The financial support provided by international partners helped Ukraine withstand the beginning of Russia’s full-scale invasion and became a significant source of funds throughout 2022. This year, our country will also need continuous financial support. However, it will be difficult for the government to reduce budget expenditures because direct injections of the National Bank of Ukraine (NBU) into the budget must be stopped to meet International Monetary Fund requirements and, at the same time, NBU’ independence.
On Feb. 24, 2022, Ukraine was left with no choice. With delays in the receipt of funds from international partners, the government could not finance the national army and make critical social expenditures without the support of the NBU. The NBU made the difficult decision to buy domestic government bonds, setting a limit of 400 billion hryvnia, Ukraine’s national currency. This became the foundation for a continued valiant struggle against the Russian aggressors.
However, like every remedy, taking this step has had adverse side effects, which appeared when monthly issuance volumes were at their peak in the second quarter of last year. This resulted in a significant increase of pressure on the foreign exchange market and international reserves. The key suppliers of dollars and euros to these reserves were Ukraine’s Western partners who supported us with grants and loans.
In response, the NBU was forced to raise its interest rates significantly, adjust the exchange rate and tighten currency restrictions.
The set of these measures, together with the reduction of issuance volumes and the increase in foreign aid inflows improved the situation in the foreign exchange market and laid the foundation for the restoration of international reserves. This had a positive impact on inflation, which slowed down at the end of the year.
Ultimately, despite all the apocalyptic forecasts of the consequences of the NBU’s tough steps and the destruction of Ukraine’s energy infrastructure in the fourth quarter, the economic decline last year was much less than expected.
However, even when the volumes of issuance became more moderate, and its effects became more controlled and offset by the above-mentioned set of measures, another important side effect of monetary financing of the budget appeared.
With access to the central bank’s resources, the Ministry of Finance lost interest in the development of the domestic debt market and actually refused to place domestic government bonds on market conditions. For example, in the second half of 2022, the volume of Ukrainian domestic government bonds owned by banks decreased by 53 billion hryvnia.
The bet was mainly on the patriotism of investors at low rates of return and, of course, on the bond issue.
Apparently, some believed that during a full-scale war, it is possible to abandon the domestic debt market and rely on the issuance only. However, when the Ministry of Finance has access to 30 billion hryvnia a month for issuance, why should it make additional efforts to attract resources from the market?
Still, it is high time to make every effort to build a liquid secondary market for domestic government bonds. This would allow raising the level of rollover and balance the portfolios of domestic government bonds.
What do we witness instead? As a consequence of the NBU’s dependence on the Ministry of Finance and the unwillingness to work at attracting resources on market conditions, we have a slow monetary transmission, which resulted from the increase of the discount rate in June.
I am sure that if the Ministry of Finance had refused funding the budget during the last months of 2022 and had borrowed more from the market, offering market rates, the NBU would have had more opportunities to discount rates.
After all, issuance should be the last option to finance the budget deficit, not the first. However, there is still light at the end of the tunnel. Thanks to outside intervention, namely the IMF, we have a different option.
In the new IMF monitoring program, the recovery of the domestic debt market is one of the central issues. Although the possibility of domestic bond issuance remains, unlike last year’s practice, the IMF recommends that it be used only when other instruments are no longer available. Thus, according to the IMF report, monetary issuance financing will be possible for the Ministry of Finance only when external financing is less than proposed and the rollover in the domestic market exceeds 100%.
In other words, the Ministry of Finance will be able to count on the NBU funds only if it exhausts all the possibilities of the domestic market in the absence of the proposed international support.
Further to that, the Ministry of Finance would at least slightly reduce the pressure on the NBU and put an end to the encroachment on its independence.
Although, as for me, it would be possible to set more ambitious targets than 100% rollover, especially given the level of liquidity surplus in the banking system.
Eventually, I expect that outside support for Ukraine will be adequate and the Ministry of Finance will be able to jump over its head in the domestic market so that the country can do without monetary financing this year. Such a chance is real, provided that everyone in the country is interested in making use of it.
Kyrylo Shevchenko is the former head of the National Bank of Ukraine.
Submit a letter, of no more than 400 words, to the editor here or email [email protected].