(Monthly advisory for clients, with a special section on recommendations for financial authorities: Special ed.)


Mykhailo Kukhar, Grigory Kukuruza, Mykola Lesyk, Adrian Pantiukhov

Independent group of macroeconomic analysis and forecasting

Ukraine Economic Outlook

Even before the publication of complete statistical data for 2019 available to business and the public, there were sufficient grounds to say the country’s economic growth – which has continued since Q2 2016 – slowed significantly. There is every reason to predict that growth will be replaced by a decline during Q2 2020. This report highlights the main macroeconomic factors contributing to the possible negative change in the country’s economic outlook.

Macroeconomic indicators:

  1. Accelerated decline in industrial production to negative 7.5% during Q4 2019.
  2. Slowdown in real export growth rates from 12% to 3% (clearly the result of the National Bank of Ukraine’s excessively aggressive 20% revaluation of the exchange rate during 2019). Despite the lack of final data on trade and balance of payments in 2019 and the lag effect (resulting from the need to fulfill unprofitable export contracts due to usually envisaged penalties and the “previously accumulated reserves” of export-oriented enterprises over approximately six months of unprofitable activity), we predict a slowdown in the growth rate of exports to “zero” and their subsequent decline from Q2 or Q3 2020, if the NBU does not return the exchange rate within UAH 25.5-26.5 / USD 1.
  3. An important (but still partially indirect) factor evincing the growing problem of domestic enterprises selling their products to retail chains (due to crowding out by their foreign competitors) is the decrease to the level of industrial prices below zero (deflation) by year-end 2019. Not finding sales for their products, enterprises began to sharply reduce prices for finished products, attempting to sell inventory even at a loss. This is followed, inevitably, by the “programmed” decline in production during the next period and a further drop in employment and domestic consumption, which could further spiral into an economic downturn.
  4. Deterioration of the qualitative structure of real GDP growth. In 2018, Ukraine achieved 3.2% of real GDP growth, of which 43% was due to the increase in agricultural yield, 12.8% in financial sector profit and 10% from IT and construction – highly sustainable industries. The final structure of GDP growth changed significantly in 2019 when up to 35% being generated by trade and indirect taxes (generated by the same trading). This reflects an increase in retail turnover (in physical terms) associated with higher consumption of imported consumer goods. For example, in January-September, imports of clothing and cars increased by 50.7%, and 38.1%, respectively.

5. The fifth most important indicator, or rather “wake-up call,” which shows the economy is experiencing a decline in “production” and “consumption” as reflected in the Finance Ministry’s operational data, which shows a drop in tax revenues in January (54% under-fulfillment of the plan during the first 27 days). The economic “downturn” is already generating losses. This results in underpaid taxes due to reduced business activity. Measures to address the problem and prevent further deterioration have not been taken.

The above factors are INSUFFICIENT for predicting the slide of Ukraine’s economy into a “recession” or “crisis.” So far, the data only indicate a “slowdown” (albeit, a significant one) and the possibility of a short-term decline in the long-term, four-year economic recovery trend (2016-2019) that followed the deep financial and economic crisis of 2014-2015.

There are well-known macroeconomic policies for dealing with the above-mentioned problems. We can only remind the country’s financial authorities of the measures that can be taken and offer additional solutions (based on some developments in the existing macroeconomic outlook for the second half of 2019).

The key to understanding the accumulated imbalances is assessing the impact of features of the NBU’s monetary policy in 2019 on the slowdown in economic growth and the observed economic decline. We, therefore, outline the following schematic description of the problem before prescribing measures to rectify it.

Impact of central bank’s exchange rate and monetary policies in 2019 on the slowdown of economic growth in early 2020

Throughout 2019, we observed the protracted phenomenon of the two-fold separation of the NBU’s discount rate from the “forecast inflation rate for the current year.” Throughout 2019, inflation was within the forecast range, from 4% to 5%. At the same time, the NBU’s discount rate for 2019 decreased from 18% to only 13.5%.

It is patently obvious that interest rate policy was out of sync with the prevailing macroeconomic situation. The “avalanche-like” reduction in the discount rate can pose more problems than it can solve in the banking market, given the inertia and limited elasticity of interest rates on household deposits. Therefore, the NBU will have to “manage carefully” its decline during the first quarter. Returning to NBU monetary policy in 2019, as a fait accompli, we can state the central bank made the following systemic policy errors:

  1. Artificial deficit of money supply
  2. Impermissible limits for hryvnia devaluation
  3. Failure to address the ‘extra liquidity’ problem of the banking system (locked in deposit certificates and which poses a growing threat of disrupting the country’s macroeconomic stability.
  1. Artificial deficit of money supply. The nominal dollar GDP of Ukraine, as well as exports and the dollar equivalent of wages, increased in Ukraine over the past three years at an average rate of 15-20%. Until the second half of 2019, this was provisioned by an ADEQUATE (i.e. corresponding to the growth rate) increase in money supply (monetary base growth).
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The artificial decrease in the “money supply” (new money) to the economy in 2019 was only 1.2% (in fact, close to zero), along with the artificial retention of 3-4 times higher NBU interest rates. These were the key tools used to successfully suppress annual inflation. (They also contributed to the negative trend of such an important indicator as “monetization of GDP,” which dropped from a historical maximum of 60% to less than 32%).

However, the same statistics in 2019 show that the NBU, for the sake of “absorbing” its money issue, “exited” from its government domestic loan bonds (OVDP) portfolio, entailing the issuance new loans for refinancing the second tier banking system at less than the level of repayment of previous loans.

Both these measures have led to a “contraction” of the monetary base. (When the central bank does not give out new loans in return for those returned, it reduces the amount of money in circulation. As well as buying government bonds, it issues new national currency into circulation. Without further refinancing this debt in 2019, it, in essence, withdraws this money back from circulation).

Without reserves in the form of billions of hryvnias withdrawn from circulation due to the repayment of its own government bonds or loans to refinance banks issued in previous years, the central bank simply did not redeem the “excess” of foreign currency inflows on the domestic interbank foreign exchange market. It acted not as a regulator of the foreign exchange market, but as a currency broker for the Finance Ministry. The NBU left it up to banks themselves, through artificial absorption of the hryvnia and seasonal, unstable inflows of foreign currency (from non-residents in government bonds, election money, etc) to seek a balance of supply and demand.

2) Forbidden limits of hryvnia devaluation. As a result of NBU policy, out of $4 billion of net demand for Ukrainian government bonds by non-residents and another $4 billion more than the inflow of foreign exchange from grain exports, labor migrant remittances and “investment in elections,” the central bank “bought” a little over a half-billion dollars into reserves. The remaining $4.5 billion “overhang” of currency supply over demand “pushed the exchange rate” from UAH 27 / USD 1 to around UAH 23.5 / USD 1 by the end of 2019.

The NBU said consistently its main motivation for this exchange rate policy was the aforementioned “inflation targeting.” The NBU deliberately did not expand “money supply” in the fiscal year 2019 without buying government bonds, without issuing refinancing to banks and without redeeming into reserves the completely obvious “excess” of foreign currency inflows. (The “smoothing out” of temporary speculative or other inflows of supply has long been demonstrated in world practice, starting with China, is the NBU’s only correct strategy.) According to Ukraine’s Constitution, this is the central bank’s direct responsibility. On the other hand, the strengthening of the hryvnia slowed consumer inflation to just 4.1% in December, instead of the 6.3% forecast by the NBU.

3) Failure to address the problem of ‘extra liquidity’ in the banking system. The financial crisis of 2014-2015 and the sharp devaluation of the hryvnia that accompanied it, leading to the loss of confidence in the national currency and the “flight of depositors,” should also be taken into account. (Here we are speaking about the “run on banks,” which the banking system managed to stop only thanks to the unlawful introduction of an “unofficial moratorium on early issuance of deposits,” despite the absence of such a decision by the NBU, which was politically explainable, but did not comply with the standard list of measures available to the central bank in crisis).

The NBU in 2015, after receiving a $15 billion stabilization loan from the IMF, was able to again become the “main market-mover” in the foreign exchange market. This was due in part to administrative restrictions on the purchase of foreign currency, “which were removed over time (in 2016-2018) to stabilize the exchange rate within the bounds of the natural market balance of supply and demand.

However, as a result of the excessive refinancing of banks in order to “save” and “maintain” their current liquidity in 2015-2016, an overhang of excess liquidity in the amount of UAH 50-60 billion (equivalent to about $2 billion dollars) was created.

Over the past few years, this has been a little-discussed phenomenon of Ukrainian monetary policy, which has very few analogs in other countries, which have overcome financial crises akin to Ukraine’s in 2014-2015. According to the standards of short-term liquidity and the banking system, it was enough to keep UAH 50-55 billion on the NBU’s “aggregate correspondent account.” But statistics from 2016 to 2019 showed an “overhang” of excess hryvnia liquidity in the amount of an additional UAH 50 billion was formed (on average, over the last three years) over required reserves.

The NBU, on the one hand, “locked-in” this additional “extra liquidity” in the system by administratively limiting the size of the “open position in foreign currencies for clients’ money” for banks and, on the other hand, by selling them short-term (mainly 2-week) “certificates of deposit” (a special NBU monetary instrument, which provided banks with a return on their extra liquidity based on risk-free papers (NBU CDs) with an interest rate at the level of “discount rate minus 1%.”

Thus, the NBU (at least in 2018-2019) solved the problem of its formal “inflation targeting” when it linked all (!) of the free liquidity of Ukraine’s banking system using the super-profitable “NBU CDs” tool, without giving banks any motivation to try to lend to the real sector of the economy. In 2018, banks attracted hryvnia deposits of the population on average at 14% per annum, immediately placing them in risk-free securities of the central bank at 18%, and in 2019 attracting deposits at 10-12% per annum and depositing them in accounts bearing 17% (at the beginning of the year) and 12.5% (year-end).

We reiterate: There was no financial motivation to lend to enterprises of the real sector of the economy “starved for cash,” which throughout the period had difficulty attracting loans in hryvnia at 20% + per annum from Ukraine’s banking system, because: 

  1. The NBU (in the form of CDs) and Finance Ministry (in the form of government bonds), provided them with an excellent financial alternative, regularly offering state-guaranteed (!) and refundable financial instruments with a positive difference in rates compared to the average rate of deposits for householder deposits.
  2. This was already provided for by the zugzwang in Ukraine’s banking system but was unexpectedly (in exaggerated form) strengthened by the fact that the “overhang” over the “normative” aggregate correspondent account” increased in December 2019 from UAH 50 to UAH 156 billion, which were locked in CDs.
  3. It has become another (not publicly discussed and hardly the most important) risk of a breakdown of the country’s macro-financial stability. This is because NBU reserves are sufficient to cope if the “overhang” of UAH 50 billion suddenly “runs away” to foreign currency. But the “overhang” of almost $6 billion (UAH 156 billion) of potential demand for the currency in the event of a change in exchange rate trend (UAH 156 billion) would be an unsurmountable problems.

Conclusions and recommendations for our main clients:

We do not have any information about to what extent the IMF Mission, which checks the degree of stability of the main macro-indicators in Ukraine, assesses the above-described macroeconomic risks according to the “current program” and “parameters” of the new macro-financial stability program. However, based on the development trends of Ukraine’s financial market, we would like to voice our recommendations to “financial authorities” and “market participants” as our main customers. We note Ukraine Economic Outlook never gives recommendations to state institutions but acts only in the interests of its clients and private investors.

During this transitional (and decisive) period, we, with the consent of our key clients, will make public our medium-term forecast and recommendations

A traditional (classic) recipe for the “most rational” (from a macroeconomic point of view) model of behavior when the economic growth cycle slows down and the risk of a short-term recession arises would be “controlled expansion of the money supply.”

Our recommendations (according to industry standards) are addressed to “market participants” and the country’s “financial authorities” (notwithstanding the obvious conflict of interests between them).

So, in the case of the above-mentioned factors of “decline” and “slowdown” of economic growth in the long-term trend of “recovery,” Ukraine Economic Outlook’s main recommendations are as follows:

Recommendations to financial authorities:

  1. Termination of the policy of “inflation targeting” without taking into account the factors of “employment” and “maintaining the pace of economic growth.” We believe that in the long run, it undermines the NBU’s ability to adhere to the set goal of tampering down inflation. In other words, the NBU should rectify the mistakes of the previous “inflation targeting” and focus on the growth of the loan portfolio of the real sector of the economy. These should become new priorities for the NBU. Accordingly, a new benchmark – the rate of economic growth – should be improved in the NBU’s strategy.
  2. Rejecting of knee-jerk monetary policy for establishing the official hryvnia exchange rate based on a short-term balance of supply and demand and “inclusion” of a long-term, meaningful strategy of the “smooth devaluation” of hryvnia by 5% -10% per year (analogous to the Chinese economic model of export stimulation). This is as a strategic goal. The short-term obvious task of the NBU should be the return of the hryvnia to the corridor of 25.5-27 UAH / USD 1, with the aim of sharply stimulating exports.
  3. Carrying out the policy of the discount rate according to the formula “expected inflation for the next 12 months + 1%,” or returning to the Taylor formula that was actively discussed in 2016-2017. For the NBU, this will result in 8-11% inflation for the current year.
  4. In fiscal policy, it is necessary to temporarily (for the current year) expand the budget deficit (as an anti-crisis measure) in order to stimulate aggregate demand. In fact, this is already a “programmed” measure, because of the political impossibility of reducing budget expenditures based on a more pessimistic revenue plan. This can be done by slightly increasing the NBU’s OVDP portfolio in order to maintain the necessary level of budget expenditures in the context of the onset of a short-term decline/deceleration of growth rates. The economy no longer brings in the form of tax revenues the amounts planned for this year. The sooner the financial authorities acknowledge this fact and take adequate measures, the faster it will be possible to resume economic growth. From Q2 2020, it would also be extremely useful to sequester non-critical expenses in case the recession continues.
  5. Targeted lending programs through interest rate compensation programs should already be launched in the current year’s budget. As long as banks remain “split” between “expensive” deposits made previously by the population and the need for a real sector to receive loans at 12% per annum, it is precisely such programs that will allow “unloading” the “overhang” in the form of NBU deposit certificates in the aggregate correspondent account. When banks, due to the artificially created positive difference in rates, can resume lending to the real sector of the economy (the net domestic lending indicator has only declined over the past five years), this will become an additional driver for growth.
  6. After the stabilization of the situation and the resumption of economic growth, a number of laws on tax tightening for business, promoted by the tax and customs committee of the new parliament, should be “revised”. And a group of international and government experts, with the mandatory involvement of representatives of the country’s leading business associations, should draft a comprehensive “Liberal Tax Code” project based on the draft of the previous parliament over the next six months. This pertains not only on the need to replace income tax with a  tax on withdrawn profits but on reviewing the entire range of lower average tax rates, taking into account the growing international trend of “tax competition” between countries (many neighboring countries of Ukraine, in particular Russia, Belarus, Poland, the Czech Republic and especially Bulgaria has lower tax rates, which makes Ukraine not competitive in the long run, especially when the wage gap between Ukraine and the countries of eastern Europe evens out in the next five years. During 2016-2019, this was our main competitive advantage). The target long-term policy of reducing the level of aggregate taxation should be on the level of 30% of GDP.
  7. Prior to the tax reform, an additional preferential tax regime for small and micro-businesses should be urgently introduced, as well as possible special tax regimes for certain priority sectors. This could jumpstart increased exports this year. It would also allow for depreciation, due to an increase in the number of self-employed persons (in the context of a short-term economic decline) and increased unemployment in the manufacturing sector and also partially prevent additional migration of Ukrainian workers abroad.

Recommendations for UEO clients:

  1. Be the first to close positions on government bonds (only a decreasing yield on hryvnia securities and a reduction in the currency premium on them, which is inevitable in the context of devaluation this year, awaits you). Explore opportunities to buy industrial facilities (or blocks of their shares) as part of initial privatization. Given the speed and volume of privatization, situations which will inevitably arise in the market as enterprises will be sold at a lower price than they will cost in the medium term.
  2. In the short term, for the next three to nine months, the best opportunities will be to open positions on foreign currency. This will allow you to simultaneously maintain mobility for the purchase of undervalued assets as part of large privatizations.
  3. Against the background of the expansion of the money supply by the NBU and the reduction of rates on all types of government securities denominated in dollars and euros to 3-4% per annum with a downward trend, corporate bonds with a spread of + 2-4% higher than sovereign benchmark will become available in the domestic financial market.


We predict that even partial adoption of the above anti-crisis measures by politicians will be low. Most likely, they will either not be accepted in the form described above or will be accepted (for example, the sequestration of the budget that becomes inevitable or a smoothly planned depreciation of the hryvnia) with a great delay. This will push back resumption of growth. At the same time, low inflation will remain this year (below 10%), the Finance Ministry will service all external payments and the inflow of foreign currency from privatization and the opening of the land market will have a local short-term effect on budget and balance of payments support. Despite a significant slowdown in growth, we assess the risks of default on government securities, a banking crisis or a sharp devaluation as close to zero.

Whether Ukraine’s financial authorities will be able to cope with the temporary economic downturn during Q1 2020, or whether it will take them the entire year to deal with it, remains the key question. In either case, prospects for the further recovery of Ukraine’s economy over the next three to five years remain strong. 

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