Speech by NBU Governor Yakiv Smolii at the opening of the joint Annual Research Conference of the National Bank of Ukraine and Narodowy Bank Polski on Interaction of Fiscal and Monetary Policies

Dear participants,

Welcome to the Annual Research Conference, which is traditionally organized jointly with Narodowy Bank Polski, with the support of Canada-IMF technical assistance project and Kyiv School of Economics. For the third time the event brings together representatives of central banks, international organizations, prominent researchers from the leading universities, and experts from Ukraine and all over the world.

Over the next two days, we are united with a topic that is of high interest and concern for any country: the interaction of fiscal and monetary policies.

At first glance, the goals of the government and the central bank are somewhat different. Fiscal policy is about redistributing funds in the economy to fuel its growth. The aim of the government is to ensure jobs with reasonable wages for the working-age population and social security for the dependent citizens. At that, financing of budget deficit should not lead to accumulating debts that would be hard to service.

Meanwhile, the monetary policy of modern central banks is usually aimed to ensure price stability. To put it in other words, they strive to maintain inflation at a rate at which it can be said that the purchasing power of money is stable.

However, the central bank and the government have one bigger common goal, which is macroeconomic sustainability. It is the cornerstone of economic growth.

In the modern world of complicated economic and financial processes, neither a government nor a central bank can afford to be a ship that charts its own course. Today, success of the country’s economy depends on their ability to find common ground. Without a shared understanding, the central bank cannot curb inflation, while the government cannot maintain the sustainability of government finances.

Nevertheless, the coordination of fiscal and monetary policies can be easily mistaken for the subordination of one policy to another. It is especially true for the developing countries.

First, the quality and stability of their institutions lag behind those in advanced economies.

Second, the relationship between growth and inflation is different. In advanced economies, recession is usually accompanied by deflation. To the contrary, economic crises in developing countries are characterized by a fast depreciation of domestic currency and, thus, high inflation.

Third, developing countries often use non-market pricing mechanisms for certain categories of goods and services, including the ones set by the government. It affects the central bank’s ability to manage inflation.

Last but not least, the structure of sovereign debt is different. A large part of a developing country’s sovereign debt is denominated in foreign currency. It makes their governments sensitive to exchange rate fluctuations and creates so called “fright of floating”, a dislike of the floating exchange rate regime that is an essential part of inflation targeting.

Therefore, developing economies are more prone to the temptation of turning policy coordination into the dominance of fiscal policy over monetary policy.

Over time, fiscal dominance has become less common in developing countries. Practice has shown that a well-thought fiscal policy that has been coordinated with the central bank improves the efficiency of monetary policy, provided the central bank is independent. Conversely, the divergent and uncoordinated policies followed by the government and the central bank pose a threat to the economy. Especially, when fiscal dominance occurs.

For instance, a too loose fiscal policy that runs counter to monetary policy objectives may result in an increase in public debt and an acceleration in inflation. When this creates risks to achievement of inflation targets, a central bank has no other choice but to raise the key policy rate. This in turn pushes up budget expenses on debt servicing.

If the government respects the independence of the monetary authority, it usually ends up doing fiscal consolidation.

A country where fiscal dominance is a standard practice faces worse scenarios. In such a case, the government may be tempted to ask the central bank for financing. If the central bank grants this request, the country’s debt starts to accumulate in the books of the central or commercial banks. At the same time, monetary policy loses its focus on price stability. Instead, it starts to be used in the government’s interests – to reduce debt servicing costs. The outcome is easy to predict – sharp domestic currency fluctuations and, ultimately, regular FX and economic crises.

I could give you historical examples that have already become classical cases, or more recent ones that took place in other countries as early as last year.

But why look at other countries when Ukraine’s recent past is no less illustrative?

Until 2015, it was common practice in Ukraine to subordinate monetary policy to the government’s objectives. For years, the central banks had to conduct a loose monetary policy in order to meet nationwide needs. Sometimes this was done to prove the political loyalty of the top management of the central bank, which at that time had no real institutional independence. And sometimes this was done to avert a major financial crisis.  In 2014 alone, when a military conflict was escalating in eastern Ukraine, and economic, FX and banking crises were deepening, the NBU financed about 40% of the country’s consolidated budget.

Regardless of the reasons, however, this practice was inappropriate and prevented the central bank from performing its main purpose of delivering price and financial stability in the country.

Three year ago, Ukraine terminated the practice of fiscal dominance. The central bank got real institutional independence and a new mandate. Since then the NBU’s official policy has been aimed at ensuring price and financial stability to promote sustainable economic growth. 

Concurrently, there were other economic reforms. For instance, energy sector reform because of which Naftogaz of Ukraine, the country’s largest state-owned energy company, no longer needs funds from the NBU purchase of government bonds. As the cleanup of the banking sector was completed, the Deposit Guarantee Fund ceased to require the central bank’s financial support.

All this paved the way for the departure from fiscal dominance and the implementation of inflation targeting. Since that time, we have been making steady progress towards achieving our goal of decreasing and maintaining inflation at 5% in the medium term. While hitting over 40% in 2015, the headline inflation rate now stands at 13%. Already this year, inflation will decrease to a one-digit figure, entering the target range in the middle of 2019 and meeting the target of 5% in 2020.

Looking back, we are convinced that Ukraine must not return to fiscal dominance under any circumstances.

Is there an internationally accepted correct way of bringing this vision to life?

Where should the dividing line between independence and coordination of the central bank’s and the government’s polices lie?

This list of questions gets even longer when one remembers the challenges the global economy has faced over the last decade and the unconventional solutions to these challenges.

How should fiscal and monetary policies be coordinated under negative real interest rates? How not to cross the line between coordination and fiscal dominance when conducting quantitative easing? In what direction does this line move when one has to save the banking system? And how should the government and the central bank coordinate their actions in order to prevent risks which highly volatile capital flows pose to the economy?

Overall, there are a lot of questions, to which we, speakers and guests that came to Kyiv from over 15 countries, will have to look for answers over the next two days.

I wish you an interesting and fruitful discussion!

Thank you for your attention!