In June, annual inflation in the United States rose to 5.4% from 5% in May and 4.2% in April. The inflationary surge will inevitably force the Federal Reserve to tighten monetary policy, which will increase the cost of external financing for emerging market economies. Ukraine should prepare for such a turn now, so that the world’s troubles do not catch us by surprise and do not provoke a debt or currency crisis.
During the COVID-19 pandemic, interest rates of the global financial market were quite low under the influence of unprecedented fiscal and monetary stimulus measures. The weighted average yield on sovereign bonds from emerging market economies in December 2020 was 3% per annum. In the first quarter of 2021, the yield on such bonds went slightly up (to 3.7%), but then went down again and settled at 3.5-3.6% per annum.
As for Ukraine, even under favorable external conditions, the cost of international financing for our borrowers was significant and rising comparing to the pre-epidemiological level. For example, if in the middle of February 2020 the weighted average yield of Eurobonds of Ukraine was 5.1% per annum, at the end of the first half of 2020 it was 6.7%. Over the last year, the yield on Ukrainian Eurobonds ranged from 5.3% to 7.9%, and on July 21, 2021 it reached 6.2% per annum.
Loose conditions of the global financial market allowed many emerging market economies to avoid currency and debt crises (frequent attributes of economic crises) and to implement a rather expansionary fiscal policy in 2020-2021. In Ukraine, as in many other countries, fiscal impulse became positive, which is a definite achievement after decades of chronically pro-cyclical fiscal policy. By maintaining access to the international capital market, the Ukrainian government and corporate borrowers continued to borrow and thus loosen existing financial constraints.
But this situation may change in 2022 under the influence of inflationary and monetary processes in the United States. In May, annual inflation in the United States rose to 5%, and in June to 5.4% after the traditional 1.4% in January 2021.
According to analysts, inflationary pressure in the United States increased as result of the following main factors:
- The rapid growth of the monetary base in the United States since the beginning of the corona-crisis and the long loose monetary policy since the 2008 crisis. The assets of the balance sheet of the US Federal Reserve (Fed) almost doubled or by 93.4% from March 1, 2020 to July 13, 2021. In nominal terms, the growth of Fed assets was almost USD 4 trillion.
2) A significant increase in import duties on Chinese products by D. Trump – from an average rate of 3% in 2018 to more than 20% in 2021. This directly affected the prices of consumer goods purchased by low-income American households, as well as products that include Chinese parts and components. The increase in tariffs indirectly affected the prices of goods produced in the United States and substituted for Chinese imports.
3) Tax cuts for corporations and wealthy Americans in 2017 and large fiscal stimulus measures in 2020-2021 (the latest package of fiscal assistance from the Biden Administration reaches USD 1.9 trillion). This increased aggregate demand in the US economy and boosted prices.
So far, inflation expectations in the USA do not exceed the target level of 2%. But if the population and business realize that high inflation is becoming permanent, then the stability of inflation expectations will be violated. Under such conditions, business pricing policies and wage requirements will cause a new inflationary surge and form a spiral of price-wage growth.
In this context, O. Issing, President of the Center for Financial Research, notes that after a decade of strong influence of downward pressure on prices, the world is now in a “regime change” phase, after which a high-inflation environment will become the norm. The sources of pressure on the price level, in his opinion, are the increase in health care spending around the world, the reversal of globalization, the destruction of global production and supply chains, the relocation of production sites to high-cost countries.
N. Rubini, a former chairman of the Council of Economic Advisers during the Clinton Administration, points to the painful dilemma facing central banks in advanced countries as inflation rises. If central banks start phasing out unconventional monetary policies and raising policy rates to fight inflation, they could trigger debt crises and a severe recession. But if central banks maintain a loose monetary policy, they will risk double-digit inflation, which could turn into deep stagflation.
In any case, if high inflation persists in the United States for a long time, the Fed will be forced to raise the key policy rate and phase out asset repurchase programs. Moreover, S. Wei, a professor at Columbia University, warns that politicians around the world should prepare for the fact that interest rates in the United States will rise much faster than currently projected.
In addition, tighter monetary conditions in the United States will inevitably rebalance global capital flows and cause their outflow from emerging market economies. Many analysts fear that if the US Federal Reserve tightens monetary conditions before 2023 (as officially announced), the phenomenon of “taper tantrum” of 2013 is likely to repeat.
If interest rates in the United States rise considerably, countries with significant amounts of external borrowing, external short-term debt and relatively low levels of international reserves will face serious economic and financial difficulties.
In particular, the IMF emphasizes in the Global Financial Stability Report that sudden changes in interest rates in international markets will increase financial constraints for emerging market economies, especially those with significant external financing needs or a high share of external debt.
In this regard, we should mention the events of the 80s of last century. The then Chairman of the US Federal Reserve, Paul Volcker, in 1980-1982 raised interest rates to combat inflation. As a result, the United States experienced a double recession, and Latin American countries fell into debt crises. The 1980s were later called the “lost decade” for developing countries.
Nowadays, if there is a massive capital outflow from countries dependent on external financing, some of them will obviously have to declare defaults and restructure their external debts. Such processes, in turn, can trigger a cascade of sovereign defaults and a large-scale debt crisis globally.
Unfavorable economic prospects of most developing countries should also be taken into account. Advanced countries have already begun to emerge from the recession, and in the near future are likely to enter a pre-crisis trajectory of economic growth due to mass vaccination. On the other hand, the unavailability of vaccines for the majority of the population in developing countries will cause new outbreaks of coronavirus and its strains. This will prompt the governments of these countries to announce another lockdown, which will undermine the prospects for economic recovery in these countries.
According to leading world scientists, emerging market countries still have six months to implement self-help measures until the tightening of monetary policy in the United States. The main among such measures are creating a “safety cushion” in case of troubles in international markets (bringing the size of international reserves to an adequate level), as well as reducing the share of debt in foreign currencies.
In Ukraine, public debt has traditionally been characterized by a high share of foreign currency debt, and the share of hryvnia debt was insignificant, and in recent years it has even decreased. If at the end of 2014 in the structure of public and publicly-guaranteed debt the share of hryvnia debt was 41.6%, at the end of May 2021 it was only 36.2% (see Figure 2).
Minimizing the impact of external shocks on the monetary and financial system of Ukraine requires a reorientation of the state’s debt policy from foreign markets to domestic ones and full use of the potential of the domestic financial market. Moreover, it is a good practice to get rid of the anomalous situation when the Government is willing to place billion-dollar loans on foreign markets at rates of 6-7% in dollars, while domestic market rates are twice lower: 3.8% per annum for dollar loans and 2.5% for loans in euros.
The stance and dynamics of Ukraine’s international reserves are not optimistic and demonstrate a low degree of professionalism of the National Bank in this area. In nominal terms, international reserves decreased from USD 29.1 billion in early 2021 to 28.4 billion at the end of the first half of 2021. It is difficult to explain the fact that with increasing inflows of foreign currency into the economy and increasing external financial risks, the NBU revaluated the hryvnia, rather than increased international reserves.
During the first half of the year, the ratio of international reserves to short-term external debt and to monthly imports of goods and services also deteriorated (see Figure 3). Currently, the basic indicators of reserve adequacy – as a % of short-term external debt and to IMF composite metric – still do not reach the thresholds and continue to deteriorate. Reducing the risks of Ukraine’s external financial vulnerability requires the NBU to pursue a prudent policy of forming international reserves and bringing them to standard adequacy ratio.
So far, the actual size of Ukraine’s international reserves is 92% of IMF composite metric of adequacy of reserves, lagging behind by 8% of the threshold (which provides for the adequacy of reserves at the equivalent of 30% of short-term debt, 15% of other long-term external liabilities, 5% exports and 5% of broad money).
Thus, the long-term pandemic, the complication of Ukraine’s geopolitical situation and the likely deterioration of the situation on global financial markets in 2022 require authorities of macroeconomic regulation of Ukraine to proactively manage monetary and financial processes. This especially concerns the management of Ukraine’s public debt structure and the NBU’s foreign exchange intervention policy, which should focus on meeting the standard criteria of reserve adequacy.
Tetiana Bogdan, Doctor of Economics, Scientific Director of the Growford Institute on LB.ua.