Since the beginning of the year, the hryvnia has risen by 7% to the dollar, showing unprecedented stability, becoming one of the best currencies in the world in terms of strengthening tempo. Moreover, for the first time, this year hryvnia exchange rate does not show its usual seasonality, when it grows in the first half of the year and devaluates in the second one. But it is too early to be happy about these trends, because the reasons that led to such a revaluation, as well as the strengthening of the national currency itself, poses some risks for public finances.

Beneficial markets and generous investors

The vast majority of currency that gets to Ukraine comes from exports of commodities – grains and metals. And this year we are very lucky because once again Ukraine set a historical record for grain exports – 49.7 million tons that is 10 million tons more than the last year. In particular, wheat exports amounted to 15.5 million tonnes, corn – 30 million tonnes, barley – 3.6 million tonnes, rye – 89 thousand tonnes. At the same time, now, grain prices in the world markets are high and will rise, due to the fact that southern EU countries have lost part of their harvest due to this year’s abnormal heat. Record harvests of corn and sunflower have led to an increase in the growth rate of physical volumes not only of the exported oil but also of the oilcake, which is a valuable animal feed in Asian countries. We have also increased our exports of meat, including chicken to Saudi Arabia, which earlier this year restricted exports of these products from Brazil.

Also in the last year, prices for iron ore, which is another major export of Ukraine, have doubled. In January-July, Ukrainian enterprises sent 23.3 million tonnes of ore worth 2.09 billion USD. Exports of mechanical engineering products have also grown thanks to the shipments of our freight wagons to neighboring Belarus.

These factors have directly affected the volume of currency in Ukraine, increasing its supply and strengthening the hryvnia. However, the national currency hiked up not only due to export victories. Its revaluation was directly influenced by the rapidly growing demand of non-resident investors for our government bonds. At the beginning of the year, non-residents owned only 1% of Ukrainian government bonds, while by July their share had increased to 9%.

According to the Ukrainian Ministry of Finance, non-residents increased their government bonds portfolio for seven months of 2019 in 13.6 times from 6.3 billion UAH to 86.4 billion UAH, which was facilitated by macroeconomic stability, prudent fiscal and monetary policies, and Ukraine’s accession to the international central securities depository Сlearstream, which has greatly facilitated the process of buying our securities abroad. It is clear that government bonds are bought by non-residents for currency, which again increases its domestic volume and strengthens the hryvnia. Whether investors will be interested in the future will depend on the predictability of Ukrainian politics and many other factors, but their demand for our government bonds remains stable, as the NBU’s high-interest rate together with tax privileges make Ukrainian securities very attractive. The yield on Ukrainian bonds is about 15-17% per annum, it makes them one of the most expensive in the world.

However, analysts warn that the sale of bonds is both an opportunity to attract investment and a risk of losing exchange rate stability. As a matter of fact, bonds are a debt instrument. Their buyers lend funds to Ukraine, expecting to get back not only the borrowed sum but also a considerable interest. Excessive sale of government bonds leads to an accumulation of debt load, which Ukraine can hardly afford, given that debt servicing is already our largest object of expenditures in the State Budget. The uncontrolled accumulation of debt in itself affects the financial stability of the country, even more in times of crisis.

If Ukraine’s relations with international financial institutions suddenly deteriorate, a military confrontation with Russia intensifies, diplomatic relations with leaders of influential states get tense, or another domestic political crisis looms, non-residents will start to sell bonds en masse, prompting a reverse process – hryvnia devaluation.

Stunned Finance Ministry

The Ministry of Finance of Ukraine also does not share this widespread optimism about hryvnia’s price increase, even though a strong hryvnia saves the government spending on debt servicing. Significant payments on public sector external liabilities in May and the retention of capital outflows by the private sector led to a net outflow of capital into the financial account as a whole in January – May. As the latter exceeded the current account surplus, the balance of payments was brought to the deficit ($ 0.5 billion in January-May). This, together with payments on IMF loans, led to a temporary decline in international reserves as of the end of May (up to $ 19.4 billion or 3 months of future imports). However, the government’s involvement in the international capital market and the inflow of non-residents’ funds in hryvnia based government bonds have offset significant public sector payments on external liabilities. As a result, by the end of June, the foreign exchange reserves of Ukraine, despite peak debt payments, were close to the level of the beginning of 2019 – 20.6 billion USD.

But the downside of the strong hryvnia is the chronic underperformance of the State Budget revenue. Its “import” components – customs duties and VAT on imported goods – depend directly on the exchange rate, the higher it is, the more you can replenish the treasury. According to the operative data of the State Treasury on the execution of the budget for seven months, the revenues of the General Fund of the State Budget amounted to UAH 584.1 billion, which is 97.4% of the list. According to the plan VAT revenues from goods imported into the territory of Ukraine were 88.8% fulfilled, revenues from customs duties – 90%. As a result of replenishing the General Fund of the State Budget in January-July, it was fulfilled with a deficit of 1.1 billion UAH.

In its budgetary calculations, the Ministry of Finance set an average annual rate of 29.4 UAH per dollar, respectively, at a rate of 25-26 UAH per USD the Ministry of Finance cannot implement its plans. Worst of all, this situation is repeated for the second year in a row, but neither the NBU nor the Ministry of Finance made any attempt to adjust its own exchange rate forecasts. Only now, the Minister of Finance O.Markarova has finally asked the National Bank to clarify the hryvnia exchange rate for at least 2020 so that more precise exchange rate forecast could be inserted into the draft State Budget next year, and the Ministry of Finance could break out of the self-made trap.

The fact is that the increase in the volume of government bonds placement is largely related to the need to finance the State Budget deficit. The Ministry of Finance not only responds to investors’ demand, but it is also driven by the objective needs of funding budget expenditures. Since the beginning of the year, 255.3 billion UAH was raised from the sale of securities to cover this deficit: 164.1 billion UAH worth bonds were denominated in hryvnia, 3.2 billion USD and 0.2 billion EUR were denominated in foreign currency. But as we noted earlier, excessive demand for Ukrainian government bonds is one of the factors in strengthening the hryvnia, which in its turn leads to an increase in the budget deficit and an increase in bond sales to cover it.

It is clear that attempts to get out of this stalemate in one way or another will lead to a slight devaluation of the hryvnia and by the end of the year, it is likely to weaken by 1.5 – 2 hryvnias. But if we avoid global political risks, continue cooperation with the International Monetary Fund, and correct mistakes in forecasting the exchange rate for the next year, then, obviously, we will still be able to see another revaluation of the hryvnia in the first half of next year. Of course, the NBU has taken a course on reducing the interest rate, which in the future will lead to a decrease in the yield of our government bonds, but the regulator’s plans are too long-term. The discount rate could drop to 16% by the end of this year and up to 14% the next year. Of course, this will reduce the yields of our government bonds, but given that they are now maybe the most profitable among the countries in our group, the demand from investors will not significantly affect it, giving the national currency additional opportunities for further growth in the medium term.

By Valentyna Yushchenko

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