CURRENCY OPTIONS FOR UKRAINE
May 20, 2004
by
Katerina Tarasova
Association of Universities and Colleges of Canada
Abstract
A sound monetary/exchange rate policy is a key ingredient of successful economic
development, particularly in the case of the formerly Communist transition economies
of Eastern Europe. This paper analyzes monetary/exchange rate policy in Ukraine. It
presents the development of such policy throughout the 1990s, and analyzes the present
policy regime and its strengths and weaknesses. The paper also compares the Ukrainian
experience to a variety of exchange rate regimes practiced by numerous transition
economies in Central and Eastern Europe, and argues that countries that selected more
fixed exchange rate regimes demonstrated better economic performance than those that
selected more flexible regimes. Finally, I propose alternative policy options that could
help Ukraine to further stabilize its economy and improve its macroeconomic
performance.
2
INTRODUCTION
Ukraine has been going through a process of difficult transition from a centrally planned to a market
economy. After almost thirteen years of intensive reforms, the country has neither managed to stabilize its
economy nor transform its political system into a fully democratic state. The list of current economic and
political concerns in Ukraine is extensive, as I will try to demonstrate, but the focus of this paper will be
Ukraine’s monetary/exchange rate policies.
This paper outlines the necessity of the monetary policy reform in Ukraine and identifies several
alternative policy options that are potentially beneficial for Ukraine in its objective to reach sustainable
economic growth. The hypothesis of this paper is formulated as follows: Ukraine needs to reconsider its
exchange rate regime and monetary policy goals and adopt a more fixed exchange rate regime in order to
increase financial stability and expedite its economic development. The current policy is trying to target
the exchange rate as well as the monetary aggregates, given the free flow of capital, which in practice is
considered to be impossible. In addition, Ukraine has been giving preference to more flexible exchange
rate regimes over more fixed ones, which is historically not the best choice for a transition economy. If
Ukraine adopts a more fixed exchange rate regime, it could improve financial stability and increase
economic growth as it was clearly demonstrated by a vast majority of other transition economies in the
1990s. Moreover this would bring Ukraine closer to its goal of joining the European Union in the future.
The following questions appear to be of particular interest: 1) Why does Ukraine need to restructure its
current monetary policy? and 2) What would be an alternative monetary policy for Ukraine? These
questions will be addressed through a combination of an examination of relevant theory, and comparative
case study analysis.
Section I of this paper introduces the main theoretical principles, which are essential in understanding the
past and current concerns Ukraine has experienced in conducting its monetary policy. It presents the
notion of ‘impossible trinity’ and the spectrum of exchange rate regimes advocated by economists today.
Section II summarizes the development of the Ukrainian monetary policy since the country’s
independence in 1991 and the reforms, which have taken place until today. Special attention is given to
the IMF intervention into Ukraine’s monetary system and its consequences. It proceeds with the
assessment of the current policy and its deficiencies including inflationary pressures, dollarization, and
many other micro and macroeconomic problems. Section III presents the comparative analysis of the two
relative regimes (fixed and flexible) in the context of all Central and East European countries. It will
present the evidence that the countries that were more successful in their transition and have recently
become member states of the EU tended to use more fixed exchange rate regimes. Conversely, the rest of
the former Soviet bloc states that have demonstrated poorer economic achievements tended to use more
3
flexible regimes. This section further examines the two case studies of Latvia and Estonia, USSR
successor states that successfully implemented fixed exchange rate and currency board respectively, and
compare them to the case of Ukraine. The purpose of this analysis is to compare political, economic and
institutional indicators demonstrated by each of the three countries under a certain type of exchange rate
regime. The indicators include initial state of affairs, Central Bank’s independence, foreign direct
investment inflows, real GDP growth, and inflation. The main argument in this section is that Ukraine has
to consider a more fixed type of exchange rate regime in order to achieve the desired economic
development. In addition, if Ukraine ever considers this option, the anchor currency should be the euro
rather than the US dollar despite a high level of de facto dollarization of the Ukrainian economy.
4
SECTION I: Theory
The three key elements of the monetary policy framework are 1) Central Bank (CB) independence; 2)
domestic monetary policy, and 3) determination of the exchange rate regime.1 Traditionally, monetary
policy was aimed at basic economic goals such as price stability, high employment, stability in interest
rates, financial market and foreign exchange market.2 The difficulty with these goals is that they cannot
be achieved all at once and often conflict with each other.
Central Bank Independence
Independence is simply a legal insulation of a Central Bank from political and fiscal pressures in a
country. In other words, an elected government cannot fire a Central Bank governor at will and the CB is
not required to finance government deficits.3 In terms of its importance in the monetary framework,
independence frees Central Banks from politically-driven pressures, for instance monetizing the fiscal
deficit and exploiting seigniorage; and it allows to pursue national objectives. Nevertheless, legal
independence is not enough to grant Central Banks flexibility they need. The elected government can
grant CB’s independence, but it can also take it away; therefore, continued independence requires
political support and enforcement of existing laws.4
Domestic Monetary Policy
In theory, there are two main types of monetary policy targets: an intermediate target (e.g. monetary
target) and an ultimate target for policy goals (e.g inflation target). Monetary targeting has been rather
popular in the 1970s because of its relatively simple monitoring procedure. Since then, the money
demand (MD) became unstable, and inflation targeting became popular. In addition, there was the
problem of which monetary aggregate to target. Both monetary and inflation targeting are fairly
transparent. Monetary targeting is responsible for announcement of targets for monetary aggregates, and
accountability mechanism to preclude large and systematic deviations from the monetary targets.5
Inflation targeting is a more complex policy, which covers an institutional commitment to price stability,
increased transparency of the monetary policy strategy through communication with public and greater
1
Kuttner, K. and A.S. Posen. “Beyond Bipolar: A Three Dimensional Assessment of Monetary Frameworks”,
International Journal of Finance and Economics, No. 4, (2001), p. 370.
2
Dean, James W. “Monetary Policy in Advanced and Transition Economies: Illustrations from Canada, Poland and
Ukraine.” Center for Information and Social Programs, CASE, 2002.
<http://www.cisp.org.ua/cisp/CISP_uk.nsf/0/180b298c2d391b47c2256d27000fbcb4?OpenDocument> Accessed:
October 2nd, 2003.
3
Kuttner, “Beyond Bipolar”, p. 375.
4
Ibid. p. 206.
5
Mishkin, Frederic S. The Economics of Money, Banking and Financial Markets, 6th Edition, (Addison-WesleyLongman, Reading, Mass 2001), p. 100.
5
variety of economic variables.6 There are advantages and disadvantages to both of these policies. The
primary advantage of the monetary targeting is that it is relatively easy to implement and observed time
lags are fairly short.7 It also enables monitoring of Central Bank’s performance but not achievements of
its ultimate goals.8 In case of inflation targeting, time appears to be a problem, because there is a time lag
between policy’s implementation and its outcome. In addition, inflation targeting takes into consideration
many more indicators, which makes the decision-making process more complex.9 Inflation rate targeting
is more visible to the public. Stable prices and wages convey a clearly positive message to the public and
this in turn builds up people’s confidence in the Central Bank as well as in the government. Especially,
confidence is important in case of emerging market economies, most of which have had a past history of
economic and monetary mismanagement and are trying to gain back their trust in the new authorities.
There are also several downsides to both monetary and inflation targeting. Monetary targeting requires
fulfillment of certain prerequisites in order to achieve best outcomes. These prerequisites are stable
money demand (MD), ability to control the money supply with reasonable degree of precision and ability
to practice flexible exchange rate regime.10 Inflation targeting, on the other hand, is considered to be a
soft rather than a hard target. It is very difficult to forecast inflation because Central Banks do not control
a variable that may provide accurate information on future inflation.11 Targeting inflation rate in the
future requires that the Central Bank can accurately predict the effect of current policy and economic
condition on future inflation rate that they are targeting.
Determination of Exchange Rate Regime
An exchange rate targeting, in comparison to monetary and inflation targeting previously discussed, has
its own advantages. It is considered to be more transparent to the public; and if the exchange rate is fixed,
it automatically links domestic inflation rate to that of the anchor country, which makes interactions (e.g.
business and financial operation, trade) between states more secure. However, it also carries some
disadvantages and those are partial or full loss of autonomy over its monetary policy, and vulnerability to
speculative attacks.12
Whether fixed or flexible, a stable currency (i.e. liquid and widely acceptable) is a reflection of reliability
and strength of the domestic financial system. International investors feel more confident directing their
6
Mishkin, Frederic S. “Inflation Targeting in Emerging Market Countries”, American Economic Review, vol. 9, no.
2, (May 2000), p. 105.
7
Rich, G. “Approaches to Monetary Policy”, HEI, Spring 2003, <http://www.ewheri.ch/geneva/Chapter1.pdf>
Accessed: October 13th, 2003.
8
James W. Dean. “Monetary Policy”.
9
Cabos, K., M. Funke, and N. Siegfried. “Some thoughts on Monetary vs. Inflation Targeting”, Quantitative
Macroeconomic Working Paper Series, No. 8, Universität Hamburg, (1999), p. 1.
10
Ibid. p. 3.
11
Ibid. p.4.
12
Rich, G. “Approaches to Monetary Policy”, p. 4.
6
investments into countries with stable national currencies and stable monetary systems, so they would not
have to risk their money in conditions of high inflation rates and unforeseen currency devaluations.
Nevertheless, it is important to keep in mind the concept of the ‘impossible trinity’ and the fact that no
economy can simultaneously have full capital mobility, fixed exchange rate and fulfilment of domestic
macroeconomic goals.13 In effect, this implies that there are two options: to fix the exchange rate and take
the required real adjustment through relative price movements or pick a monetary policy rule, e.g.,
monetary targeting or inflation targeting, and allow exchange rate to float freely.14 Monetary authorities
cannot achieve their goals for two nominal variables inflation and nominal exchange rate at the same
time.
There are nine exchange rate regimes presently found in existing economies. These are shown in Figure 1
below.
FIGURE 1
15
Hard Pegs
Intermediate Regimes
Free Float
Managed float
Target zone
Basket peg
Crawling peg
Adjustable peg
Fixed peg
Flexibility
Currency Board
Currency Union
Fixity
Floats
The two extremes of this spectrum are an independent or free float exchange rate and a currency union. In
other words, a country has to determine whether it is prepared to take full responsibility and manage its
own monetary policy or whether it would be better off delegating this task to a supranational body.
13
Dehejia, V. “The Choice of Monetary/Exchange Rate Regimes: Concepts and Arguments,” Carleton Economic
Papers 2003-12, (November 2003), p. 3.
14
Ibid., p.5.
15
Kuttner, K. “Monetary Policy Frameworks: The Quest for Disciplined Flexibility,” presented at the Federal
Reserve Bank of New York, Central Banking Seminar, October 22, 2002,
<http://app.ny.frb.org/cfcbsweb/kuttner.pdf> Accessed: October 6th, 2003.
7
For years there has been a debate about which of the regimes is a superior one. Unfortunately, there is still
no clear answer to this question. In this particular study, I will outline the advantages and disadvantages
of the three main groups of regimes: hard pegs, intermediate regimes and floats.
A hard peg is an exchange rate regime that does not allow for an independent monetary policy. It ties the
domestic currency to another currency or currency composite.16 This kind of regime reduces the Central
Bank’s discretion and potentially can reduce the transaction costs associated with international trade and
investment. It can also work through reducing exchange rate risk premia and generate greater interest rate
convergence. The transaction costs argument suggests that exchange rate volatility can impede trade and
investment flows, therefore fixed exchange rate may stimulate trade, investment and economic growth.17
There are also some other political and economic arguments for and against fixed exchange rate regimes.
On the one hand, in economies with poor monetary management, such as some countries in Central and
Eastern Europe, fixed exchange rates can result in prevention of hyperinflation, tight monetary policy,
and provide it with greater credibility. On the other hand, fixing the exchange rate is perceived as a loss of
monetary “sovereignty” or as a lack of political accountability.18 This is usually a strong argument
presented by newly independent states against the fixed regimes because they do not want to jeopardise
their independence and do not want to be portrayed as politically fragile states.
A free float is a regime in which the exchange rate moves freely in response to market forces and the
Central Bank’s intervention is limited. In 1953, Milton Friedman articulated the ‘classical argument’ in
favour of flexible exchange rate regimes: “by freeing monetary policy to pursue domestic policy goals
(eg. full employment, price stability), a flexible exchange rate can ‘insulate’ or ‘buffer’ the economy from
external shocks.”19
Intermediate regimes are the ones with limited flexibility. Limited flexibility means that the value of the
currency is maintained and allowed to fluctuate within certain limits.20 The distinct features of
intermediate regimes are a lesser degree of market determination and a greater degree of central bank
intervention. Central Bank monitors exchange rate behaviour on a daily basis.
Clearly, all of the regimes have their advantages and disadvantages and “no single exchange rate regime
is suitable for all countries or in all circumstances.”21 The selection of an exchange rate regime depends
on many internal factors such as political, economic and cultural environments and external factors such
16
Kiljunen, “Fixed vs. Flexible”, p.5.
Dehejia, V. “The Choice of Monetary/Exchange Rate Regimes,” p. 6.
18
Ibid., p. 8,9.
19
Friedman, Milton. “Studies in the Quantity Theory of Money”, University of Chicago Press, 1956.
20
Kiljunen, “Fixed vs. Flexible”, p.4.
21
International Monetary Fund. “Exchange rate arrangements and currency convertibility - developments and
issues”, World Economic and Financial Surveys, Washington, DC, (1999), p.7.
17
8
as country’s geopolitical role, its involvement in the global trading and investment system. Especially
lately, there has a been a debate among economists about the trend in the selection of exchange rate
regimes, and this trend identifies that many countries tend move away from intermediate regimes towards
more extreme policies. This phenomenon has also been called the “hollowing out” of the middle. Soft peg
systems or intermediate regimes have not proved to be viable in the long-run. For some countries in
transition, they served as a good temporary exchange rate regime, for others - they led to currency crises.
The ‘impossible trinity’, discussed earlier, is certainly one of the explanations of the ‘hollowing out’
phenomenon. Free capital mobility, fixed exchange rate and monetary policy dedicated to domestic goals
cannot exist simultaneously, and this fact in itself dooms intermediate regimes to failure because soft pegs
often conflict with domestic policy goals.22
The selection of the exchange rate regime is clearly a challenge. As we have seen, there are strong
arguments made in favour of both full flexible and perfectly fixed exchange rate regimes. However, the
pervasiveness of intermediate regimes in practice underlines the fact that neither fixed nor flexible
regimes serve the needs of all states and that such states have had to come up with alternative policy
arrangements i.e. intermediate regimes.
22
Fischer, S. “Exchange Rate Regimes: Is the Bipolar View Correct?”, Delivered at the Meetings of the American
Economic Association New Orleans, January 6, 2001, p. 1.
<http://www.imf.org/external/np/speeches/2001/010601a.pdf> Accessed: September 17th, 2003.
9
SECTION II: History of Ukraine’s Monetary/Exchange Rate Policy
According to the constitutional law on “The National Bank of Ukraine”, monetary policy is a complex set
of instruments in the spheres of monetary circulation and credit, directed towards regulating economic
growth, inflation trends, stability of the national currency unit and provision of employment.23 These
policy objectives are similar to those set by well developed Western economies. However, their
realization in Ukraine has not been very successful in comparison to the West and some other transition
economies. The purpose of this section is to outline some key obstacles Ukraine came across since its
independence in 1991. Below is the summary of some major political and economic trends in Ukraine in
the early 1990s, the history of the development of the monetary/exchange rate policies and the reasons for
which the objectives laid out by the constitution were not accomplished.
Initial Conditions
Ukraine received its independence during the process of disintegration of the former Soviet Union.
Ukrainian independence was as much of a surprise as it was inevitability. Most of the countries in Central
and Eastern Europe, where democratic movements began much earlier than the fall of the Berlin Wall,
experienced much smoother initial transition than the newly independent states of the former USSR.
Ukraine became sovereign; however, among other critical problems, it was faced with fundamental
deficiencies in the state apparatus, which did not allow for proper functioning of the country in the new
international setting. However, at that time people were more concerned with the compounding economic
chaos rather than newly attained independence, democracy and Ukrainian national heritage.
The reality was that the country was faced with major economic problems: massive unemployment due to
demobilization of major industries, uncontrollable hyperinflation robbing them off the little savings they
had and the rapid growth of black market economy. Ukraine’s close interdependence with other former
soviet republics became a real burden. A large part of the Soviet industrial sector was located in Ukraine,
particularly coal-mining, chemical processing, and machine building and most of these industries were
dependent upon raw materials imported from the other republics. In addition, Ukraine used to be the socalled “bread basket” of the former USSR since the country possessed almost sixty percent of the world’s
most fertile black soils. The break-down of the Soviet Union automatically distorted this ‘symbiosis’.
There were problems concerning the low demand for heavy industry goods, problematic inter-bank
relations, and financial issues such as introduction of new currencies in the former Soviet republics.24
Subsequently, Ukraine, as an independent state could not sustain Soviet-born unprofitable and inefficient
industries, which in turn resulted in dramatic rise in unemployment.
23
Stelmah, V., A. Yepifanov, N. Grebenik, and V. Mischenko, Monetary policy in Ukraine. (Kiev “Znannya”,
2003), p.83.
24
Central and Eastern European Team, “Ukraine: Country Employment Policy Review,” International Labor Office,
International Labor Organization, (1998), p. 7.
10
Another major barrier to adjustment was highly centralized structure of the economy. Consumer goods
and services were produced in large enterprises, and small and medium entrepreneurship was practically
non-existent. These industrial giants provided employment for a large part of Ukrainian population and
the government realized that their collapse would be catastrophic. For that reason, the government
continued financing and subsidising many of them and newcomers experienced discriminatory legal and
institutional obstacles.25 Thirdly, the transition from centrally planned to a market economy required the
creation of consumer, financial and labour markets, where the laws of demand and supply could operate.
This was an enormous financial burden on the country, because all of those institutions had to be created
from scratch. Therefore, Ukraine had to borrow from abroad, while building up its international debt.
Economic decline in the USSR began earlier than 1991. In the 1990, consumer price inflation reached the
level of approximately 44%.26 In 1991, after independence, consumer prices increased by 390%, while
producer prices increased by 260%. The domestic market fell into a deep disequilibrium characterized by
widespread shortages of consumer and intermediate products, leading to further falls in production.27 The
main economic indicators in the period between 1991 and 1997 are illustrated in Table 1 below:
TABLE 128
1989
1990
1991
1992
100)
100.0
96.0
85.8
77.5
Annual change in GDP (%)
—
-4.0
-10.6
Annual inflation rate (%)
—
4.2
Employment ratio (%)
83.2
Unemployment rate (%)
1993
1994
1995
1996
1997
1998
1999
2000
2001
66.5
51.3
45.0
40.5
39.3
38.5
38.5
40.7
44.4
-9.7
-14.2
-22.9
-12.2
-10.0
-3.0
-1.9
-0.2
5.9
9.1
91.0
1210.0
4734.0
891.0
377.0
80.0
15.9
10.5
22.7
28.2
12.0
81.9
80.5
78.5
76.2
73.1
76.8
77.2
76.7
74.9
65.6
67.1
67.1
—
—
—
0.3
0.3
0.4
0.4
1.3
3.0
3.7
4.3
4.2
3.7
Age 15-24 unemployed (%)
—
—
—
—
31.8
25.8
27.8
24.5
22.0
—
—
—
—
Real wages
100.0
109.3
114.2
123.7
63.2
56.5
62.3
59.3
57.7
55.8
48.4
48.9
59.1
Real GDP growth (1989 =
In 1992, the government made a decision to liberalize prices. The initial shock was underestimated and
inflation rate reached 1210% that year and 4734% in 1993. It is important to remember that price
liberalization itself does not cause hyperinflation. Hyperinflation is caused by excessive monetary growth
(increase in MS). However, the public in Ukraine saw rising prices and were not aware of the excessive
monetary growth. If addition, there was a rapid fall in investment by 7.1% in 1991 followed by 36.8%
decline in 1992 and it kept falling in subsequent years. Real wages and employment also experienced a
significant downfall. Therefore, it was concluded that liberalization of prices was the primary cause of
25
Ibid., p. 7.
Ibid., p. 8.
27
UNICEF IRC, “Social Monitor Review of Countries in Transition,” (2003), Statistical Annex p. 68,
<http://www.unicef-icdc.org/publications/pdf/monitor03/annex2003.pdf> Accessed: November 3rd, 2003.
28
Central and Eastern European Team, “Ukraine”, p. 8.
26
11
hyperinflation, and western-type economic policies resulted in decreasing wages and growing
unemployment, which acted as a catalyst to the growing skepticism about the market economy as a
whole.
Poor initial conditions and destructive economic forces of the early 1990s were calling for a new
economic strategy. After all, along with its inefficiencies and hardships of the transition period, Ukraine
possessed very exceptional natural resources such as coal, magnesium, iron, carbonate, clay and building
stone, which have been waiting to be utilized appropriately. The country has also had outstanding human
resources. The general level of education among population was and remains very high and providing
favorable economic and social conditions, long-term economic growth in Ukraine would be feasible.29
Unfortunately, neither the government nor the newly established ministries had a clear vision of the
realities of the Ukrainian economy at that time and the scope of reforms which had to be pursued. The
state was lacking strong institutional framework, which could have facilitated smoother transition period
and secure internal stability.
Monetary/Exchange Rate Policy in the Early 1990s
One of the most important economic and institutional achievements was the creation of an independent
banking system in Ukraine. This was created according to the law on “Banks and Banking activity”
adopted by Verhovna Rada (the Ukrainian Parliament) on March 20th, 1991.30 However, this notion of
‘independence’ of the banking system as discussed earlier in its traditional meaning did not apply in case
of Ukraine. The NBU was by no means independent from the Verhovna Rada.31 As stated by this law, the
banking system in Ukraine has a two-level structure. The National Bank of Ukraine (NBU) occupies the
first level and the commercial banks occupy the second one. The functions of the NBU were stated as
follows:
1. Set the level of required reserves for commercial banks;
2. Provide credits to commercial banks according to regulations;
3. Buy and sell government securities;
4. Provide credits to banks in collateral for securities;
5. Buy and sell foreign currency;
6. Print money and regulate their supply and circulation in the economy;
7. Set the level of interest rates.32
It is worth noting that the NBU began its functioning within the old ruble zone. By 1992, Ukrainian
government began developing a strategy of introducing an independent currency unit (karbovanez) and
29
Ibid., p. 7.
Stelmah, V., Monetary policy in Ukraine. p. 84
31
Dean, James W. “Monetary Policy”.
32
Stelmah, V., Monetary policy in Ukraine. p. 85
30
12
establishing it as a base for a more stable monetary system. The same year, Ukraine became a member of
the International Monetary Fund (IMF). Taking into account recommendations of the IMF and other
international financial advisors, the responsibilities of the NBU were extended to assisting the
government with major economic reforms, restructuring of the main industrial sectors, increasing credits
to commercial banks, dealing with deficits in the balance of payments and improving mechanisms of
interaction within Ukraine as well as its interaction with other countries.33
The early 1990s was a period of great uncertainties in the monetary/exchange rate policy. People’s
knowledge of market economy and Western-type financial apparatus was far from sufficient. In the
environment of hyperinflation and economic discourse it was very difficult to determine what kind of
strategies and objectives should be pursued. One of the obvious monetary goals in 1992 was dealing with
inflation, or to be more precise hyperinflation, which required immediate scrutiny of the Verhovna Rada
and the National Bank. People were seeing their savings melt on a daily basis in the process of major
devaluation of the ruble, prices were sky-rocketing and crawling wages could not keep up with those
processes. The general feeling was that money was becoming worthless and the direct effect was a
reduced incentive to work.
By the end of 1992, the new currency unit karbovanez was introduced into circulation, represented by
coupons issued by the National Bank. The two major challenges posed to the NBU in that period were
persistent hyperinflation, which struck many other economies in transition, and stabilization of the newly
introduced currency unit. “Since coupons, unlike rubles, were issued domestically, Ukraine was able for
the first time to obtain seigniorage. However, domestic currency issuance also fuelled inflation.”34 In
addition to these problems, the lack of the Central Bank’s independence led to the NBU financing
Ukraine’s consolidated budget deficits. The burden of the budget deficit was two-fold. It included
government expenditures as well as the subsidies given to giant enterprises in order to keep them “halfalive and barely working”35.36 This resulted in the fall in efficiency and of economic activity as a whole.
Since Ukraine did not have any foreign exchange reserves when karbovanez was introduced, it was
allowed to float freely against foreign currencies. Between 1991 and 1994 there was a system of multiple
exchange rates within an official exchange rate.37 The reason for this was that ruble was still in circulation
until the end of 1992 and continued to be used in financial/trade transactions with Russia for another two
33
Ibid, p.87
Dean, James W. “Monetary Policy”.
35
Cornia, G. and V. Popov, “Transition and Long-term Growth: Conventional vs. Non-conventional Determinants,”
MOCT-MOST: Economic Policy in Transitional Economies, (1998), p. 8.
36
Dean, James W. “Monetary Policy”.
37
Kereya, Ihor, “Effectiveness of Exchange Rate Interventions in Ukraine”, MA Thesis, the National University of
"Kyiv-Mohyla Academy", (2002), p. 5.
34
13
years. Only in 1994 karbovanez was finally legalized as the only medium of transaction and exchange in
the country.
Due to hyperinflation of karbovanez in 1994-1995 Ukrainian public was granted more access to foreign
currencies. This was an important episode because in the time of economic depression and hyperinflation,
people had much more confidence in stable foreign currencies rather than the national one. Some used
foreign currencies simply as a ‘store of value’ of the savings they managed to accumulate, others used it
as the means of exchange. The most popular foreign currency unit in Ukraine was the US dollar.
Therefore, on the one hand, the liberalization of the foreign exchange market brought about a greater
diversity in the newly accumulated foreign reserves, but on the other hand, it also contributed to the
persistent problem of dollarization, which I will discuss later in detail.
Monetary and Exchange Rate Stabilization: 1996
By far, the most successful economic event in Ukraine in the last decade was the currency reform initiated
in 1996. The new permanent currency hryvnia (UAH) was introduced. The original rate of conversion
was 1 hryvnia for 100,000 karbovanzi. This procedure successfully ‘scratched off’ five digits from all
price labels in the country. The initial exchange period, where all karbovanzi in circulation were supposed
to be exchanged for hryvnias, was estimated at two weeks; however, in the end it took more than two
months. There were two major indicators, which signalled the success of the reform: 1) relatively stable
prices in the period following the reform, and 2) fairly stable hryvnia-to-dollar exchange rate.38 The
consumer prices responded with moderate increase of only 2%, in comparison to the previous months
when inflation was much higher. The NBU set its exchange rate at 1.76 UAH per dollar, 1.18 to the DMark, and 3,000 Russian rubles per hryvnia.39
The process of stabilization was an important event, not only from the economic point of view; it also had
a political significance. It began in 1994 and reached its peak in 1996. It coincided with presidential
elections in 1994 and often the successful process of stabilization is attributed to Leonid Kuchma, the
winner of those elections. Stabilization is politically and procedurally very difficult to achieve and
‘credible commitment’ on behalf of the government is necessary in order to convince the citizens in the
sincerity of their actions and the potential improvement of the country’s economic wellbeing.40 Looking
from the purely economic perspective, it is clear that the reforms of the mid-1990s were inevitable. The
National Bank could not continue to fuel inflation by printing and feeding more worthless money into the
38
Kravchuk, Robert S. “Budget Deficits, Hyperinflation, and Stabilization in Ukraine: 1991-96,” Ukrainian
Research Institute, Harvard University, (1997), <http://www.huri.harvard.edu/work4.html> Accessed: November
10th, 2003.
39
Ibid.
40
Ibid.
14
economy. In addition, monetary authorities, which were subordinated to Verhovna Rada, were placed into
a situation where they had to accommodate the lack of fiscal discipline and bare an extra burden of
financing government budget deficits.
There were three major monetary goals set by the National Bank that year: reduce inflation, limit the
decrease in output and improve investment climate. Referring back to Table 1, there was a significant
improvement in all three of those variables beginning in 1996. In 1996, the GDP decline was 10.1% and
in 1997 it fell by only 3.2%. Inflation was reduced from 39.7% in 1996 to 10.1% in 1997. And finally,
reduction in investment of 20% in 1996 went down to 7.5% in 1997.
In 1998, Ukraine encountered another problem – the Russian currency crisis. It had a significant impact
on the Ukrainian economy and the hryvnia. In the 1990s, the total inflow of foreign capital into Russia
was greater than the one flowing into Ukraine. By 1998, Russian ruble was significantly overvalued and
when the country announced its intentions to pay off its foreign debt and free its exchange rate, Russian
ruble fell from 6 to 22 RUR/USD in just a couple of days.41 Considering that Ukraine and Russia were
economically codependent, which was usually reflected in Ukraine echoing Russia’s economic swings,
the Ukrainian public anticipated devaluation of hryvnia and looked for a more reliable currency to store
their savings, particularly the US dollar and the German Mark. As a result, the NBU’s foreign reserves
were depleted to the point that the Bank had to place a limit on the amount of hryvnias one could
exchange for foreign currencies. However, all the measures applied by the National Bank could not
reduce the excess demand for foreign currency. High supply of foreign currency helped to stabilize the
exchange rate, but despite the NBU’s resistance, hryvnia depreciated by almost one half of its value
before the crisis. It fell from 1.8 UAH/dollar at the beginning of the 1996 monetary reform to
3.5UAH/dollar after the Russia currency crisis. The Russian currency crisis was a signal to Ukraine that
despite the successful monetary and economic reforms, its economy was still very vulnerable and
responsive to external shocks.
In 1999, the “Law on the National Bank of Ukraine” relieved the Ukrainian National Bank from the direct
financing of the government budget deficit. Net credits to Central Government stopped growing for the
first time since independence, reflecting diminishing pressure to repay foreign debt due to successful
rescheduling and improved tax collections.42 In 2000 and 2001, the NBU tried to ease the monetary
policy, instituted open market operations and increased credits to the private sector. It tried to limit any
exchange rate fluctuations by purchasing foreign currency, which led to an increase in their foreign
reserves up to 3 billion US dollars by the end of 2001. Monetary policy goals in 2002 included inflation
41
42
Kereya, Ihor. “Effectiveness of Exchange Rate”, p. 9.
Dean, James W. “Monetary Policy”.
15
targeting, stimulating real GDP growth and maintaining a stable real exchange rate.43 The nominal
exchange rate that year averaged 5.5 - 5.6 UAH per dollar.
During 1992-2002, the NBU conducted the monetary policy, in accordance with concurrent economic
conditions. Monetary policy in that period was mainly directed towards saving the national economy from
hyperinflation, stabilizing financial system and introducing and strengthening the national currency unit.
The NBU used the so-called ‘mixed’ methods in conducting this policy. Both market and administrative
forces were involved in the reform process and although it took a long time, the country managed to
stabilize its financial system.
Ukraine and International Monetary Fund
The International Monetary Fund has played a major role in helping and guiding Ukraine throughout the
transition period. Ukraine became a member of the IMF in 1992, following its independence. The legal
foundation of this agreement, which also applied to membership in the World Bank, was “The Law on
Ukraine’s membership in the International Monetary Fund, International Bank for Reconstruction and
Development, International Financial Corporation, International Development Association and
Multilateral Investment Guarantee Agency.” According to this law, the Cabinet of Ministers was given
responsibility to decide on all the issues concerning Ukraine’s involvement with those organizations. The
communication process with the IMF consisted of the memorandum on Ukraine’s economic policy, the
request letter to the IMF (which guaranteed Ukraine’s responsibility to comply with all the regulations
applied by the organization), and detailed reports on the up-to-date economic conditions in the country.
One of the prerequisites to receive IMF credits was for the borrowing country to have a balance of
payments deficit. Ukraine’s quota in the IMF was 1,497 billion US dollars. Between 1994 and 1996
Ukraine received 1,960 billion US dollars in credits from the IMF. The conditions placed on Ukraine in
that period were the following:
•
Intensive development in trade and export-oriented strategies;
•
Liberalization of exchange rates;
•
Stabilization of prices and inflation rates;
•
Separation of state and market.
The next memorandum offered by the IMF, which came into force in 1995 was focused on establishing
stricter monetary policy in Ukraine. The board of IMF directors decided to pursue the “Standby” lending
program, which amounted for 1,492 billion dollars. However, due to Ukraine’s non-compliance with all
(or some) of the conditions, the funding was reduced and the country received only half of the funding
planed for that year. The goals that Ukraine failed to achieve were the full liberalization of prices,
decreased number of monopolies, and increased utility prices.
43
Ibid.
16
The Memorandum of Ukraine’s economic policy for the following years (1996-1999) reflected the
Government’s intentions to tighten monetary policy even further. The “Standby” program was renewed
and the IMF decided to continue its cooperation with Ukraine’s authorities and take a more rigorous
approach to coordinating the country’s compliance. The program became more complex, but so did the
conditions that had to be fulfilled by Ukraine in return for the loans. It involved:
•
Close consultations with IMF representatives and the provision of detailed information for the
IMF’s monitoring;
•
Active IMF involvement in formulating Ukraine’s economic policy goals;
•
Weekly reports on Ukraine’s budget distribution;
•
Active IMF involvement in coordinating Ukraine’s exchange rate regime and monetary policy,
and introduction of ‘managed float’ exchange rate regime;
•
Fully transparent monetary and financial apparatus.44
The ‘Standby’ was not the only program initiated by the IMF in Ukraine. The organization was very
active in determining Ukraine’s economic goals in the late 1990s and has continued participating up until
the present day. The outcomes of the IMF’s involvement can be viewed from two different perspectives.
One of the perspectives prevails in Western economic literature, which argues that due to Ukraine’s
limited access to international financial markets in the 1990s, the IMF’s involvement was the optimal
solution to Ukraine’s desperate need of funds for financing its reform process. Another perspective is
usually expressed by some representatives of the National Bank of Ukraine and the advocates of
Ukraine’s freedom to regulate its own reforms. They argue that the IMF’s involvement was an
‘intervention’ into the natural course of reforms in Ukraine. The IMF also burdened it with greater
external debt.
To my mind, both perspectives are valid and can be justified, however, it is important to keep in mind that
the International Monetary Fund has no power over the country to accept the conditions unless it choose
to borrow money. In other words, if a country chooses to borrow, it must meet all of the requirements in
order to receive continued disbursement of funds. Therefore, it was Ukraine’s conscious choice to borrow
the funds and place itself under the IMF’s conditionality.
The two parties’ stance on the issue of Ukraine’s economic development was as follows. On the one hand
the IMF was faced with the critical economic situation in Ukraine, which required immediate dedication.
It had funds and expertise to help the country manage its reform process. Therefore, in the eyes of the
IMF itself and most Western critics, its role in Ukraine was essential and worthwhile. On the other hand,
there were also several negative outcomes experienced by Ukraine as a result of some economic reforms,
44
The Standby program was much more complex than outlined in this essay; it encompassed different spheres of
Ukraine’s economic activity. I outlined only the major ones, which are most relevant for this study.
17
which led to the formulation of public’s negative attitudes towards the IMF. The tight anti-inflationary
policy led to a reduction in domestic production and limited domestic credits. Sometimes, there the lack
of money in circulation led to delays in salary payments, pensions and other social aid. A lack of
investment activity that led to deterioration in productivity and in the development of the techno-scientific
potential of Ukraine was also attributed to the tight monetary policy.
On the positive side, in 1999 and 2000 Ukraine did not experience government budget deficits, due to
successful OVDP (Treasury bill) operations and successful collection of tax payments. In 2000, for the
first time in the transition period, the country experienced positive export-led economic growth, which
hence coincided with an improvement in its trade balance. In addition, inflation was under control for
most of the late 1990s and in the new millennium. Despite all the positives and negatives, it is essential to
realize that they are not entirely a product of either the IMF’s or Ukraine’s policy. They are a combination
of both as well as other international actors and circumstances.
Current Monetary/Exchange Rate Policy in Ukraine
The current monetary policy in Ukraine seems to contradict the ‘impossible trinity’ argument previously
discussed in Section I. Ukraine continues its attempts to simultaneously manage monetary aggregates and
the exchange rate, which is practically impossible to do under the free flow of capital.45 Today, Ukraine
continues to work on strengthening its financial system and making the policies more efficient. Targeting
monetary aggregates and exchange rate does contradict the conventional wisdom, but the fact is that this
method has been working successfully in Ukraine for several years. Moreover, Ukraine is not the only
country that has been practicing this at the intermediate level of transition.
There are many structural and functional problems associated with the current monetary/exchange rate
policy, which poses a real challenge to the NBU. Firstly, Ukraine’s dependence on the IMF loans inhibits
the proper development of monetary policy targeted at domestic economic growth. The biggest concern in
this area is accumulation of external debt. Growth of the external debt draws more attention to the real
intermediate monetary goals such as the exchange rate, rather than the nominal ones such as inflation and
monetary aggregates. Secondly, the policy of external borrowing, including loans from the IMF, does not
follow an efficient financial strategy, which would direct the funds into development of domestic
industries, technologies and expertise. This strategic deficiency ultimately leads to the misuse of finances,
and they often end up in the pockets of domestic oligarchic clans. Thirdly, there is a serious problem of
dollarization of the Ukrainian economy, which I will discuss in detail at the end of this Section.
45
Dabrowski, Marek. “Ukraine Has a Chance to Survive,” EEAC Newsletter, Vol. 4, (January, 1999),
<http://www.eerc.kiev.ua/ne/ne/4-01-1999.pdf > Accessed: November 5th, 2003.
18
Problems of Inflation Targeting
Inflation targeting is very complex from the technical point of view. The important prerequisite for this
regime is independence of the Central Bank in developing intermediate and ultimate goals of the
monetary policy as well as selecting the policy tools. The lack of the National Bank’s independence
remains central in Ukraine. Even though the “Law on the National Bank” that was passed in 1999
supposedly relieved the NBU from the Verhovna Rada’s influence, there is still a need for NBU’s
assistance in financing the government budget deficit. There is no normative agreement between the NBU
and the Verhovna Rada, which would allow the former to determine an inflation target. Therefore, legally
the independence has been achieved, but in practice, the NBU is still not as independent as it would be
desired.
Essential elements of inflation targeting are communication and forecasting. Communication is an
important factor in case of Ukraine, because having experienced many years of uncertainty and economic
instability people need to see clear results of the work done by the government and the Central Bank in
order to gain more confidence. On the other hand, forecasting requires accurate statistical data and good
econometric models. This element appears to be trickier for Ukraine, because the NBU has been having
difficulties developing a proper econometric model, which would provide accurate forecasting.
Problems of Exchange Rate Targeting
The current exchange rate regime is the ‘managed float’. The existing policy has prevented significant
revaluation of the hryvnia and provided it with a virtual absence of volatility.46 How has Ukraine
managed to keep it so stable? Firstly, there is a large inflow of foreign currency into Ukraine reflected in
positive trade and current account balances; and secondly, this intensive foreign currency purchase helps
the NBU accumulate reserves. Despite the pervasiveness of the exchange rate stability, Oleksiy
Kuznetsov47 argues that ‘managed float’ is a regime that is “neither conducive to exchange-rate
regulation, nor to any consistent policy of disinflation.”48 He also thinks that currently, exchange rate
targeting overshadowed other objectives and there is too much attention devoted to sustaining the stability
of the exchange rate and it is treated more importantly than for instance stable prices.
Exchange rate targeting in Ukraine is associated with several problems. Firstly, there is a danger of
speculative attacks and the ability to sustain the exchange rate at a certain level requires sufficient foreign
reserves. Secondly, inadequate level of development of financial and currency markets allows certain
46
Mykhaylychenko, Sergiy. “Exchange Rate Regime in Ukraine”, speech given at the CASE conference in Kiev,
(December 3, 2001), <http://www.case -ukraine.kiev.ua/downloads/books/CBinTE_67_69_eng.pdf > Accessed:
November 4th, 2003.
47
Policy Analyst at the National Bank of Ukraine.
48
Kuznetsov, Oleksiy “Exchange Rate Regime in Ukraine,” speech given at the CASE conference in Kiev,
(December 3, 2001), <http://www.case-ukraine.kiev.ua/downloads/books/CBinTE_74_76_eng.pdf > Accessed:
November 4th, 2003.
19
market actors to interfere into the level of exchange rate. Thirdly, Ukrainian economy is very open. Sixty
percent of GDP comes from export revenues. However, export diversification in Ukraine is limited to raw
materials, which makes domestic market very responsive to changes in nominal exchange rates. The good
example of this was the case of Russian currency crisis demonstrated above. Fourthly, in case of Ukraine
being dependent on the IMF financing, the exchange rate targeting limits the possibility to pursue an
independent monetary/exchange rate policy. This in turn does not facilitate the strengthening of the
National Bank’s political independence.
Problem of De Facto Dollarization
What is de facto dollarization? An economy is considered to be dollarized if a foreign currency,
specifically US dollar, performs some of the major monetary functions (unit of account, means of
exchange and, in particular, store of value) along with the domestic currency. Many countries around the
world, including the emerging economies of the former Soviet Union countries, became subject to partial
dollarization. Ukraine became dollarized at the early stage of its independence, in the beginning of 1992.
The phenomenon of dollarization was enduring in Ukraine throughout the 1990s and still persists today.
Interestingly enough, neither of the monetary/exchange rate policy reforms undertaken in Ukraine since
independence managed to significantly reduce or eliminate dollarization.
The rapid increase in the circulation of US dollars began in 1992, when the ruble began loosing its value.
People were looking for other stable currencies such as the US dollar to secure the value of their labor and
assets. For dollars to serve as a store of value, they had to be made available to the public.49 The National
Bank had to manage excess demand for dollars and began issuing licenses to certain institutions such as
commercial banks and financial companies, which would be allowed to trade currencies. By 1993, in
addition to their primary role as a store of value within the country, dollars also became a unit of account
(e.g. in advertisements for apartments) as well as the preferred medium of exchange (e.g. rents on those
apartments).50
Russian currency crisis also did not help Ukraine tackle dollarization. Depreciation of the Russian ruble
quickly drove the hryvnia down against the US dollar. The NBU had to use up most of its foreign
reserves to prevent further depreciation of the hryvnia. People’s confidence in the national currency,
which significantly increased after the 1996 monetary reform, was once again undermined. When the
hryvnia fell from 3.4 to 5.2 UHA/ US dollar, people began accumulating more dollars and giving
49
Antinolfi, Gaetano and Keister, Todd. “Dollarization as a Monetary Arrangement for Emerging Market
Economies,” Federal Reserve Bank of St Louis Bulletin, (November 2001), No. 83, p. 30.
50
Curtis, Elisabeth S., Roy Gardner and Christopher J. Waller, “Dollarization in the CIS: the Case of Ukraine,”
Conference Paper, Scientific Conference on International and Development Economics
in Honor of Henry Y. Wan, Jr., Cornell University, (September 2003), p. 4.
<http://www.arts.cornell.edu/econ/wanconf/CGWUkraine2003.PDF > Accessed: November 4th, 2003.
20
preference to foreign currencies rather than the hryvnia. Table 2 below, presents inflation rates, exchange
rates and dollarization ratios between 1991 and 2001.
TABLE 251
Year
1991
1992
390
210
**
**
1993
1994
1995
1996
1997
1998
1999
2000
2001
10260
50
280
40
10
20
19
26
6
0.0064
0.1261
1.0420
1.7940
1.8890
1.8990
3.4270
5.2163
5.4345
5.3556
20
28
42
37
30
26
39
44
38
32
Inflation
Rate (%)/year
Exchange rate
UHA/$
Dollarization
ratio
The highest dollarization ratios are in the years 1994 and 1999, which correspond to the times of major
karbovanez depreciation (1994) and hryvnia’s depreciation after the currency crises (1999). These two
dollarization peaks are illustrated in Figure 2 below.
FIGURE 2
Dollarization ratios
Dollarization Ratios in Ukraine (19912001)
50
40
30
20
10
0
1991
1992
1993
1994
1995
1996
1997
1998
1999
2000
2001
Year
How does partial dollarization affect the choice of monetary/exchange rate policy? Firstly, if there is
significant dollarization of the economy, the conventional wisdom is that fixed exchange rates provide a
more effective nominal anchor.52 Partial dollarization increases the cost of exchange rate volatility, which
encourages the central bank to intervene further in the foreign exchange markets to prevent fluctuations in
the nominal exchange rate.53 “This results in an implicit or soft peg, and thus induces more liability
dollarization, creating a vicious circle from which it is difficult to exit.”54 This has been the case in
Ukraine with its managed float regime. Secondly, the availability of dollar deposits, as it is in case of
Ukraine, increases capital mobility. Since foreign currency reserves play an important role as automatic
liquidity stabilizers, they can sterilize or discourage capital inflows. In this regard, flexible exchange rate
may be better than fixed because it would increase monetary autonomy.55 Thirdly, if a country is heavily
51
National Bank of Ukraine Statistics, <http://www.bank.gov.ua/ENGL/Statist/index.htm >
Yap, Josef T., “Dollarization: Concepts and Implications for Monetary and Exchange Rate Policy in the
Philippines”, Discussion Paper Series, No. 2001-03, Philippine Institute for Development Studies, (2000), p. 13.
53
Ibid., p. 14.
54
Ibid., p. 14.
55
Ibid., p. 13.
52
21
dependent upon a foreign currency, any fluctuations in the value of that currency can have detrimental
consequences for the host country, such as inflationary pressures for instance.
Dollarization also appears to be a problem for Ukraine when considering its current foreign policy
oriented towards closer cooperation with the European Union. As of January 1st, 2002 the European
Monetary Union established a common currency mechanism, where twelve member-states out of fifteen
welcomed the euro as their new transaction medium and the official unit of national currency. If Ukraine
is anticipating closer relations with Europe and the possibility of becoming a candidate for the EU
membership, it would be logical to make the euro its primary reserve currency as well as its means in
international transactions. The volume of trade figures indicates that Ukraine’s trade with the euro-zone
accounts for almost 20% of total trade, which is a significant share indeed. However, keeping in mind the
EU’s enlargement in May 2004 and the fact that most of the candidate countries are preparing to join the
European Monetary Union as well, in the matter of 2 years the EMU-12 can become the EMU-22 or even
EMU-25 and then the total volume of Ukraine’s trade with the euro-zone as a percentage of total trade
will account for approximately 35%-40%. Therefore, it is reasonable to expect the eventual decline of
dollarization in Ukrainian economy and the increased significance of the euro-currency.
22
SECTION III: Alternative Monetary/Exchange Rate Policy for Ukraine
This section will present a general assessment of the exchange rate regimes that other Central and Eastern
European (CEE) economies utilized during their transition periods. I will show that the countries that
chose more fixed regimes at the earlier stage of transition, generally demonstrated better economic
performance than those countries that chose more flexible regimes. To further emphasize my argument I
selected two case-studies of Estonia and Latvia, which used a currency board and a pegged exchange rate
respectively throughout the transition period, and compare them to the case of Ukraine. Finally, I will
argue that Ukraine should consider a more fixed exchange rate regime if it wants to stabilize its economy
and achieve good economic growth. In addition, if Ukraine should ever consider a more fixed regime, the
anchor currency should be the euro rather than the US dollar, despite the high level of de facto
dollarization of the Ukrainian economy.
Exchange Rate Regimes in Central and Eastern Europe in the 1990s
After the end of the Cold War, Central and Eastern Europe began intensive restructuring. Many countries
were inspired by the possibility of attaining EU membership after the Maastricht Treaty was signed and
the opportunity to leave Soviet legacies behind. They proceeded with democratization, liberalization, and
thorough economic reforms. Some CEE states achieved better transition results than others due to several
factors such as initial conditions, nature of implemented economic reforms, and ability to establish good
international ties. These, of course, are not the only factors, but for the purpose of this essay the CEE
countries will be divided into two categories: 1) EU candidate states, which have joined the European
Union in May 2004; and 2) non-EU candidates – the countries that have not been as successful in their
transition to well-functioning market economies and are still in search for stability. The EU candidates
considered are: Estonia, Latvia, Lithuania, Poland, Hungary, Slovakia, Slovenia, and Czech Republic.
The non-EU candidates in this study are: Bulgaria, Romania, Ukraine, Russia, Moldova, Belarus,
Albania, Croatia, and Macedonia.56
The reason for this categorization is the fact that the countries that joined the EU this year have
completed a complex negotiation process with the European Union, and have gone through a series of
structural reforms in order to comply with the requirements of aquis communitaire. This is considered to
be a great achievement for all of the candidate countries, because they succeeded in living up to the
European standards during the twelve year period. This is also the success of the EU itself, because it
decided to consider the former Soviet bloc states for future membership and thereby encouraged them to
succeed. The EU enlargement has also become a great stimulus to all other CEE states, which are
considering their candidacy and potential membership in this organization.
56
Serbia & Montenegro and Bosnia-Herzegovina are the residual European transition economies, which were
omitted from this study due to the pervasiveness of the conflict situation in those countries and the absence of the
required data for this comparative analysis.
23
In the case of monetary/exchange rate policy Central and Eastern Europe clearly demonstrated that there
was no “one fit all” policy and the choices of exchange rate regimes ranged from currency board to free
float. Some countries wanted to achieve a certain level of independence of their institutions and
consequently established independent Central Banks and adopted more flexible regimes; others
considered stability more valuable than independence and preferred to fix their currencies to another
currency or a basket of currencies. The anchor currencies were carefully selected and in most cases they
were the currencies of the strongest world economies such as Germany and the US. It is also important to
note that some CEE countries changed their exchange rate regime more than once in the process of
transition.
Despite the variety of exchange rate regimes in Central and Eastern Europe, there are clear patterns
between regimes chosen by the former EU candidates and the rest of the CEE countries. This pattern is
illustrated in Figure 3 below.
24
FIGURE 3
EU Candidate (now member) Countries
Non-EU Candidate Countries
Figure 3 shows that EU candidates tended to select more fixed57 regimes and the non-EU candidates
evidently gave more credit to more flexible exchange rate regimes. The figure also takes into
consideration the changes in the regimes throughout the 1990s. Some countries like Estonia, Latvia and
Lithuania established fixed regimes in the early 1990s and it has been working well for them until the
present day. Others like the Czech Republic and Slovakia gradually moved from fixed to more flexible,
but the important observation is that the transition from a more fixed regime to a more flexible one in
those countries occurred at the later stage of transition (1997 for CZ and 1998 for Slovakia) when both
57
For the purpose of this analysis, the regimes will be divided into two groups: more fixed (from Currency Board to
Crawling Peg) to more flexible (from Basket Peg to Free Float).
25
economies were stabilized and well-functioning. The changes of the regimes that happened in the non-EU
candidate countries were of a different nature. Those states never crossed the border from flexible into
intermediate regimes and the biggest shift that happened in some countries was from flexible regime to
managed float or wise versa.
Although Figure 3 clearly identifies the separation of preferences of the regimes between EU and non-EU
candidate countries, this phenomenon can also be justified empirically by comparing their major
macroeconomic indicators such as GDP growth and inflation rates during the transition period. Figure 4
below illustrates the average GDP growth of the CEE countries under the relative regimes during 19892002.
FIGURE 4
Av erage Real GDP Growth (index=1989), 1989-2002
(Grouped by Flexible & Fixed)
GDP Growth Index
120.0
100.0
80.0
60.0
40.0
20.0
0.0
1989 1990 1991 1992 1993 1994 1995 1996 1997 1998 1999 2000 2001 2002
Y ear
Flexible
Fixed
The average indices for each year are separated into two groups – flexible and fixed. The blue trend,
which represents a more flexible exchange rate regime, is the average of GDP growth indices of all
countries that were using a more flexible regime in a particular year. The red trend, which represents a
more fixed exchange rate regime, is the average of GDP growth indices of all countries that were using a
more fixed regime in a particular year. This figure also takes into consideration all the changes of
exchange rate regimes in each country under study. This illustration evidently shows that under the more
fixed regimes countries tended to have better GDP growth than those under more flexible regimes. This
phenomenon can be explained by the impacts of exchange rate regime on investment and international
trade. Fixed exchange rate regimes secure the value of domestic currency. Investors are mainly interested
in doing business in the countries with stable currencies to guarantee good returns on their investments.
On the other hand, trade partners are also interested in avoiding any potential delays or defaults on
payments from countries with unstable financial systems, thus they prefer to deal with more stable
economies. Therefore, fixed exchange rate regimes create more favorable investment environment as well
as encourages more exchanges (trade) among states.
26
Another significant indicator in that period for transition economies was inflation rate and how the
countries were managing their inflation trends utilizing certain exchange rate regimes. Figure 5 below
demonstrates the inflation trends in Central and Eastern European countries in the period of 1991-2002.
1
0
2
20
0
20
0
20
0
19
94
19
95
19
96
19
97
19
98
19
99
1 0 0 0 .0 0
9 00.00
800.00
7 00.00
6 00.00
5 00.00
4 00.00
3 00.00
2 00.00
1 0 0 .0 0
0 .0 0
Average Annual Inflation Rates
(1991-2002)
19
91
19
92
19
93
Inflation Rate %
FIGURE 5
Av g Flex ible
Year
Av g Fix ed
The behavior of the inflation rates is similar to that of GDP growth. The averages of inflation rates for all
countries were also grouped according to the regimes being either more fixed or more flexible in a
particular country that year. The blue trend represents more flexible regimes and the red trend represents
more fixed regimes. The average inflation rates experienced under flexible regimes were much higher
than those experienced under fixed regimes. This is true not only for the critical period of 1991-1994,
when most of the transition economies were combating hyperinflation, but it is also true for later periods
such as 1995-2002 and 1998-2002, which is illustrated below in Figures 6 and 7:
FIGURE 6
FIGURE 7
Av erage Annual Inflation Rates
Zoom (1998-2002)
1 6 0 .0 0
1 4 0 .0 0
1 2 0 .0 0
1 0 0 .0 0
8 0 .0 0
6 0 .0 0
4 0 .0 0
2 0 .0 0
0 .0 0
5 0 .0 0
Inflation
Rate %
4 0 .0 0
3 0 .0 0
2 0 .0 0
1 0 .0 0
Yea r
1
0
2
20
0
20
0
20
0
19
99
19
98
19
97
0 .0 0
19
96
19
95
Inflation Rate %
Av erage Annual Inflation Rates
Zoom (1995-2002)
Av g
Flex ible
d
1 9 9 8 1 9 9 9 2 000 2 001 2 002
Av g
Yea r
Flex ible
i d
An alternative way to demonstrate that the countries with more fixed regimes (EU candidates) tackled
inflation better than those that used more flexible regimes is to rank them according to the regimes they
used throughout the 1990s (see Figure 8). The correct approach to use in this case is the geometric
average of the inflation rates for each country during the existence of a particular regime. Geometric
mean is preferred to arithmetic mean in measuring average inflation because inflation is measured
27
annually and thus has a compounding effect. Therefore, a geometric average approach takes the
compounding effect into account.
FIGURE 8
The positively sloped linear relationship shown on the graph reinforces the statement that the inflation
rates in the countries, which used more fixed regimes, were lower than in those countries that used more
flexible ones.
Another significant indicator, which reveals a country’s performance in transition, is Foreign Direct
Inflows (FDI) into its economy. Generally, in case of Central and Eastern Europe, countries can be
separated into those that managed to attract larger amounts of FDI and those who attracted very little. The
level of a country’s attractiveness for FDI is a good indicator of the improvement in its overall economic
performance, investment climate, market security and potential for worthwhile investment. Figure 9
shows the annual average FDI/capita during 1989-2001.
28
FIGURE 9
2,570
2,500
2,177
2,000
1,637
890
1,000
1,050
1403
1,200
925
1,065
771
491
500
356
444
241
332
132 116
79
67
Russia
1,500
Ukraine
3,000
Moldova
FDI, $US/capita
Foreign Direct Investment
(net inflows in $US per capita) 1989-2001
Average C
Average N
Belurus
Croatia
Macedonia
Albania
Romania
Bulgaria
Latvia
Lithuania
Estonia
Slovenia
Poland
Slovakia
Hungary
CZ
0
Countries
This figure illustrates that the EU-candidate countries (indicated in blue in the figure) managed to attract
much more Foreign Direct Investment in the non-EU candidate states (indicated in red). The average
amount of FDI/capita received in an EU candidate states between 1989 and 2001 was US $1,403 annually
(indicated in dark blue). The average amount of FDI/capita received in a non – EU candidate state
between 1989 and 2001 was US $332 annually (indicated in orange). The countries, which used more
fixed exchange rate regimes, seem to have attracted more FDI than the countries that used more flexible
regimes.
The empirical evidence has shown that the countries that adopted more fixed exchange rate regimes
experienced better GDP growth, lower inflation and larger FDI inflows than those countries that used
flexible regimes. There are many other indicators that can also be examined to further emphasize the
advantages of more fixed regimes such as unemployment, industrial production, and trade volume.
However, the fact that the EU candidates had to complete 32 sections of aquis communitaire dealing with
the variety of areas including social, economic and political issues and they have been accepted into the
EU leaves no doubts that their overall performance has been superior to that of the other CEE states in
many respects. Of course, the prevalence of more fixed regimes in the EU candidate states was not the
only factor that made the successful transition possible, but it was certainly among the most important
ones.
In order to further explore fixed exchange rate regimes, it is useful to look at their practical application.
Estonia and Latvia, two Soviet successor states, will serve as case studies for hard peg and intermediate
regimes respectively. There are two reasons for which those countries were selected among all others.
Firstly, because they were part of the former Soviet Union and inherited economic weaknesses similar to
29
those of Ukraine; and secondly these countries did not experience frequent changes in exchange rate
regime during the transition period.
Estonia – Currency Board
Estonia became one of the success stories of transition among the former Soviet Bloc state. During the
twelve year period the country of 1.3 million people has gone from being a part of a closed inefficient
Soviet economy to being one of the most promising transition economies. After pronouncing its
independence in 1991, Estonia moved quickly in establishing its own independent state institutions,
financial and banking systems, and its own national currency – the kroon.
One of the most important institutional arrangements was the creation of the currency board (CBA) in
1992. The rationale for the choice of the currency board in Estonia was firstly due to its simplicity. In an
environment characterized by rapid political and economic changes, Estonian authorities were uncertain
what type of regime would be most appropriate for the Estonian economy. Secondly, Estonia was trying
to insulate itself from spillovers of economic instability from its neighbor countries, Russia in particular.
The anchor currency was the Deutsche Mark. The exchange rate was fixed at 8 kroons (Estonian
currency) per 1 DM. One particularity about the currency board regime is that it sets explicit constraints
on the use of other targets of monetary policy.58 Considering the high mobility of capital, the interest rates
of the Estonian national currency did not play an independent monetary policy role. Interest rates
developed in compliance with money market demand and supply, and in the longer perspective - in
compliance with the base currency (de facto DM, today euro) interest rates.59 There was also to be no
credits given by Eesti Pank (Estonian Central Bank) to the government or enterprises, and lending to
banks could only occur under special circumstance when the entire banking sector was at risk. The
currency board also provided a framework for the fiscal policy, whereby any budget deficit had to be
constrained to what could be financed in the domestic financial market outside the Essti Pank or abroad.60
The choice of a currency board implied certain advantages and disadvantages for Estonia. Major
disadvantages included the loss of monetary sovereignty thus full reliance on the policy making of the
anchor country (i.e. Germany), and limited flexibility of the monetary policy. In terms of Estonia’s
monetary policy, the lack of flexibility proved to be an advantage as it was shown above; it did not allow
any government intervention into monetary structures and provided tight fiscal discipline.
58
Lepik, Ilmar. “Basic Features of the Estonian Currency Board: Convertibility and Liquidity Management”,
International Workshop on Currency Boards, Hong Kong Baptist University, (October 1999), p.1,
<http://www.hkbu.edu.hk/~econ/99workshop/99wsLepik.PDF > Accessed: November 15th, 2003.
59
Ibid. p.1.
60
Knobl, et el. “The Estonian Currency Board”, p. 17.
30
Advantages of the currency board regime in Estonia included confidence and stability ‘borrowed’ from
the anchor country. Many European countries, Germany in particular, contributed large amounts of FDI
and financial aid to ease Estonia’s transition. In comparison to other transition economies, Estonia
managed to avoid hyperinflation and get its inflation gradually under control. There was less vulnerability
of the economy to speculative attacks because the currency demand and supply was under strict
supervision. The currency board system did not require an elimination of the national currency. This
allowed Estonian government to retain its seigniorage privileges. In addition, nationalistic sentiments for
a national currency remained satisfied in the country.
Table 3 below shows several economic indicators characterizing Estonian economy in the period between
1993 and 2002.
TABLE 361
Indicators
1993
1994
1995
1996
1997
1998
1999
2000
2001
2002
Inflation
89.8
47.7
29.0
23.1
11.2
8.2
3.3
4.0
5.8
3.6
21826.3
29866.7
40896.8
52422.8
64044.7
73537.9
76327.1
87378.5
97894.5
108023.6
-8.8
-2.0
4.3
3.9
9.8
4.6
-0.6
7.3
6.5
6.0
4401.3
6843.4
8760.7
12313.2
16466.8
19528.6
17538.6
14427.4
10.9
18.0
9.7
3.3
10.4
7.3
-3.8
2.0
1.9
GDP current prices (EEK mln)
GDP real growth (%)
Investments
Estonian kroon (REER;
change from previous year, %)
Unemployment rate
6.6
7.6
9.7
9.9
9.7
9.9
12.3
13.7
12.7
Exports (EEK mln)
−
15622.9
19008.9
21246.9
31607.4
37545.0
36774.3
55836.8
57856.5
56863.1
Imports (EEK mln)
FDI inflow (EEK mln)
Gross external debt (EEK mln)
−
20100.4
27425.0
34666.5
48868.9
55215.4
50494.7
72217.1
75076.3
79467.0
2152.9
2819.2
2312.9
1814.4
3694.1
8071.4
4448.0
6644.5
9429.6
4800.2
−
−
−
−
36726.6
38887.7
43832.8
50577.8
58006.8
70257.4
The main economic indicators demonstrate Estonia’s successful performance in the transition period. The
main properties of a currency board – limited discretion, rule-based set-up, legal barriers, and the inability
to monetize fiscal deficits – provided more credibility for the arrangement when compared with other
monetary regimes.62 This strict monetary policy foundation constituted a starting point for restructuring of
the economy in the early years after the reintroduction of the kroon.63 In addition, the implementation of
liberal economic reforms, liberal privatization process and foreign investment facilitated a fairly smooth
economic transition.
61
Esti Pank (Bank of Estonia) Statistics: www.eestipank Table:
http://www.eestipank.info/dynamic/itp2/itp_report_2a.jsp?reference=503&className=EPSTAT2&lang=en
62
Batiz, Rivera, Luis & Sy, Amadou. “Currency Boards, Credibility, and Macroeconomic
Behavior,” IMF Working Paper No. WP/00/97, International Monetary Fund, (2000), p.6.
<http://www.imf.org/external/pubs/ft/wp/2000/wp0097.pdf > Accessed: November 5th, 2003.
63
Eesti Pank Official Website, “Estonian Monetary System,”
<http://www.bankofestonia.info/pub/en/majandus/rahasysteem/yldalused/> Accessed: November 10th, 2003.
31
Today, when Estonian economy is fairly strong and the country has joined the European Union, Estonian
authorities are anticipating some complications associated with the currency board regime and their future
membership in the European Monetary Union (EMU). The current challenges associated with the
currency board regimes in Estonia are two-fold. First of all, since prices tend to adjust rather fast, and
Estonian prices are lower than those of the EU, Estonia fears excessive inflation and pressure on financial
markets due to increased capital flows. Secondly, there are doubts whether Estonia would be able to
maintain its fiscal discipline after the transition, because the membership in the EU will require higher
government spending, dedication of some national funds to the EU budget and other responsibilities.
Latvia – Pegged Exchange Rate
Latvia is another Baltic state that separated from the Soviet Union in 1991. Baltic States have always been
considered more advanced countries of the former USSR, and like Estonia, Latvia also had a good
foundation to launch a successful transition. In the first two years of transition, Latvia experienced a
significant drop in economic activity (~40% decline in output). The Latvijas Banka (Bank of Latvia) was
restored as an institution in 1990 before the country became independent and later assumed the functions
of the Central Bank in the wake of the dissolution of the USSR.64 In 1992, Latvia adopted its own
currency – Latvian ruble, which was completely different from the Russian ruble. However, in 1993
Latvia introduced a permanent national currency unit – the lat. It was one of the means to implement
independent economic reforms. At that point inflation targeting was in the focus of Latvian monetary
policy, because Latvian ruble followed the hyperinflation of the Soviet ruble and the country was trying
to resist inflationary pressures.
Latvia began an intensive stabilization program anchored by the exchange rate and in February 1994 the
lat was fixed to a basket of currencies (SDR) at the level of 1 SDR=0.8 lats.65 Consequently, the attention
was drawn to exchange rate targeting to provide exchange rate stability. The basket consisted of five
currencies: US dollar, Japanese yen, Deutsche mark, French franc, Pound sterling. In comparison to the
other two Baltic republics – Estonia and Lithuania – Latvia did not select a currency board and preferred
to fix its exchange rate to a basket of currencies. One of the explanations is that in the wake of great
economic instability, Latvia could not select a fully reliable anchor currency. Therefore, the lat was fixed
to a basket, so it would not fluctuate greatly against any of the currencies in the basket.
In order to sustain the pegged exchange rate regime, the Bank of Latvia was allowed to intervene into
foreign exchange rate market by buying and selling national currency at a fixed exchange rate. The Bank
is also eligible to manage liquidity in the banking system by navigating short-term interest rates. Similar
64
Ganev Georgy, Marek Jarociñski, Rossitza Lubenova, Przemysaw WoŸniak, “Credibility of the Exchange Rate
Policy in Transition Countries”, CASE Reports No. 38, Center for Social and Economic Research, Warsaw, (2001),
p. 49.
65
Ibid., p.49.
32
to the Estonian currency board arrangement, Latvia’s monetary base is backed up 100% by foreign
reserves; however, there is no legal boundaries and institutional restrictions present in the currency board
system, which has been considered as a big advantage by Latvia.
Table 4 below demonstrates the main economic indicators in Latvia between 1992 and 2001.
TABLE 466
Indicators
1992
1993
1994
1995
1996
1997
1998
1999
2000
2001
Inflation (%)
951.2
109.2
35.9
25
17.6
8.4
4.7
2.4
2.6
2.5
GDP current prices (LVL bill)
1.005
1.467
2.043
2.349
2.829
3.275
3.589
3.897
4.336
4.741
GDP real growth (%)
-34.9
-14.9
0.6
-0.8
3.3
8.6
3.9
1.1
6.8
7.6
Investments (mln USD)
45.1
214.5
179.6
381.7
521.1
356.7
347.5
407.5
200.6
Latvian lat (REER; yearly average)
100
121.6
114.2
122.5
130.1
163.1
170.7
175.1
172.7
2.3
5.8
6.5
6.6
7.2
7
9.2
9.1
7.8
7.7
Exports (USD mln)
861.2
1002.4
988.3
1303.8
1443.1
1671.5
1811.7
1723.8
1869.3
2000.7
Imports (USD mln)
814.3
948.4
1240.3
1817.5
2319.2
2720.7
3191.8
2946.8
3190.8
27
45
521
357
44.6
232.3
2755.6
3098.5
Unemployment rate
FDI inflow (USD mln)
Gross external debt (USD mln)
214
344
180
403.4
382
2091.4
366
3853.9
407
4728.6
3504.5
201
5374.5
The table shows that the pegged exchange rate implemented in 1994 became an anchor against inflation.
The inflation rate went down from 109.2% in 1993 to 35.9% in 1994 and kept falling in the subsequent
years. The pegged exchange rate also facilitated the creation of a healthy economic environment fostering
economic growth and development in the country.67 The latter is obvious from looking at the GDP
growth, investment and volume of trade figures.
Estonia-Latvia-Ukraine
Estonia, Latvia and Ukraine represent hard peg, intermediate and flexible regimes respectively. In order
to compare their economic performance in the 1990s, I have selected five comparative criteria:
•
Average annual change in GDP
•
Persistence of hyperinflation (number of years)
•
Net Foreign Direct Investment inflows per capita
•
The level of Central Bank’s independence
•
Openness to trade (exports as % of PPP GDP)
The values of those criteria are summarized in the Table 5 below:
66
The Bank of Latvia Official Statistics:
<http://www.bank.lv/eng/main/finfo/?PHPSESSID=f037db9308b51843a914da42f6666f7b> Accessed: November
10th, 2003.
67
Beguna, “Competitiveness and the Equilibrium Exchange Rate in Latvia”, p.7.
33
TABLE 5
Criteria
Estonia
Latvia
Ukraine
(Currency Board)
(Pegged exchange rate)
(Flexible exchange rate)
-0.4
-1.25
-5.3
1
1
3
(1992)
(1992)
(1992-1994)
1,637
1,200
79
13
12
5
31.3
21.6
10
GDP (Average annual
change in, %) 19892002
Hyperinflation
(Number of years)
FDI (net inflows in
US $ per capita)
1989-2001
Central Bank’s
independence
(political + economic)
Openness to trade
(exports as % of PPP
GDP)
1990-2000
The selected indicators show that Estonia and Latvia, which used currency board and pegged exchange
rate regimes, achieved better economic results than Ukraine, which used more flexible regimes. In
Ukraine, the annual average change in GDP was approximately five times worse than that in Estonia and
Latvia. Hyperinflation in Ukraine persisted for three years, in contrast to the other two countries, which
managed to combat in 1 year. Estonia’s and Latvia’s FDI amounts per capita and openness to trade are
also significantly larger than that of Ukraine.
Policy Options for Ukraine
According to the analysis of the current monetary policy, Ukraine has been practicing policy that
contradicts the wisdom of ‘impossible trinity’. This shows that the monetary authorities haven not fully
recognized the force of the ‘impossible trinity’ in trying to both manage the exchange rate and the
monetary aggregates. The fact that they have been able to manage this type of policy is a contradiction to
the conventional wisdom; however, the NBU has recognized that the current monetary/exchange rate
policy is not capable of guaranteeing the desired long-term economic growth.
There are two plausible monetary/exchange rate policy options Ukraine could implement: inflation
targeting or the introduction of a more fixed exchange rate regime. The third possible option, which is the
restriction of capital flows, is generally not recommended for the emerging economies such as Ukraine,
because in today’s international environment it would further isolate the country from the rest of
international community and thus numerous investment and business opportunities.
34
Inflation Targeting
Inflation targeting is a difficult policy objective to achieve even for well-developed Western economies,
because they have to predict the effects of the current policy on the future inflation. In addition, the case
of Latvia, where inflation targeting was pursued in 1993 and then shortly after replaced by a pegged
regime, also demonstrated that this was not a good idea at the early stage of transition. There are several
difficulties associated with this monetary policy objective in Ukraine. Firstly, as we have seen, Ukraine
has had a history of monetary mismanagement in the early 1990s. If inflation targeting appears to be a
challenge for the developed economies, this task will be even trickier for Ukraine and is not likely to
bring desired outcomes. Secondly, as it was mentioned earlier, the NBU has been having difficulty
developing proper forecasting models, which is essential for a country that attempts inflation targeting.
Thirdly, the determination of inflation target is still in the hands of the Ministry of Economics and not the
NBU. So, if Ukraine ever considered inflation targeting as a primary objective of monetary policy, the
NBU would have to reach sufficient level of independence from the Verhovna Rada. Therefore, inflation
targeting could become a feasible monetary policy objective in the future. For now, however, significant
changes are essential to improve CB’s independence and policy management in Ukraine.
More Fixed Exchange Rate Regime
Flexible and managed float regimes, Ukraine practiced in the 1990s, have not succeeded in fully
recovering the economy from the ruins of post-communist era. Moreover, the pervasiveness of those
regimes facilitated further deterioration of economic conditions in certain points in time (e.g. the Russian
Currency Crisis). A more fixed exchange rate regime would be a good option for Ukraine at this point of
its transition. It is fairly easy to implement, and, as the experiences of many EU candidate states have
demonstrated, more fixed exchange rate regimes was one of the instruments that helped those countries to
achieve adequate economic growth and join the European Union. There are two main questions that arise
with regard to a more fixed exchange rate regime in Ukraine. First is what should be the degree of fixity
of the exchange rate? And secondly, what should be the anchor currency?
In response to the first question, I think that Ukraine should consider either a currency board or a pegged
exchange rate regime. Although, according to the IMF classification pegged exchange rate is referred to
as an intermediate regime, this option is still very reliable as the case of Latvia and some other EU
candidates have demonstrated. In addition, pegged exchange rate leaves some room for the Central
Bank’s involvement in the monetary policy, in comparison to the currency board, where the power of the
Central Bank is minimized.
Both currency board and the pegged exchange rate would certainly shift the focus of the NBU from trying
to manage monetary policy on a daily basis to transferring the power over the monetary policy to the
anchor country and dealing primarily with domestic matters such as managing commercial banks and
35
financial market in general. One or the other of those options would be feasible for Ukraine and the
choice between the two would be left up to the NBU deciding what degree of independence it wishes to
maintain and whether they are prepared to fall under monetary discipline of an anchor country.
Another argument in favor of hard pegs rather than intermediate regimes is the ‘hollowing out’
phenomenon discussed earlier. It has been observed that the intermediate regimes have not been as
reliable in the long-run as for instance hard pegs or flexible regimes. Intermediate regime mainly served
as good temporary exchange rate regimes for some countries, for others they led to currency crises. This
argument can also be reinforced using the ‘impossible trinity’ theory. The fact that fixed exchange rate,
full capital mobility and monetary policy dedicated to domestic goals cannot exist simultaneously dooms
intermediate regimes to failure because they would always conflict with domestic policy goals.
The question about the selection of an anchor currency is an interesting one. Due to the high level of de
facto dollarization, and the fact that Ukraine has been using US dollars in many of its international
transactions, may lead to a conclusion that the US dollar should be the anchor currency. However, if we
consider the current foreign policy of Ukraine and its intentions to begin negotiations with the European
Union in the future, my argument is that Ukraine should select the euro as the anchor currency, in case it
decided to move to a more fixed exchange rate regime.
When the euro was introduced into circulation in the euro-zone, some argued that its impact on the
Ukrainian economy was going to be minimal and will not cause a Europhilia; others thought that the euro
will replace the US dollar. In reality, the only way the introduction of euro has affected the Ukrainian
economy was through the US dollar-euro exchange rate, due to the high level of de facto dollarization.
The role of the euro in Ukraine became no different from that of the German Mark, which was its
predecessor in terms of its significance in everyday transactions.
Currently, only around 14% of transactions take place in euros. The currency stored ‘under the
mattresses’ of Ukrainian citizens are still the US dollars. Ukrainian banks traditionally offer lower interest
rates on the euro deposits than on the US dollar deposits. The value of real estate, automobiles, and
tourism are still denominated in the US dollars. Therefore, the current situation shows that even if the
NBU established a currency board or a pegged exchange rate with the euro-zone, it would take some time
to erase the influence of the US dollars from the Ukrainian economy and most importantly from the
minds of the Ukrainians, for some of whom the US dollars were the only reliable currency during the
whole transition period.
Transaction costs are the biggest concern when it comes to establishing the euro as the anchor currency.
They include the accumulation of larger euro reserves, pursuing international transactions in euros rather
36
than dollars, various institutional changes and many other costs. An important cost associated with
Ukraine pegging hryvnia to the euro is a possible disintegration of Ukraine from the CIS, if it still exists
at that time, and from Russia in particular. Russia has been known as Ukraine’s ‘big brother’ for a very
long time and has had an enormous political and economic influence on the development of the country
after the break down of the Soviet Union. Ukrainian economy is highly dependent on Russia’s oil and
energy supplies and Russian ruble is the second major foreign reserve currency after the US dollar. The
Ukrainian economy has also been very responsive to the shocks faced by the Russian economy. The 1998
Russian currency crisis applied pressures on hryvnia and caused significant devaluation of the currency.
Therefore, Ukraine’s choice of the anchor currency will also influence its future geopolitical role and may
result in its dissolution from the former Soviet bloc states.
Even though the peg of hryvnia to the euro currently appears to be problematic, it has the potential to
resolve the problem of de facto dollarization. If the euro becomes the anchor currency, eventually people
will gain more confidence in the hryvnia and the role of the dollar will diminish. Another argument in
favor of the euro as an anchor currency is the upcoming EU enlargement, in which many trade partners of
Ukraine from Central and Eastern Europe will become part of the Union, and consequently after they join
the European Monetary Union, Ukraine’s share of trade with the EU will increase from 20% to
approximately 35-40% of the total volume of trade. In addition to trade, Ukraine will also establish closer
links with the EU through the new entrant states, because of its historical, political, economic, social and
cultural connections with the many of the current EU candidate states. The case of Estonia with its close
relations to Finland showed that geographic, political and social proximity to well-developed states can
also play an important role in transition period.
The establishment of a pegged regime with the euro can become Ukraine’s trump card in its intention to
become a member of the European Union in the future. This arrangement can further stabilize Ukraine’s
economic development, encourage better GDP growth and attract more foreign investment and trade
partners, as it did in many current EU candidate states. In addition, Ukraine has many cases to learn from
in order not to repeat the mistakes made by others.
37
CONCLUSIONS
This paper has examined the evolution of Ukraine’s monetary policy in the post-communist period.
Unfortunately, Ukraine cannot be called a success story of transition, because the economy has
deteriorated significantly over the 1990s. Only recently has Ukraine began to show some signs of
improvement and positive growth, however, its economic system and its status in today’s international
economic community is very fragile and weak.
Ukraine is a large country with a great potential to achieve good economic growth in the future, provided
that its plentiful resources are utilized appropriately. The country needs to intensify economic, political
and social reforms to give a ‘charge start’ to the market forces that would be able to normalize their
economic activity. Currently, Ukraine is faced with many problems such as corruption, policy
mismanagement, weakening of economic operability, social tensions, and many others, in virtually all
spheres of its development. Therefore, Ukraine should reconsider improving many political and economic
policies.
One of the vital economic policies for Ukraine was discussed in this paper – monetary policy. Ukraine has
had a long history of monetary mismanagement, which must be resolved sooner rather than later. This
paper examined the evolution of the monetary policy in Ukraine since its independence and the current
problems associated with monetary policy formulation such as increasing dependence on aid and loans
from abroad, dollarization, growing external debt, ‘managed float regime’, which along with other targets
of monetary policy has not been able to bring the desired stability and strength to Ukraine’s financial
system.
In this paper, I examined the exchange rate regimes practiced by other Central and East European
economies in the 1990s. The empirical evidence has shown that the countries that practiced more fixed
exchange rate regimes demonstrated better economic performance than those that used more flexible
regimes. Moreover, the group that used more fixed regimes will be joining the European Union in May
2004, which speaks highly of those countries’ accomplishments in a relatively short period of time.
Although the choice of a more fixed exchange rate regime was not the only factor that facilitated the EU
candidate countries’ successful transition, there are many lessons that can be drawn from their
experiences. Having compared the major economic indicators for most CEE countries and having
examined two case studies of Latvia and Estonia in more detail, I think that Ukraine should move in the
direction of a more fixed regime, because it would be able to provide an anchor not only for its currency,
but also for inflation, and eventually make Ukrainian economy more attractive to international investment
and trade partners. With regard to how hard a fixed regime should be, I think Ukraine should consider a
hard peg, due to many convincing arguments about the ‘hollowing out’ of the middle. Ukraine has
38
experienced a lot of instability in the last decade; it should consider a regime which would be beneficial in
the short-run and most importantly in the long-run.
Finally, if Ukraine ever considers a hard peg regime, I argue that the anchor currency should be the euro
rather than the US dollar, mainly due to Ukraine’s current determination to move closer towards Europe
and establish closer links with the European Community, hoping to join the European Union in the future.
Of course, the current debates in Ukraine about the possible membership are very futuristic and there is a
lot of work to be done before the country could even be accepted into the negotiations process with the
EU. However, directing its efforts in policy making towards Europe, can certainly help Ukraine succeed
in the future.
*
*
*
39
APPENDICES
AVERAGE REAL GDP GROWTH (INDEX, 1989=100)
(Data from: UNICEF IRC, “Social Monitor Review of Countries in Transition,” Statistical Annex 2003.)
Czech
Republic
Hungary
Poland
Slovakia
Slovenia
Estonia
Latvia
Lithuania
Bulgaria
Romania
Albania
Croatia
FYR
Macedonia
Belarus
Moldova
Russia
Ukraine
Flexible
Fixed
1989
1990
1991
1992
1993
1994
1995
1996
1997
1998
1999
2000
2001
2002
100.0
100.0
100.0
100.0
100.0
100.0
100.0
100.0
100.0
100.0
100.0
100.0
98.8
96.5
88.4
97.5
95.3
93.5
102.9
95.0
90.9
94.4
90.0
92.9
87.4
85.0
82.2
83.3
86.8
80.8
92.2
89.6
80.3
82.2
64.8
73.3
86.9
82.4
84.3
77.9
82.0
69.3
60.0
70.5
74.4
75.0
60.1
64.7
87.0
81.9
87.6
75.0
84.3
63.2
51.1
59.1
73.3
76.1
65.9
59.5
88.9
84.3
92.1
78.6
88.8
62.0
52.2
53.3
74.6
79.1
71.4
63.1
94.2
85.5
98.6
83.9
92.5
64.6
51.8
55.1
76.8
84.7
80.9
67.3
98.2
86.6
104.5
89.1
95.7
67.1
53.7
57.6
69.6
88.0
88.2
71.4
97.4
90.6
111.6
94.6
100.1
73.7
58.2
61.8
65.7
82.6
82.1
76.0
96.5
95.1
116.9
98.5
103.9
77.1
61.0
65.0
68.3
78.2
88.6
77.9
96.9
99.1
121.7
100.4
109.3
76.6
62.7
62.5
69.9
75.7
95.1
77.2
100.1
104.2
126.6
102.6
114.3
82.1
67.0
64.8
73.6
77.0
102.5
79.5
103.4
108.2
127.9
106.0
117.8
86.2
72.1
68.7
76.6
81.1
109.2
82.5
106.0
111.7
129.5
110.2
121.2
91.1
76.1
72.8
80.0
85.1
114.3
86.2
100.0
100.0
100.0
100.0
100.0
100.0
100.0
90.1
97.0
97.6
100.0
96.0
95.1
91.8
83.8
95.8
80.5
94.5
85.8
84.1
83.5
77.1
86.6
57.1
76.9
77.5
73.0
78.5
70.1
80.1
56.4
66.9
66.5
67.4
78.9
68.8
70.0
38.8
57.9
51.3
66.4
73.1
68.0
62.7
38.3
55.5
45.0
67.2
76.2
68.8
64.4
36.0
53.6
40.5
67.6
79.5
69.8
71.8
36.6
54.1
39.3
71.0
79.5
72.1
77.8
34.2
51.5
38.5
74.3
80.6
75.2
80.5
33.0
54.2
38.5
76.0
82.1
78.7
85.1
33.7
58.7
40.7
79.4
86.4
75.5
88.6
35.8
61.6
44.4
82.4
90.0
75.5
92.8
38.4
64.3
46.5
85.5
93.5
- Flexible Regime
- Change of regime within fixed spectrum
- Fixed Regime
- Change of regime within flexible spectrum
40
AVERAGE ANNUAL INFLATION RATES
(Data from: UNICEF IRC, “Social Monitor Review of Countries in Transition,” Statistical Annex 2003.)
Cz
Hungary
Poland
Slovakia
Slovenia
Estonia
Latvia
Lithuania
Bulgaria
Romania
Albania
Croatia
Macedonia
Belarus
Moldova
Russia
Ukraine
Avg Flexible
Avg Fixed
1991
1992
1993
1994
1995
1996
1997
1998
1999
2000
2001
2002
52.00
35.00
70.30
61.20
117.70
210.50
172.20
224.70
333.50
170.20
35.50
123.00
114.90
94.10
98.00
92.70
91.00
137.86
55.50
11.10
23.00
43.00
10.00
207.30
1076.00
951.20
1020.50
82.00
210.40
226.00
665.50
1664.40
970.80
1276.40
1526.00
1210.00
792.69
25.33
20.80
22.50
35.30
23.20
32.90
89.80
109.20
410.40
73.00
256.10
85.00
1517.50
338.40
1190.20
788.50
875.00
4734.00
867.52
38.32
9.90
18.80
32.20
13.40
21.00
47.70
35.90
72.10
96.30
136.70
22.60
97.60
126.50
2221.00
329.70
311.40
891.00
425.38
32.86
9.10
28.20
27.80
9.90
13.50
29.00
25.00
39.60
62.00
3.30
7.80
2.00
16.40
709.30
30.20
197.70
377.00
141.92
24.09
8.80
23.60
19.90
5.80
9.90
23.10
17.60
24.60
123.00
38.80
12.70
3.50
2.50
52.70
23.50
47.80
80.00
39.44
17.63
8.50
18.30
14.90
6.10
8.40
11.20
8.40
8.90
1082.00
154.80
33.20
3.60
0.80
63.80
11.80
14.70
15.90
127.05
11.30
10.70
14.30
11.80
6.70
7.90
8.10
4.70
5.10
22.20
59.10
20.60
5.70
2.30
73.20
7.70
27.60
10.50
21.09
11.03
2.10
10.00
7.30
10.60
6.10
3.30
2.40
0.80
0.70
45.80
0.40
4.20
1.30
293.80
39.00
86.10
22.70
46.55
4.08
3.90
9.80
10.10
12.00
8.90
4.00
2.60
1.00
9.90
45.70
0.10
6.20
6.50
168.90
31.30
20.80
28.20
30.23
6.23
4.70
9.20
5.50
7.30
8.40
5.80
2.50
1.30
7.40
34.50
3.10
4.90
5.30
61.40
9.80
21.60
12.00
15.73
5.28
1.80
4.80
1.70
3.30
7.50
3.60
1.90
0.30
5.90
22.50
5.40
2.40
2.40
42.60
5.30
15.70
0.80
9.97
3.03
- Flexible Regime
- Change of regime within fixed spectrum
- Fixed Regime
- Change of regime within flexible spectrum
41
GEOMETRIC AVERAGE OF INFLATION RATES (1990-2002)
(Data from: UNICEF IRC, “Social Monitor Review of Countries in Transition,” Statistical Annex 2003.)
Countries
1991
1992
1993
1994
1995
1996
1997
1998
1999
2000
2001
2002
52
11.1
20.8
9.9
9.1
8.8
8.5
10.7
2.1
3.9
4.7
1.8
35
23
22.5
18.8
28.2
23.6
18.3
14.3
10
9.8
9.2
4.8
70.3
43
35.3
32.2
27.8
19.9
14.9
11.8
7.3
10.1
5.5
1.7
61.2
10
23.2
13.4
9.9
5.8
6.1
6.7
10.6
12
7.3
3.3
Slovenia
117.7
207.3
32.9
21
13.5
9.9
8.4
7.9
6.1
8.9
8.4
7.5
Estonia
210.5
1,076.00
89.8
47.7
29
23.1
11.2
8.1
3.3
4
5.8
3.6
172.2
951.2
109.2
35.9
25
17.6
8.4
4.7
2.4
2.6
2.5
1.9
Lithu 94
224.7
1,020.50
410.4
72.1
39.6
24.6
8.9
5.1
0.8
1
1.3
0.3
Bulgar 91
333.5
82
73
96.3
62
123
1,082.00
22.2
0.7
9.9
7.4
5.9
170.2
210.4
256.1
136.7
3.3
38.8
154.8
59.1
45.8
45.7
34.5
22.5
35.5
226
85
22.6
7.8
12.7
33.2
20.6
0.4
0.1
3.1
5.4
CZ 93
CZ 97
Hung 91
Hung 95
Poland 91
Poland 95
Slovak 91
Slovak 94
Slovak 98
Latvia 91
Latvia 94
Lithu 91
Bulgar 97
Roman 91
Roman 98
Albania
Croatia
123
665.5
1,517.50
97.6
2
3.5
3.6
5.7
4.2
6.2
4.9
2.4
Maced
114.9
1,664.40
338.4
126.5
16.4
2.5
0.8
2.3
1.3
6.5
5.3
2.4
Belarus
94.1
970.8
1,190.20
2,221.00
709.3
52.7
63.8
73.2
293.8
168.9
61.4
42.6
98
1,276.40
788.5
329.7
30.2
23.5
11.8
7.7
39
31.3
9.8
5.3
92.7
1,526.00
875
311.4
197.7
47.8
14.7
27.6
86.1
20.8
21.6
15.7
91
1,210.00
4,734.00
891
377
80
15.9
10.5
22.7
28.2
12
0.8
Moldova
Russia 91
Russia 97
Ukr 91
Ukr 96
Geomean
11.33198
4.297767
24.1565
12.87213
43.05401
9.512677
24.21474
8.277029
7.285842
16.81618
12.17815
261.5226
6.418337
454.8566
4.638835
148.4169
5.826852
81.96233
39.48882
9.706186
16.8751
14.18525
204.8849
47.53071
267.2386
25.03847
705.7564
13.50838
42
Elements of Political (PI) and Economic (EI) CB independence. Overall independence OI=EI+PI.
G1: Governor not appointed by the government
G2: Governor appointed for more than 5 years
G3: Provisions for governor's dismissal non-political only
B4: None of the board appointed by the government
B5: Board appointed for more than 5 years
R6: No mandatory government representative in the board
R7: Government approval of monetary policy is not required
C8: Statutory responsibility to pursue monetary stability
C9: Presence of legal provision supporting bank in conflicts with the government
D10: Direct credit facility is not automatic
D11: Direct credit facility is at the market interest rate
D12: Direct credit facility is temporary
D13: Direct credit facility is of limited amount
D14: CB does not participate in the primary market
D15: All direct credit is securitized
M16: Discount rate is set by the central bank
M17: Supervision of commercial banks is not entrusted to the central bank or not entrusted to the central bank alone
43
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