How to mitigate the effects of global shocks and reduce the external financial vulnerability of the economy.
Avoidance of the balance of payments crisis and large-scale defaults during the economic crisis of 2020-2021 was a pleasant exception to the established rule of interdependence (mutual strengthening) of financial and economic crises in Ukraine. However, this state of affairs largely reflected not the achievements of Ukraine’s macroeconomic policy, but the unique nature of the current crisis, the side effects of which were the slowdown in imports while maintaining access to the international capital market. These factors restrained the transmissions of external shocks in Ukraine’s economy through trade and financial channels.
During 2020 and January-February 2021 there were both positive and negative phenomena in Ukraine’s balance of payments:
- formation of an unprecedented current account surplus (at the level of 4% of GDP) with a 7-fold reduction in the deficit in trade of goods and services, which increased the degree of external sustainability of the economy and painlessly financed capital outflows from Ukraine;
- minimal reduction in wages in the context of the pandemic and economic crisis, which kept the national economy from plummeting and supported Ukraine’s balance of payments;
- resumption of foreign portfolio investment in the domestic government bond market, which indicated a satisfactory level of solvency of Ukraine and provided some support to the state budget;
- beginning of the outflow of direct and portfolio investments from the economy of Ukraine, which became a significant factor in the decline in capital investment and the stagnation of the credit process in Ukraine;
- excess of external debt repayment over borrowing amounts, which highlighted liquidity and solvency risks in the non-financial corporations sector;
- active purchase of foreign assets by residents of Ukraine, which intensified the processes of financial exhaustion of the national economy;
- prolongation of instability risks of balance of payments associated with large needs for refinancing accumulated debts and volatility of foreign capital flows.
Since 2016, Ukraine has had a chronical deficit of current account and a surplus of financial account of the balance of payments. In 2020, however, the situation became directly opposed: a positive current account balance (USD 6.2 billion) and a negative financial account balance (USD 4.2 billion) were recorded for the year. The first months of 2021 reproduced the general trends of the previous year: the current account remained positive and the financial account remained negative (see Figure 1).
Source: Compiled by the author based on National Bank of Ukraine
In terms of GDP, the current account surplus in 2020 reached an unusually high level of 4%, which became an absolute record after 2004. The transformation of the chronical deficit into a surplus was caused primarily by falling import purchases due to the crisis reduction in consumer demand, lower world energy prices, disruption of international production and supply chains, and reduced opportunities to sell imported products within the country.
The rate of decline in exports of goods and services in 2020 (4.5% compared to 2019) lagged significantly behind the rate of decline in imports (17.9%), which resulted in a narrowing of the trade deficit from USD 12.5 to 1.8 billion. At the same time, the positive balance of trade in services increased 2.75 times. A nearly twofold reduction in imports of tourist services from USD 8.5 billion to USD 4.6 billion significantly improved the balance of services.
Following the results of 2020, the share of food and raw materials for their production in the structure of Ukraine’s exports of goods was almost 50%, and in 2018 this share was 43%. The steady external demand for food products supported the physical and value volumes of their exports. In the structure of Ukraine’s exports of goods, the share of all raw materials (food, mineral products, ferrous and nonferrous metals) was at a consistently high level of 80%.
However, in the geographical structure of Ukrainian exports there were significant changes. Exports of goods and services to the EU in 2020 fell by 10.6% compared to 2019; at the same time, exports to Asian countries grew by 15.7%. As a result, the EU’s share in Ukrainian exports decreased by 2.2 percentage points (to 35.1%), and the share of Asia increased by 5.9% (to 33.4%). The decrease in exports to the European Union was due to tight quarantine restrictions in the EU and the restraining nature of some articles of the Association Agreement (in terms of quotas for agricultural products, technical regulation of industrial exports and restrictions on exports of services).
The net outflow on the financial account and capital account in 2020 was USD 4.2 billion, which stands in sharp contrast to the net inflow of funds in previous years. In January-February 2021, the outflow continued and reached USD 1.3 billion. In 2020, a significant growth of external assets was combined with a slight increase in external liabilities, as a result of which residents of Ukraine were net creditors of the rest of the world (in the amount of USD 6.2 billion) (see Figure 2).
Source: Compiled by the author based on National Bank of Ukraine
The significant components of the net outflow of capital from Ukraine in 2020 were as follows:
a) an increase in external assets of the private sector by USD 6.9 billion, including the accumulation of foreign currency cash outside the banks which amounted to USD 5.1 billion;
b) net repayment of debt securities by the public and private sectors of Ukraine which was USD 0.9 billion;
c) net withdrawal of foreign direct investment in Ukraine by non-residents which was almost USD 1 billion.
The growth of external assets in 2020 was almost the same as in 2019. But if we analyze the structure of asset growth in the dynamics, then in 2020 direct and portfolio investments of residents of Ukraine decreased several times, while the cash currency outside banks doubled. Cash accumulation accelerated due to growing economic uncertainty during the crisis, a surge in devaluation, and reduced funding for shadow operations under permanent quarantine restrictions.
The analysis of the financial account for 2018-2020 clearly shows that the liberalization of capital movements after the introduction of the Law “On Currency and Currency Operations” caused a huge capital outflow of residents of Ukraine: the growth of external assets increased from USD 0.9 billion in 2018 to USD 7 billion in 2019 and to USD 6.9 billion in 2020. The outflow of capital triggered decapitalization and financial exhaustion of the economy, which undermined the prospects for economic recovery.
In the structure of assets of the international investment position (see Fig. 3) foreign currency cash outside banks played the dominant role: its position at the end of 2020 reached USD 93.7 billion. Trade credits and advances and foreign direct investment which accordingly amounted to USD 4.0 billion and USD 8.8 billion were also important components of the international investment position assets.
Source: Compiled by the author based on National Bank of Ukraine
The absolute size of official foreign exchange reserves of Ukraine in 2020 went up by USD 3.8 billion, but for two months of 2021 it diminished by USD 0.6 billion. At the same time, the basic indicators of reserve adequacy are still lower than the threshold ratio. In particular, at the end of 2020 the actual size of NBU’s international reserves was at the level of 95% of the IMF composite criterion, lagging behind the threshold ratio by 5%. The ratio of reserves to short-term external debt increased from 45.5% in 2018 to 60.1% in 2020, but still did not reach a critical level (100%).
According to the NBU, in 2021-2022 Ukraine will have to pay more than USD 17 billion on public and publicly-guaranteed debt in foreign currency, not to mention the debt payments of private borrowers. This value is equivalent to 60% of the current level of Ukraine’s international reserves. This situation indicates the fragile nature of the achieved macro-financial stability in the country and the lack of alternatives to Ukraine’s cooperation with official creditors.
That is, today the key risks to the stability of Ukraine’s balance of payments are associated with the massive outflow of national capital and the unreliability of sources of debt refinancing. An alarming symptom is that since the beginning of 2021, the volatility of financial markets has increased with the growth of long-term interest rates in advanced economies.
The market yields on 10-year US Treasury bonds grew from less than 1% at the beginning of the year to 1.7% in April 2021. There has also been a sharp rise in interest rates in the UK and a moderate rise in Japan and the Eurozone. This reflected investors’ expectations about future inflation and money supply. There are now fears that central banks in advanced economies will respond to this situation by raising the key policy rate; then portfolio investors will begin to leave emerging markets in large numbers.
This means that for Ukraine, as well as for other emerging market economies, the risks of access to external market financing are becoming relevant. To offset such risks, the IMF advises central banks of emerging market economies to pursue an easier monetary policy that will be able to offset rising global interest rates (Shifting Gears: Monetary Policy Spillovers During the Recovery from COVID-19). The National Bank of Ukraine, as always in such situations, is following its own unique path and while strengthening external financial risks it has already moved to a cycle of raising interest rates.
Mitigation of global shocks and reduction of external financial vulnerability of Ukraine’s economy should be based on the implementation of the following economic policy measures:
Increase in volume and improvement of the structure of international reserves by:
a) repurchasing the surplus of foreign currency supply by the National Bank during the seasonal growth of export revenues and a gradual increase in reserves to USD 31-32 billion; b) raising the share of gold from the current 5.3% to at least 15%; of the total value of international reserves; c) enhancing investments in AAA-rated corporate bonds issued by the corporates from the EU and the USA.
Implementation of stimulating monetary policy through: a) refraining the National Bank from further raising the key policy rate (even with rising inflation); b) launching targeted long-term refinancing operations of banks to the real sector of the economy; c) easing standards for banks to reserves provisioning related to the credit risks.
Development of the domestic capital market on the basis of: a) expansion of liquid markets of financial instruments and risk mitigation mechanisms/ instruments; b) modernization, consolidation and development of the exchange and depository infrastructure of the market (introduction of the institution of a regulated market operator, creation of a model of the Multilateral Trading System, etc.); c) establishment of the Private Investment Guarantee Fund to cover the losses in the event of bankruptcy of professional stock market participants.
Gradual narrowing of the budget deficit starting from 2022 and the use of the following instruments of fiscal consolidation: a) increase in taxes on property, wealth and capital gains; b) improved administration of corporate profit tax; c) growth of environmental taxes and rent payments (especially for the extraction of iron and manganese ores); d) reduction in budget expenditures on state administration, security and judiciary.
Scientific Director of the Growford Institute Tetiana Bogdan for Dzerkalo Tyzhnia.