Summary of Key Policy Rate Discussion by NBU Monetary Policy Committee on 7 September 2022

Date of the meeting: 7 September 2022.
Attendees: nine out of ten members of the Monetary Policy Committee (MPC) of the National Bank of Ukraine:

• Kateryna Rozhkova, First Deputy Governor
• Yuriy Heletiy, Deputy Governor
• Yaroslav Matuzka, Deputy Governor
• Sergiy Nikolaychuk, Deputy Governor
• Oleksii Shaban, Deputy Governor
• Pervin Dadashova, Director, Financial Stability Department
• Volodymyr Lepushynskyi, Director, Monetary Policy and Economic Analysis Department
• Oleksii Lupin, Director, Open Market Operations Department
• Yuriy Polovniov, Director, Statistics and Reporting Department. 

During the meeting, members of the MPC discussed whether economic developments were in line with the baseline scenario of the NBU's July macroeconomic forecast, and reviewed changes in the balance of inflationary risks over the policy horizon. Special focus was placed on evaluating the effectiveness of monetary transmission and discussing further measures to strengthen it to increase the stability of the FX market and maintain control over price dynamics.

In the course of the discussion, it was noted that inflationary risks on the short-term horizon have eased. In the longer term, however, the balance of risks remains shifted upward, while the level of uncertainty is still extremely high.

Specifically, inflation in July and August was slightly below the NBU’s forecast, in particular due to lower fuel prices and increased supply of some food products. Imbalances in the FX market decreased after the cancellation of import tax relief, the adjustment of the hryvnia’s official exchange rate, additional measures taken by the NBU to reduce depreciation pressure, and the opening of Black Sea ports for grain exports. The negative balance of the NBU’s FX interventions, compared to May–July, has significantly narrowed since the MPC’s previous meeting.

In addition, thanks in part to significant amounts of international aid, the state budget’s monetary financing needs declined, easing pressure on Ukraine’s international reserves. In particular, the volume of monetary financing decreased to UAH 30 billion in July and August, down from UAH 105 billion in June, while international reserves exceeded USD 25 billion at the beginning of the autumn.

These factors and the already approved USD 12 billion in financing to be disbursed to Ukraine by the end of the year under multiple programs, as well as the emergence of new initiatives from the U.S., will give the NBU sufficient FX reserves to keep the official hryvnia exchange rate fixed, which is currently the primary tool for curbing inflationary pressure. On the other hand, with monetary financing being limited, the significant international financial assistance will enable the government to fully cover the budget deficit planned for this year.

The NBU’s June decision to increase the key policy rate to 25% will continue to affect market rates. Specifically, the growth in deposit rates continues. At some banks, they already are 15%–20%. In addition, the increase in the interest rates on long-term hryvnia deposits has also accelerated recently. After the secondary market returned to business as usual, the response of the yields on hryvnia domestic government debt securities has also strengthened. Government bonds with a maturity of at least one year are traded in the secondary market with yields above 20%.

At the same time, russia’s full-scale military aggression against Ukraine will continue to pose significant risks to economic development and elevate uncertainty.

Ukraine’s export potential, and thus its ability to generate more FX earnings, is significantly limited. Despite the launch of the “grain corridor,” total food exports remain below pre-war levels. In addition, the uninterrupted operation of maritime logistics is under constant threat, as evidenced by the latest statements from the aggressor state’s authorities.

Metals-and-mining exports, which were one of the key sources of Ukraine’s FX earnings before the war, also remain weak. Deliveries of iron ore and ferrous metals have declined, even compared to previous months, due to supply chain disruptions and low demand. After all, external conditions are not contributing to the growth in FX earnings, as prices for Ukraine’s main exports have been falling more significantly than expected.

In contrast, natural gas prices in Europe have been hitting new highs as russia has taken its energy blackmail to a new level. On the one hand, provided there are no significant frosts and energy infrastructure remains intact, natural gas reserves in Ukrainian storage facilities should be enough for the heating season. However, probable terrorist attacks by russia and a cold winter can seriously complicate the energy situation in Ukraine. russia’s natural gas blackmail is also intended to sow discord among EU countries and thus impede further aid to Ukraine, which it desperately needs in order to finance its wartime budgetary needs.

In particular, despite a certain improvement in the tax revenue situation in recent months, the budget deficit has reached an all-time high. Budget needs, even taking into account deferred debt payments, are still estimated at USD 4.5–5 billion per month until the end of the year. The army’s needs account for a significant portion of these expenditures. Military expenditures must be covered from domestic sources.

It is almost impossible to ensure the required amount of revenue without reimposing the excise duty on fuel and additional import taxes, but these decisions have yet to be made. In addition, the interest rates on hryvnia domestic government debt securities at primary auctions are actually still not high enough for the government to be able to borrow domestically.

Nonmilitary expenditures are primarily financed by international aid, but its amount for the next year is not yet known. These factors pose risks to fiscal stability and reduce prospects for the nonmonetary financing of the budget deficit in 2023.

The fundamentals outlined above, as well as the negative publicity surrounding the monetary financing of the budget deficit, are fueling depreciation pressure and adversely affecting inflation and exchange rate expectations. On the other hand, the yields on deposits and military domestic government debt securities, despite having increased, remain significantly lower than the current and expected inflation rates. This encourages economic agents to look for other ways to protect their savings, including by buying foreign currency and imported goods. As a result, pressure on the hryvnia and international reserves persists.

Global inflationary pressures continue to intensify, and the probability of a global recession, many experts and think tanks estimate, is rising. If a negative global economic scenario materializes, it may lead to a drop in commodity market prices and a corresponding decline in export revenues, putting further pressure on the hryvnia to depreciate and on consumer prices to rise.

Another reason that long-term risks to the economy remain significant is because the pace of migration is higher than the NBU assumed. Excessive labor mobility threatens to shrink the workforce and have a long-term adverse impact on the labor market and economic recovery.

Given this balance of risks, the MPC members unanimously spoke in favor of maintaining the key policy rate at 25%.

This level of the key policy rate is sufficient to maintain exchange rate stability and keep inflationary processes in check over the policy horizon, the discussants agreed. Such a decision is consistent. It meets the baseline scenario of the macroeconomic forecast and the expectations of market players, and will therefore help reduce uncertainty. In addition, this decision takes into account the easing of inflation risks in the short run.

Inflation at the end of the year may therefore come out even lower than the NBU projected in its July Inflation Report, two MPC members pointed out. This may be partially due to an increase in the supply of fruits and vegetables by households, a faster decrease in fuel prices, and the lack of measures to impose additional import taxes.

At the same time, there are no grounds for cutting the key policy rate, given the looming protracted war, uncertainty around the terms and volumes of official funding next year, and the risks of a further unbalancing of expectations.

In view of the persistence of strong price and exchange rate pressures and deteriorating expectations, the discussants agreed that in the coming months, the NBU should prioritize measures to strengthen monetary transmission to maintain exchange rate stability and safeguard international reserves.

The real yield on hryvnia domestic government debt securities in the primary market is becoming increasingly negative, meaning these securities are no longer perceived as a savings instrument. Bank deposit rates have only recently recovered from the decline of the earliest months of the war and are slightly above their pre-war levels. As a result, despite a certain increase in market rates on hryvnia instruments, further steps are necessary to improve their investment appeal.

The main reason for the banks’ slow response to the key policy rate hike is the further growth in the banking system’s liquidity, which attained new historical highs in early September. A significant source of its growth remains the monetary financing of budget expenditures, despite the decrease in the monetary financing of domestic government debt securities in July–August.

An additional obstacle to monetary transmission is the uneven distribution of liquidity between the banks: the lion’s share of it is concentrated in financial institutions that have the most retail deposits. These banks are not particularly interested in drawing in new deposits and are therefore in no rush to compete for depositors by raising interest rates. Low rates at primary auctions to issue hryvnia domestic government debt securities are not encouraging the banks to hike their deposit rates either.

With hryvnia rates being low and hryvnia liquidity in the banking system being excessively high, there is a risk that demand for foreign currency may intensify, in part due to ad hoc factors. The widening of the spread between the hryvnia’s official and cash exchange rates in recent weeks comes as another sign that significant depreciation pressure persists.

What is more, the FX market is still far from being self-balanced. The NBU’s FX-selling interventions, though less active in recent months, remain significant. On top of that, the decline in FX demand in August was in part driven by spontaneous factors, in particular by lower volumes of FX purchases for energy imports, the MPC members noted. Under these conditions, the NBU should continue to take steps to ease depreciation pressure and protect international reserves.

During the meeting, the MPC members discussed several instruments that could strengthen monetary transmission and absorb the banking system’s excessive hryvnia liquidity.

The most effective instrument could be transactions to sell the domestic government debt securities in the NBU’s portfolio, some MPC members suggested. This would contribute to a further increase in the yield on hryvnia instruments and reduce the impact of the monetary financing of the state budget on the FX market and the price level. Such transactions will give market participants (primarily households and businesses) an alternative opportunity to buy risk-free hryvnia financial instruments with an attractive yield and flexible maturity to safeguard their hryvnia savings from inflation.

These transactions will also help revitalize the secondary market for domestic government debt securities, where a gradual increase in yields is already happening. This will, among other things, create price benchmarks and reduce market fragmentation. A decline in the structural surplus of liquidity in the banking system will also help revive transactions in the interbank credit market and bolster its recovery.

All MPC members supported the use of such a market instrument, but they differed on the timing of its application. Several discussants said that such transactions should be launched as early as possible, taking into account the potentially long lag between this tool’s deployment and outcome. In particular, according to one MPC member, the NBU should immediately give the market a strong signal that the medium-term and long-term yields, under current conditions, should be significantly higher than those currently offered for deposits and domestic government debt securities at primary auctions. These yields should be in the range of 20%–25% to make hryvnia assets an attractive savings option, several MPC members proposed.

In addition, the discussants put forth an idea that the sale of a part of the NBU’s domestic government debt securities portfolio will not impede the market-based financing of the state budget, as the main reason for the ineffective issuing of government securities in the primary market is their low yields.

Another potential step in shoring up monetary transmission, several MPC members said, could be to increase the reserve requirement ratio. Some emerging market central banks have recently redeployed this tool to absorb excessive bank liquidity. Specifically, the central banks of Poland, Hungary, Moldova, and Indonesia have increased their reserve requirement ratios as inflationary pressures have risen.

The advantages of this tool are its speed, ease of implementation, and effectiveness. Its use will make it possible to accurately estimate, in advance, the amount of liquidity that will have to be sterilized. Raising the reserve requirement ratio will have a limited effect on the liquidity of the vast majority of the banks. At the same time, it will primarily affect the banks that have been slow to respond to the key policy rate hike. In addition, because of a differentiated increase in the reserve requirement ratio, it is possible to ensure a targeted impact on the interest rates on long-term hryvnia deposits.

Such a tool will be successful only if it is properly designed, another member of the MPC said. In particular, it is possible to apply an increased reserve requirement ratio to demand deposits and FX deposits to help achieve the desired effect of taking pressure off the FX market.

According to several discussants, however, this tool is less marketable compared to other tools, and it is extremely difficult to quantify its impact on monetary transmission. Among other things, to compensate for profitability losses, the banks can lower their deposit rates, e.g. those on retail deposits, instead of raising them. The banks are currently inclined to compete for corporate deposits, as it is operationally easier and faster to take large corporate deposits than retail ones. This means that the banks have an incentive to save on retail deposit rates, especially since retail deposit inflows have recently recovered.

In the end, most MPC members agreed that such an instrument should be introduced only after the launch of transactions to sell the domestic government debt securities held by the NBU, if such sales receive the go-ahead.

The third option, which can be implemented relatively quickly and easily, is the use of transactions to issue long-term certificates of deposit. In contrast to using the centrally administered reserve requirement ratio, certificates of deposit are a market-based instrument that will not produce most of the negative side effects outlined above. This tool makes it possible to fine-tune the sterilization of hryvnia liquidity for a relatively long time. This should stimulate the banks to raise retail deposit rates and ease pressure on the FX market.

However, several MPC members objected that this tool would not have the desired effect on monetary transmission. Specifically, there is a possibility that instead of revising the rates on retail deposits, the banks will redistribute part of their liquidity from overnight certificates of deposit to those with longer maturities.

In addition, the MPC members agreed that long-term certificates of deposit would be a redundant element in the operational design of monetary policy if the NBU were to start selling the domestic government debt securities in its portfolio.   

All members of the MPC believe that in order to maintain macrofinancial stability, the NBU will continue to pursue a tight monetary policy for a long time.

The discussants agreed that whether the NBU needs to take steps would primarily be determined by military developments. High uncertainty means that there exists a wide range of mostly upward-sloping potential trajectories of the key policy rate and different variations and combinations of additional measures.

The NBU has an action plan for either scenario: one that is more optimistic, and one in which martial law in Ukraine lasts a long time. If necessary, the NBU is ready to raise the key policy rate above the current level, as well as apply additional measures, to preserve the stability of monetary conditions and keep inflationary processes under control.