wounded soldiers and injured civilians.         

Additional budget expenditures for paying too high yields on military bonds to the National Bankof Ukraine should be returned to the budget, since any excess of revenues over NBU expenditures is subject to transfer to the budget. However, part of the NBU generated profit, by the decision of the Board, can be directed to the growth of the NBU reserve funds, which will accordingly deprive the budget of the specified revenues. In addition, the NBU has enough freedom of action to increase its own expenditures, which can minimize the excess of its revenues over expenditures.    

Supporters of the tight monetary policy of the NBU could put forward an argument such as that UAH 60 billion is the price that the society and the budget of a country at war have to pay for curbing inflation and avoiding macro-financial instability. However, these are once again idealistic ideas about the effect of monetary policy impulses, which do not work in the realities of the military economy and shallow financial markets. During the war, financial markets are objectively unable to transmit the impulses of tight monetary policy, as the transmission channels of this policy are  affected by non-market structural shocks.         

To achieve the proper anti-inflationary and anti-devaluation effect, the increase in the key policyrate should lead to the tying up of excess hryvnia in hryvnia-denominated assets, and prevent the flow of free funds to the foreign exchange market. However, since the key policy rate was actually raised,retail term deposits in hryvnia in banks have hardly changed, and commercial creditors’ investments in hryvnia government issued bonds have fallen by UAH 70 billion. The interest rate on retail termdeposits in hryvnia in banks increased from 6.4% per annum in May to 10.8% per annum in October, or by 4.4 percentage points, which is less than 30% of the increase in the NBU key policy rate for the same period. And the level of the key policy rate itself was many times higher than the average interestrate on term deposits in banks.

At the same time, free hryvnia flowed to the foreign exchange market at a regular pace. Moreover, the 2.5 times increase of the key policy rate did not affect this process in any way. In particular, according to the NBU, for four months after the key policy rate was raised (in June-September 2022), cash currency in non-bank circulation increased by USD 4.0 billion and for the four previous months of the war (in February-May), the increase in currency amounted to the same USD 4.05 billion. Furthermore, the devaluation spiral was avoided not as a result of the raised key policyrate, but as a result of the fixed exchange rate regime and its support by external infusions. The external loans and grants received by the state budget since the beginning of the war have already exceeded USD 25 billion.       

It should be noted that suppresing the excessive demand for foreign currency in wartime should be achieved not by raising the key policy rate in several times, but by updating the currency regulation system (together with other stabilization measures). Such system should restrain the demand for foreign currency not related to imported goods purchases. All other transfers of funds abroad by residents or payments for the consumption of goods/services abroad should be financed by the residents’ own foreign currency funds/savings.            

In the future, to stop wasting public funds for maintaining the illusory anti-inflation policy, it would be necessary to reduce the key policy rate to the pre-war level – 10% per annum. If suchsolution turns out to be politically impossible for some reasons, the monetary policy design would have to be radically altered. In particular, the interest rate for the NBU operations of mobilizingliquidity into certificates of deposit could be set at the level of ¼ to ½ of the current key policyrate.       

Tetiana Bogdan, Scientific Director at the Growford Institute