Currency liberalisation and a free hryvnia exchange rate: How the National Bank of Ukraine plans to lift restrictions on the foreign exchange market?

On July 7, the National Bank published its strategy (or rather, its public version) for easing currency restrictions, returning to a floating exchange rate, and inflation targeting.

The NBU explains that the liberalisation of currency restrictions and the gradual increase in exchange rate flexibility will ultimately enhance Ukraine's economy ability to adapt to external and internal factors. Additionally, it will strengthen the National Bank's ability to ensure price and financial stability, as well as sustainable economic growth in the long term.

At the same time, the NBU emphasises that the implementation of all these measures will be determined not by temporary frameworks, but by the condition of the foreign exchange market and the economy as a whole.

Mind has examined how the National Bank plans to implement this strategy and under what conditions.

How does the National Bank of Ukraine justify the adoption of the strategy? The strategy itself was approved by the NBU on June 29th. However, it has only been published now. The development of this document is one of the key milestones within the framework of the Extended Fund Facility programme with the International Monetary Fund (IMF), which was signed at the beginning of 2023.

According to the terms of the Memorandum between Ukraine and the IMF, the National Bank was supposed to prepare the mentioned strategy by July, having previously agreed upon it with the experts of the Fund.

What are the drawbacks of the current policy of currency restrictions and a fixed exchange rate? The National Bank explains that after the events of February 24th, 2022, the regime of a fixed exchange rate accompanied by strict currency restrictions played an important role in stabilising price and exchange rate expectations and contributed to reducing inflationary pressures.

However, the National Bank is concerned that prolonged market regulation through administrative measures may have negative consequences. Specifically:

• over time, currency restrictions lose their effectiveness and expectations regarding the reliability of the exchange rate peg weaken;
• preconditions for the shadow economy and a slowdown in productive business activity may develop, leading to an inevitable negative impact on the public finance sector;
• businesses will face the accumulation of currency risks, and the economy will lose the ability to adapt to changes in the external and internal environment due to exchange rate flexibility;
• prolonged fixed exchange rate complicates the task of preserving price and financial stability, as well as achieving sustainable economic growth.

What are the conditions for lifting the restrictions? The National Bank emphasises several times that the implementation of the strategy depends on certain macroeconomic prerequisites. First and foremost, the NBU will assess:

1. Inflation rates and inflation expectations.
2. Levels of international reserves and the currency market stability.
3. Interest rates, including the key policy rate level and attractiveness of hryvnia instruments.
4. Other parameters of financial stability.

How will the National Bank implement the strategy?

Currency restriction liberalisation. The NBU has developed a roadmap for the gradual relaxation of currency restrictions. It includes the following stages:

• Stage I: Minimising exchange rate multiplicity, liberalising trade operations, stimulating lending and investment inflows.
• Stage II: Restoring trade financing, managing banks' currency risks, and the possibility of the repatriation of interest on old debts and investments.
• Stage III: Unlocking repayments for loans and investments, liberalising currency operations for the public and derivatives transactions, and removing barriers for non-resident lending and foreign investments.

Some steps within these stages may be implemented earlier or later than initially planned by the NBU. For example, if conditions arise where actions related to liberalisation would be more beneficial for the economy, the currency market, and the financial system as a whole.

Transitioning to a floating exchange rate. The NBU assures that abandoning the fixed exchange rate will only be possible once capital flows are ensured. Moreover, increased exchange rate flexibility will be preceded by the relaxation of most currency restrictions on trade operations and measures that distort the functioning of the currency market due to multiple exchange rates. Nowadays, there are essentially four exchange rates: the official rate, cash rate, card rate (for non-cash transactions by individuals), and interbank rate.

The NBU explains that in the early stages, it will still rely on the exchange rate as a sort of anchor indicator for the economy.

One critical precondition for transitioning to greater exchange rate flexibility is the elimination of multiple exchange rates, which will help maintain control over exchange rate expectations.

Returning to inflation targeting. This process will occur gradually, closely linked to the relaxation of currency restrictions and the transition to exchange rate flexibility, while maintaining a disinflationary trend and improving inflation expectations.

In the context of inflation targeting, the NBU assigns an important role to the key policy rate. Specifically, while returning to inflation targeting, the key policy rate will remain "sufficiently positive". It is necessary to maintain the attractiveness of the hryvnia as a savings instrument, reduce demand for foreign currency, and alleviate pressure on the exchange rate and international reserves. In other words, the NBU does not currently plan to significantly lower the key policy rate (which currently stands at 25%).

According to the NBU's estimates, this could happen within 18 months, meaning in the year 2025.

Are the economy and currency market ready for the implementation of this strategy? While the National Bank does not provide specific timelines, we can make a general assessment of the macro factors that will serve as signals for the implementation of the strategy.

1. Inflation backdrop. In July, the annual inflation rate did not reach 15%, which is lower than the 15.3% recorded in May. The forecast for consumer price levels in 2023 is around 15.5%. Therefore, there is a clear disinflationary trend. However, factors that could potentially disrupt this trend include increased utility tariffs, rising fuel prices due to tax hikes, and the impact of the consequences of the Kakhovka Dam explosion, which will have a negative effect on vegetable and garden crop yields and fuel food inflation.

2. NBU's international reserves. The outlook is optimistic in this regard. The National Bank announced that gold and foreign exchange reserves reached $39 billion at the beginning of July, setting a new record. It is a direct result of inflows from international partners.

3. Stability of the currency market. The cash exchange rate has been moving within the corridor of 36.8-37.5 UAH/USD for almost a month, closely approaching the official and interbank rates. Additionally, in June, a positive balance in foreign currency operations by individuals was recorded on the cash market for the first time since the summer of 2022, indicating a lack of deficit.

4. Attractiveness of hryvnia instruments: The average yield on hryvnia deposits for individuals as of July 10th ranged from 14.7% to 15.2% per annum (according to the UIRD index). The maximum interest rates on bank deposits reach 19-20% per annum, which is close to the limit. However, the NBU is confident that it can further increase the profitability of hryvnia assets.

5. Overall financial stability. The National Bank does not provide a detailed description of what it specifically refers to in this case. Most likely, it encompasses the situation in the economy as a whole and in the public finance sphere in particular. In the first quarter of 2023, real GDP increased by 2.4% compared to the fourth quarter of 2022 but fell by 13.5% on an annual basis. However, the NBU has forecasted a 15.9% year-on-year economic growth in the second quarter. It is important to consider the low base of comparison as April and June 2022 were among the most challenging months for the country. As for the state budget, its deficit is largely covered by international assistance. On one hand, this ensures stability, but on the other hand, own revenues (taxes and fees) remain low.

For example, starting from 16 June, resident borrowers were given the opportunity to transfer funds outside Ukraine to repay certain categories of loans. The situation in the foreign exchange market demonstrates a smoothing out of the multiplicity of exchange rates, which is a positive signal. In addition, while the NBU's management was very vague about the transition to a floating exchange rate a few months ago, it has now made a statement about it. Thus, the start of liberalisation is imminent.