The situation in Ukraine is once more coming to a head, as it did so in 2008 and 2009. To avoid a hard default, a critical outflow of foreign funds, and a complete depletion in the central bank’s reserve assets, Ukraine should drop the peg (or widen the trading band) to the USD and devalue its currency.
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Ukraine’s currency reserves have been declining as the country seeks to protect the currency peg to the dollar. As a result, the number of a months’ import cover has fallen to its pre-crisis level. The advantages from the positive terms of trade Ukraine enjoyed as commodities – mainly base metals – rallied over much of the past few years, have all but evaporated.
Ukraine had similar problems to many of the Baltic countries (Latvia, Lithuania, Estonia) in the latter part of the last decade that came to a head as the financial crisis took grip. Specifically, it was running a large current account deficit that was funded primarily by inflows from abroad – seeking higher yields – much of which was short term in maturity.
When the bust came in mid 2008, it was brutal. Industrial production collapsed 30% on the year – mainly due to a drop in steel demand and prices, which in 2008 accounted for 40% of Ukraine’s exports and 15% of its GDP – real GDP hit a nadir of -20%, and the current account deficit jumped to almost being in a surplus as funds were withdrawn en masse from the country.
Ultimately, the IMF had to step in with a loan for $16.5 billion to avert a run on Ukraine’s banks and its currency (which devalued 60% between 2008 and 2009). However, the programme was frozen in March 2011 due to the government’s refusal to raise gas tariffs for households.
The IMF and Ukraine will meet in September to discuss restarting the programme, but this does not eliminate the problem that the IMF needs to be paid back for money previously disbursed. The payback schedule begins this year and some sizable payments are due.
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Our view however is that abandoning the peg will ultimately be needed to restore competitiveness.
