Dear members of parliament,
I’m glad to greet all of you, and would like to thank you for the invitation to speak before the Verkhovna Rada.
Today, I will inform you of the NBU’s monetary policy and current foreign exchange market conditions.
I will start by saying that one of the key decisions of the NBU was to continue to use a flexible exchange rate and not return to a fixed exchange rate regime. The NBU has finally become a money market regulator rather than a body accountable for the exchange rate, which it was when a fixed exchange rate regime was in place. From now on, the Ukrainian central bank, like the central banks of all developed countries, bears responsibility for price and financial stability. It is its main statutory function. You have voted to amend the Law On the National Bank of Ukraine, thus giving the NBU a mandate to deliver price and financial stability with a focus on sustainable economic growth.
I admit that the adoption of a flexible exchange rate was a painful process. A year ago, it coincided with the escalation of the conflict in eastern Ukraine, together with a sharp fall in the hryvnia exchange rate. So far, unfortunately, Ukrainians have not developed a habit of thinking in terms of prices instead of the hryvnia exchange rate, and still worry about every exchange rate fluctuation.
I would like to stress that the exchange rate fluctuations that occurred in recent months should not be regarded as something unusual. When the NBU decided to adopt a flexible exchange rate regime, it warned about fluctuations. Indeed, fluctuations are an integral part of any flexible exchange rate regime. The exchange rate is set as a ratio of demand for foreign currency to foreign currency supply, which changes every day. Therefore, the exchange rate may move towards either appreciation or depreciation of the domestic currency. The same happens in every market in the world and with every world currency subject to a flexible exchange rate regime.
In this situation, one has to understand why it happens rather than panic.
Let us look first at interbank foreign exchange market conditions. Currently, the interbank exchange rate ranges within USD 25.8-26.0 The exchange rate path has been recently determined by both temporary and fundamental market factors.
Most significantly, these include situational factors, which typically occur at the beginning of every year.
At the beginning of every year, business activity decreases, impacting currency supply.
Also, as the NBU has said before, excessive currency fluctuations were also due to inactivity during the long winter holiday period.
Apart from that, as you surely know, over 30 billion was paid from the Single Treasury Account in late December. Among other things, that money was spent on refunding large VAT differences. This provided bank customers with additional liquidity, which they used to purchase interbank currency.That is why the NBU always says that, in order to prevent such liquidity increases, all inflows into the economy, including those from the budget, must be predictable, arrive as scheduled, and be distributed evenly during the year.
Lately, another situational factor emerged. Namely, political instability has created uncertainty about the future of the country and might lead to speculative demand for foreign currency. Headline-making political news routinely affects developments in the financial markets. The current situation is not an exception. Financial markets have already responded to these political risks. For instance, investors in Ukrainian sovereign Eurobonds started selling off government debt, expecting that Ukraine’s short-term solvency will worsen. This moved the yield curve of Ukrainian Eurobonds. The hryvnia exchange rate is being affected in the same way.
All of these situational factors increase the influence of the main and fundamental factors that have been putting pressure on the exchange rate, and will regretfully continue to apply pressure. I’m talking here about weaker external economic conditions.
Last year, the current account, for the first time in the last three years, was practically in equilibrium. According to our estimates, the current account deficit was only USD 200 million, or 0.2% of GDP, versus 10% of GDP in 2013. Last year was the first year when our projections of an offset current account actually came true. Therefore, this indicates that, due to depreciation, the hryvnia exchange rate reached equilibrium and helped in balancing the current account.
Unfortunately, last year’s balanced current account is becoming a current account deficit this year. We estimate that the current account will record a deficit of USD 2.5 billion, or 3% of GDP in 2016. Why?
Primarily due to a drop in global commodity prices. Falling oil prices are driving down steel and food prices, which account for a huge portion of Ukraine’s foreign exchange earnings. In January, average daily sales of FX returns from the metallurgy and mining industries fell by one third compared with December.
Restrictions on exports of Ukrainian goods to the Russian Federation and the transit of Ukrainian goods through Russia to certain Asian countries also play a role. We estimate that out of USD 2.5 billion of the current account deficit, an amount of USD 1.1 billion resulted from these restrictions.
Other fundamental factors include a fall in the exchange rates of the currencies of Ukraine’s trading partners. These days, the exchange rates of almost all currencies are falling against the dollar. Since the beginning of 2015, the KZT/USD exchange rate has dropped, as well as the BYR/USD exchange rate and the RUR/USD exchange rate. All the CIS countries registered depreciation of their domestic currencies. This undermines the competitive advantage of Ukrainian exported goods not only in these countries but also in other countries.
In January, due to situational and fundamental factors, inflows declined by 26% m-o-m, while FX sales fell by 43% m-o-m in the interbank market.
- Though the exchange rate is primarily formed in the interbank market, households are more concerned about the situation in the FX cash market than interbank market developments. Additionally, the cash market rate is always slightly higher than the interbank market rate. This can be explained by the fact that the hryvnia cash exchange rate is also influenced by additional factors.
- The first and most important factor is household sentiment. Please don’t speculate on the topic of the hryvnia exchange rate, so as not to provoke excess demand.
- The second factor is the winter holiday season, which I already referred to earlier.
- The third factor is excess liquidity. As I mentioned, at the end of December, tens of billions of hryvnias were paid from the STA. Out of them, UAH 14 billion spent on social payments were not previously planned and were presumably channeled to the FX cash market.
What are the prospects for the hryvnia exchange rate?
Seasonal factors are now in the past. However, a new factor emerged, the political instability mentioned earlier. The quicker the political situation calms, the less the hryvnia exchange rate will fluctuate.
Also, it is necessary to understand that fundamental drivers of exchange rate developments are beyond the reach of the National Bank of Ukraine. A deeper dive in the prices for commodities and depreciation of partner countries’ currencies may lead to a larger deficit of the Balance of Payments than we estimate. Accordingly, it may affect the hryvnia exchange rate, as the hryvnia exchange rate is a mirror of our balance of payments.
At the same time, one should remember, that these risks may be partially offset with other factors.
- First, owing to low prices for energy.
- Second, owing to inflows from investments during the course of privatization of state-funded enterprises. According to estimates of the Ministry of Economic Development and Trade, privatization can ensure inflows of USD 1 billion in 2016, i.e. more than UAH 17 billion is planned in the budget.
- Third, Ukraine is now under an “umbrella” of assistance from international organizations. In Davos, we agreed on all technical issues with the IMF and are waiting for the upcoming signing of the Memorandum. Later, the Fund’s Board of Directors will meet. Then, we will be able to receive official funding under the IMF program, Eurobonds under US government guarantees, and financing from the World Bank, EBRD, and other international institutions. Ongoing cooperation with the IMF will allow us to further build up our reserves. We forecast that by the end of the current year they should reach USD 19.6 billion.
Additionally, the National Bank of Ukraine has not left the exchange rate to its fate. For sure, the market should regulate itself, while the task of the National Bank of Ukraine is to abstain from fixing the exchange rate. However, we take measures to mitigate excessive exchange rate volatility. That’s what we did through FX interventions when we spotted excessive fluctuations in December-January. In January alone, the NBU held five FX sale auctions for a total amount of USD 118 million.
Yet, it is important to understand: the NBU is not counteracting the effects of fundamental drivers. The NBU mitigates exchange rate fluctuations caused by situational factors.
In addition, the NBU withdraws excessive liquidity from the banking system. During last year, we put vigorous efforts into work on the NBU’s certificates of deposit (CDs). Balances of banks’ CDs held with the NBU reached UAH 80 billion by the year’s end. At the end of last year, we made a decision to cease including cash balances in banks’ cash desks and ATMs for the coverage of reserve requirements since we expected that the Government might increase budget expenditures at year-end. Currently, the balance of the cumulative correspondent account for the coverage of reserve requirements stays within the UAH 40-41 billion range compared to UAH 25-26 billion as of the end of the year. We are working on early repayment of the NBU’s refinancing. In January alone, we received early repayments of over UAH 3 billion. We expect UAH 3-4 billion more in February-March.
Furthermore, a sustainable exchange rate is surely not possible without financial sector stability, which is also in the focus of the policy pursued by the NBU.
The process of banking sector clean-up is currently close to the finish line. In particular, the clean-up among the group of Ukraine’s largest banks has been completed. Since the beginning of 2014, the NBU has put 64 banks into resolution. Thirty-three during 2015. This accounts for over a third of the banking system.
Significant progress has been made on the disclosure of banks' beneficial owners. The level of transparency of the banking system now stands at over 98%. The banks who fail to disclose their owners before the end of Q1 will be subject to liquidation.
New legislation has been introduced to strengthen the responsibility of banks’ owners and management for driving a bank into bankruptcy. However, we still do not see practical results.
We renewed our fight against one of the main problems in the banking system, which is related to lending.
We also have ambitious plans for the current year.
This year, we will finish the banking sector clean-up and reset it, so to say. We have completed diagnostic studies of the largest 20 banks. Diagnostic studies on the next 40 largest banks are planned for May. Certainly, given the difficult economic situation, banks’ recapitalization won’t be simultaneous. Our capitalization program is designed for implementation over three years. The top ten banks must ensure a capital adequacy ratio of zero by 1 April 2016, while the next 10 largest banks must do so by 1 May 2016. They have to improve this figure to a level of at least 5% by 1 September and 1 October 2016, respectively.
We are also making a determined effort towards diagnostic studies of operations with related parties. Therefore, a comprehensive capitalization program envisages repayment of loans to related parties within three years.
We expect to observe restoration of bank lending in the second half of this year owing to all these actions. However, this will be a gradual process rather than a dramatic surge.
Low bank lending is not a result of the NBU keeping interest rates high, as some may claim. The NBU keeps interest rates high in order to bind excess liquidity and prevent it from putting pressure on the foreign exchange market. The reason for the lack of lending is different.
First, in view of low economic activity, businesses do not have high needs for funds for new investments. Thus, there is low demand for borrowed resources.
Second, many companies have a burden of outstanding debts. The number of problematic debts doubled last year. Also, it is likely that they will continue to grow even during the first half of this year. We designed a three-year program of capital build-up for banks, as they had to make provisions for problem debts and were short of capital. In their turn, banks need to wait for some time until their clientele completes restructuring of their debts before extending new loans to them.
Thirdly, the heavy debt load of businesses is another reason. Currently, the amount of debt is 20 times higher compared to operating profit of enterprises in all sectors except for agriculture and mining. Whereas a comfortable level would be 2 or 3 times. The existing debt burden on an enterprise is so high that it limits their ability to obtain new borrowings. Including for repayment of old debts. This applies to both private and public enterprises.
Moreover, new enterprises in the industries where companies can apply for banking loans rather than venture capital financing are not established.
This means that one should not expect a fast resumption of lending before the banks’ balance sheets are cleaned up in full. Furthermore, this also requires strengthening creditors’ rights protection and creating an effective mechanism for voluntary financial restructuring. To this end, two relevant draft laws need to be approved - 2286a and 3555. In addition, it is extremely important to reform the judicial system and law enforcement bodies.
It is also necessary to finish drafting the Strategy for State-Owned Banks’ Development. It provides that Ukreximbank and Oschadbank will start working solely on a competitive and commercial basis. Oshadbank will focus on SME lending, while Ukreximbank will support foreign trade operations.
We don’t believe that the Ukrainian economy will have strong drivers for growth in 2016. Neither foreign trade, domestic demand, nor investments will show enough growth to significantly stimulate the economy. We are a small and open economy, dependent on global markets. That’s why last week, the NBU revised downward this year’s growth forecast for the Ukrainian economy - from 2.4% to 1.1%.
However, today our priority is to implement the NBU’s mandate - that is to ensure price and financial stability. Last year, headline inflation reached 43%. We expect it to slow to 12% this year. Anticipating your questions, I will answer: indeed, we left the inflation forecast unchanged, despite the outlined risks for the hryvnia rate, and I'll explain why.
In August 2015, the NBU Board approved the Monetary Policy Strategy for the period of 2016-2020, which is currently pending approval by the NBU Council. This document provides a transition to inflation targeting. But in fact, the NBU is already following a monetary policy that could help achieve the inflation targets of 12% at the end of this year, 8% in 2017, 6% in 2018, and finally 5% in 2019.
In particular, we continue to enhance the effectiveness of the main tool for monetary policy, which is interest rates. Lowering the NBU key rate will cause a reduction in the cost of funds in the interbank market. This, in turn, will affect the interest rates of other financial assets, as well as bank loans and deposits, and, ultimately, prices.
Given this ambitious task, the NBU requires solid support from the various Ukrainian branches of power. This primarily means efficient cooperation with the Government.
We have succeeded in reducing fiscal dominance over monetary policy to zero.
In 2014, we had to monetize domestic sovereign bonds by nearly UAH 100 billion to cover the deficit of NJSC Naftogaz. In 2015, the amount was UAH 29 billion. In 2016, this amount equals zero. This is the first year when the deficit of Naftogaz will be zero, and when the Ministry of Finance will not issue domestic sovereign bonds to finance it.
The Government’s recapitalization of state banks is ending without the NBU’s participation. Their capital will be increased through the issuance of long-term government bonds, which the NBU does not intend to monetize.
The Deposit Guarantee Fund’s (DGF) funding needs will be insignificant as the main phase of the banking sector clean-up is completed. In 2015, the amount was UAH 55 billion for DGF financing. Moreover, the DGF entered a new year with balances amounting to UAH 8 billion. Furthermore, we expect the DGF to meet its funding needs using its own resources. According to DGF, sale of failed banks’ assets will bring in UAH 7 billion. These funds will be used both to pay banks’ depositors and to return the NBU’s funds. Still, UAH 16 billion are allocated to finance the DGF if it will be necessary.
So, we see that fiscal policy no longer dominates over monetary policy. This provided the basis for the introduction of inflation targeting. We hope that the fiscal policy of the Ministry of Finance and efficient government management of finances will continue facilitating independent monetary policy. Therefore, during the recent meeting of the Financial Stability Board, among other things, we also discussed the coordination of fiscal and monetary policies.
Also, to ensure price and financial stability this year, a number of draft laws need to be approved. We expect over 20 draft laws to be considered by the Verkhovna Rada. They have already been submitted to the parliament.
I must now recite a proverb: The path “Later" leads to the city “Never”. Let's not waste time. We must accelerate reforms so that we do not to lose the chance that Ukraine has got!
Thank you for your attention!