UKRAINE'S INFLATIONARY CRISIS

Dr. Anders Aslund, Professor, Peterson Institute of International Economics,
Washington, D.C. and a long-time senior advisor to the U.S.-Ukraine Business Council (USUBC) has provided USUBC with a private copy of his latest paper which outlines his analysis, concerns (what he calls 'financial madness') and recommendations concerning Ukraine's serious inflationary crisis.

The paper found below by Dr. Aslund is being made available for the private
use of USUBC members and is not for distribution or publication.  USUBC
expresses its appreciation to Anders for making his latest inflation analysis
for Ukraine available for USUBC members.  Anders has just returned from
Yalta, Crimea, Ukraine where he participated in the annual YES (Yalta
European Strategy) conference.

UKRAINE'S INFLATIONARY CRISIS: TWO SHORT-TERM SCENARIOS

By Anders Åslund, Professor
Peterson Institute for International Economics
Washington, D.C., Tuesday, July 15, 2008

In May 2008, Ukraine's inflation hit 31.1 percent compared with May 2007,
the third highest inflation in the world after Zimbabwe and Venezuela.
Thanks to a revaluation of the exchange rate of the hryvnia, inflation
declined to 29.3 percent in June, but this is still very high.

Worse, producer prices exploded by 43.7 percent in the last year, and
Ukraine's average wages surged by 39 percent in May over May 2007.

Increases in producer prices and wages are usually passed on to consumer
prices with a delay, which suggests that inflation is likely to rise if Ukraine
does not undertake drastic policy changes.

Rising inflation, mainly in food and energy prices, is a global phenomenon,
but average inflation is currently 4 percent a year in the Western world and
8 percent a year in the emerging economies.

Neighboring Poland and Slovakia have moderate 4 percent inflation, which
shows that domestic economic policy is crucial. To fix the exchange rate to
the euro, as the Baltic countries have done, is bad, but a dollar peg is far
worse.

In this region, only Ukraine has fixed its exchange rate to the dollar,
which is the reason for its extreme inflation. Through its dollar peg,
Ukraine has imported roughly 15 percent inflation in the last year. It also
forces Ukraine to maintain negative real interest rates, currently of 13
percent a year, which boost inflation further.

Ukraine's monetary policy is not sustainable. To cure it, the dynamics must
be understood. Ukraine suffers from a massive monetary expansion. Its
money supply (M3) increased by 54.3 percent in June over June 2007.

The money supply is fed by foreign banks lending to banks in Ukraine.
These banks might finance their loans with 6 percent in Europe, but
consumer loans in Ukraine yield up to 55 percent.

This lucrative interest gap attracts huge speculative credit inflows that
are used for purchases of consumer goods, real estate, and imported goods.
They drive inflation and imports, boosting the trade and current account
deficits.

In the first five months of 2008, Ukraine's imports skyrocketed by 52
percent and the trade deficit broadened to 12.7 percent of GDP. As a
consequence, the private foreign debt is growing fast.

In several ways, the situation is reminiscent of Russia in 1997, when huge
foreign inflows of hot money into treasury bills kept the ruble exchange
rate too high, while foreign speculators benefitted from high interest rates
fixed in dollars. All were hoping to get out this Ponzi scheme in time, as
they now do in Ukraine. Some salvaged themselves, but the country
suffered.

The difference is that the Ukrainian state budget is in surplus, the public
foreign debt is minimal, and the international currency reserves of the
National Bank of Ukraine are substantial at $36 billion.

Therefore, the Ukrainian government can stop this financial madness with
limited harm to the nation, but only if it does so instantly.

Two scenarios are plausible.

[1] The first and right approach would be to immediately abandon the dollar
peg and let the hryvnia float. Initially, the hryvnia exchange rate might
temporarily rise modestly, but not much because the foreign banks will stop
their speculative currency inflows, when they no longer know the future
hryvnia exchange rate.

Since the National Bank no longer endeavors to keep the hryvnia stable, it
will stop buying foreign currency, and the money supply will no longer
increase. Then, inflation will decline, as will import purchases, and the
trade and current account balances will start improving. Some of the hot
bank money is likely to float out, and then the hryvnia will begin falling.

The National Bank should opt for inflation targeting, that is, keep the
exchange rate floating and try to keep inflation down with tighter monetary
policy, notably positive real interest rates.

Poland and Turkey have done so in similar situations in recent years, and
the NBU can learn from their experiences. Considering how suddenly the
hryvnia has surged, a depreciation in the order of 20 percent would be
possible.

Thus, Ukraine would re-establish its competitiveness and defeat inflation.
Exports will increase and imports be compressed. Economic growth might
suffer, if the domestic tightening has greater impact than the expansion of
exports, though the proportions are difficult to predict.

[2] The second scenario is catastrophic. The dollar peg is being maintained
in one way or the other. The bank inflows continue and boost the money
supply, since the National Bank continues to purchase hard currency and
thus expand the supply of hryvnia.

As a consequence, inflation increases ever more, making the speculative bank
loans even more lucrative. The imports increase so fast that Ukraine as a
country loses its creditworthiness.

Meanwhile, exports are reduced by excessive production costs. Relatively
soon, Ukraine would end up in a financial crisis. It becomes forced to
devalue and let the exchange rate float, as Russia in August 1998, and then
the exchange rate may fall by as much as 50 percent.

Because of currency misalignment, real estate prices would plummet by at
least half, and half the banks may go bankrupt. GDP would fall and it would
take years for Ukraine to recover its creditworthiness, although its
international competitiveness would be restored.

A financial catastrophe can and must be avoided, but only if the hryvnia is
swiftly allowed to float.

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NOTE:  Paper by Anders Aslund is not for distribution or for publication,
it is for the private use of USUBC members.
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