I’d like to greet all the participants at our traditional meeting following the Board meeting on monetary issues.
I would like to inform you that the NBU Board continues to ease monetary policy. It has been decided to cut the key policy rate to 18%.
As expected, twelve-month headline inflation slowed to single-digits for the first time in two years, reaching 9.8% y-o-y in April. At the same time, in monthly terms inflation was higher than in the previous months, standing at 3.5%. The increase in monthly inflation reflected the elimination of preferential natural gas tariffs for households, effective through 31 March 2016. Yet, headline inflation posted a 5.1% year-to-date increase.
The downward trend in core inflation in April 2016 was in line with the NBU's expectations, reflecting weakening fundamental factors such as lower inflation pressures.
Why does inflation keep slowing?
Disinflation was underpinned by subdued domestic consumer demand, tight monetary policy and appreciation of the hryvnia exchange rate observed in recent months, and favorable supply-side factors. Let us look at these factors separately.
First, subdued domestic demand, which is primarily implied by the annual real GDP data. In Q1 2016, real GDP posted a slight increase of 0.1%, a lower figure than projected by the NBU.
Weak retail trade performance is yet another factor pointing to subdued consumer demand. In January-April, retail trade increased by only 2.5% y-o-y. At this, surveys conducted by the NBU suggest that household consumer sentiment remained edged down.
Real wages growth is not helping much either to boost consumer demand. In March, real wages posted an increase of 1.6% for the first time in two years, albeit 6.8% lower in Q1 2016 than in the same period a year ago. Although businesses benefited from additional financial resources released as a result of lower allocations to social funds, the increase in real wages was moderate and insufficient to trigger inflation pressures.
Second, inflation was curbed by food supply-side factors related to food products. In particular, prices for raw foods have kept decreasing in resent months The annual increase in raw food prices slowed to 3.8%.
Third, disinflation was supported by a gradual appreciation of the hryvnia exchange rate, which observed since mid-March due to improved external conditions.
In recent months oil prices have rebounded from lows of below USD 30 per barrel to USD 50 per barrel, driven by both fundamental and temporary factors. In particular, the demand from the US, Russia, China, India, the EU and other countries has recovered on the back of low prices. At the same time, low oil prices have led oil produces to freeze shale oil extraction, an industrial process for unconventional oil production. Additionally, oil production has been cut due to the hostilities in Libya and Nigeria, massive fires in Canada, and strikes in Kuwait.
Prices for key Ukrainian export commodities kept recovering on the back of increasing oil prices. In particular, steel prices rose by 46% year-to-date.
The increase in steel prices was driven by stronger demand from China, a ramp-up of construction projects in the Northern hemisphere countries, the imposition of anti-dumping duties on China steel in EU countries and the US. Prices for iron ore increased by 17% year-to-date.
Preliminary data suggests that the b.o.p. current account turned into a surplus in April, reflecting more favorable terms of trade and a seasonal pick-up in exports. The increase in merchandise exports in seasonally adjusted terms accelerated, leading to a pick-up in foreign exchange proceeds from exports. The average daily inflow of foreign exchange proceeds from non-residents rose from USD 171 million in January to USD 231 million in May.
Both cash and interbank foreign exchange markets saw an increase in the foreign exchange supply. The average daily amount of cash foreign exchange purchased by banks in April increased more than twofold, compared to January, and by 34.4% m-o-m. Banks’ net foreign exchange purchases have amounted to USD 1.1 billion. In contrast, average daily sales of foreign exchange by banks remained flat during the current year. Banks channeled foreign currency that they have purchased to the interbank market.
The foreign exchange supply was ample, notwithstanding that in May the NBU moved ahead with a gradual relaxation of administrative anti-crisis restrictions on FX operations. As you know, the NBU has exempted funds intended for investments projects from surrender requirements.
At the same time, the demand for foreign exchange remained subdued. In Q2 2016, energy imports decreased due to the accumulation of large volumes of natural gas in the underground natural gas storage facilities. Non-energy imports declined due to the intensified imports substitution and realization of deferred demand in Q1 2016.
Let me remind you that imports showed a strong rebound due to the lifting of the additional import surcharge and the entry into force of the economic part of the EU- Ukraine Association Agreement. Anticipating a reduction in import duty rates, businesses and households put off purchases of imported goods. Once the purchases were made, the demand decreased.
The NBU’s measures to relax FX restrictions were the key drivers of demand for foreign exchange. First, the NBU has shortened from three to two days the provisioning period for banks to earmark funds in UAH required to purchase foreign currency upon clients’ instructions.
As a result of these factors, the supply of foreign currency on the interbank market has exceeded the demand for it, which enabled the NBU to purchase foreign exchange to smooth excessive exchange rate volatility and to replenish international reserves. Since mid-March, the NBU has held 26 FX auctions and conducted a FX intervention at a fixed exchange rate. Overall, the NBU's net FX purchases in the interbank market amounted to USD 1 million over this period.
At this, the NBU remained firmly committed to a flexible exchange regime, while not hampering a gradual appreciation of the exchange rate triggered by fundamental factors, as we declared earlier. The UAH/USD exchange rate strengthened by 5.6% since mid-March 2016.
Furthermore, these developments enabled the NBU to move ahead with a gradual relaxation of FX restrictions. For instance, yesterday the NBU shortened to one day the provisioning period for banks to earmark funds in UAH required to purchase foreign currency upon clients’ instructions, effective from 1 June 2016. This move will make it easier for banks to purchase foreign currency and will help boost liquidity available to businesses to finance current operations.
Also, the National Bank of Ukraine takes vigorous steps remove red-tape obstacles facing FX market participants. The NBU has streamlined the rules governing the issuance of permits for FX operations.
First, from now on, authorized bank customers intending to perform a FX transaction are no longer required to submit documents that can be accessed by the public.
Second, authorized bank customers are not required to translate SWIFT messages and documents that are available in a foreign language, Ukrainian (or Russian) languages.
Also, the NBU streamlines the rules governing the return of foreign investment. In the past, foreign investors intending to retrieve an investment deposit were required submit to an authorized bank a statement issued by the bank confirming the arrival of foreign currency in Ukraine, or documents confirming the creation of an investment deposit using reinvestment. This requirement has been repealed by the NBU. The NBU’s efforts to streamline the rules governing the return of foreign investment aim to make investment projects implemented in Ukraine more attractive.
What will determine the rate of inflation in the period ahead?
The NBU believes that the 2016 and 2017 end-year inflation targets set at 12% and 8% respectively remain within reach.
Given the upward adjustment of tariffs for heating and hot water recently announced by the government, administered prices are expected to be a major contributor to the Consumer Price Index in 2016. However, in 2017, their contribution to the CPI index is likely to be less significant than projected in the Inflation Report (April 2016).
Increases in administered prices and tariffs accounted for temporary surges in inflation in some months of 2016. However, their further adjustment to cost-recovery levels (market levels) will not require the NBU to pursue a tighter monetary policy.
First, in the medium-term, this move will contribute to keeping inflation on a downward path through the elimination of distortions in price-setting mechanisms in the period ahead.
Second, this adjustment will help contain pressures on inflation the household's effective demand for other goods and services as early as in 2016.
Accordingly, due to this and other factors the upward pressure on headline inflation from domestic demand-side factors is expected to be insignificant over the forecast horizon. Instead, the economic recovery will be driven by investments and supported by external demand.
The continuation of cooperation with the IMF is critical for achieving price stability. As you know, the Government and the National Bank of Ukraine have finalized talks with an IMF mission team. The mission reached staff level agreement with the Ukrainian authorities on policies needed to complete the second review under the EFF. The Government's resolve to move urgent reforms forward, and the support of parliament is essential to keeping the program back on track.
Therefore, in view of the current economic situation, and outlined downside risks to this forecast, the NBU Board has decided to resume monetary easing.
Should risks to price stability abate further and inflation keeps slowing, the NBU will move ahead with the monetary easing to support the economic recovery.
The next meeting of the NBU Board on monetary policy issues will be held as scheduled on 23 June 2016.
Thank you for your attention