The bright side of Ukraine’s government crisis

On January 15, someone leaked a recording of a meeting between Ukrainian Prime Minister Oleksiy Honcharuk and key economic policymakers in which Honcharuk appeared to criticize both his own and President Volodymyr Zelensky's knowledge of economics. But Zelensky refused to accept the prime minister's resignation. In fact, the mini-crisis revealed a qualitative improvement in the state of the Ukrainian economy.

Of course, it is strange for Ukrainian reformers seemingly to forget that they are being followed and recorded – whether by Russian security services or anti-reform oligarchs. What is more striking, however, is the subject of the leaked recording.

Three years ago, in late 2016, Ukraine's prime minister, central bankers, and finance minister were discussing how to take over the country's largest bank, PrivatBank, which had been looted by its shareholders (the takeover eventually cost Ukraine about 5% of its annual GDP).
Nationalizing PrivatBank was not easy. Besides considerable technical skills, it required genuine bravery: the bank's major shareholder, Ihor Kolomoisky, had publicly threatened policymakers with retaliation. And because PrivatBank accounted for almost half of Ukraine's retail banking system, policymakers also faced the challenge of maintaining continuity of payments during the busy holiday season.

Although the state took over the bank without major disruptions, several of the leading policymakers involved have since left the country, fearing for their safety. Last year, for example, former National Bank of Ukraine (NBU) Chair Valeria Hontareva was hit by a car in London, and her house near Kyiv was burned down.

By contrast, the discussion that was leaked on January 15 was devoted to the issue of the strong hryvnia. In a remarkable turnabout, the NBU is now being criticized on the grounds that inflation is too low and the currency is too strong.

Five years ago, the hryvnia lost half its value, and annual inflation was above 40%. The NBU – under the leadership of Hontareva and her successor Yakov Smoliy – adopted an inflation-targeting framework and promised to bring annual price growth down to 5%. This target was eventually achieved in December 2019, when year-on-year inflation fell to 4.1%.

This multiyear process required a conservative interest-rate policy. In mid-January, key policy rates – the main subject of the leaked discussion – were indeed very high, at above 9% in real (inflation-adjusted) terms. Rates would have to come down, the policymakers said, once the market accepted the credibility of the NBU's inflation-targeting framework. Two weeks later, on January 30, the NBU lowered a key interest rate by 2.5 percentage points to 11%, and announced that it aims to reduce the rate to 7% by the end of 2020. With annual inflation at 4-5%, that would mean real interest rates of 2-3% a year from now.

The hryvnia's excessive strength – it appreciated by more than 20% against the euro in 2019 – reflects an influx of foreign capital. Under the inflation-targeting framework, the hryvnia's exchange rate is flexible, and every additional billion euros coming from abroad causes the domestic currency to appreciate. That in turn results in higher imports and lower exports until the balance of payments equals zero. This is normal.

Critics argue that the benefits of short-term financial flows (attracted by high hryvnia interest rates) are limited, and that Ukraine should instead try to attract long-term foreign direct investment. But FDI also increased in 2019, with third-quarter figures (the latest available) showing 50% year-on-year growth. This spike is partly due to the resolution of political uncertainty following the appointment of a new government after last July's parliamentary election, but FDI data for the first three quarters of 2019 still show double-digit annual percentage growth.

A strong hryvnia could potentially slow economic growth, as domestic producers find it harder to compete with more affordable imports. But annual GDP growth in the second and third quarters of 2019 was above 4% – the highest rate since late 2016 and much higher than growth in the European Union and Russia, Ukraine's two key trading partners. Moreover, the International Monetary Fund, which recently signed a long-awaited staff-level agreement with Ukraine, foresees this pattern continuing in the coming years.  

In addition, a stronger hryvnia makes it easier for Ukraine to repay its dollar-denominated debt. This is important, because the country's 2015 debt-restructuring deal calls for much larger repayments if GDP growth is above 3%, and especially if it exceeds 4%.

But it is too soon for Ukraine's government to celebrate these macroeconomic successes. Although the authorities have made major progress on privatization and have improved the corporate governance of state-owned firms and banks, the reform agenda is far from completed. The anti-corruption program is moving ahead more slowly than expected – and it remains unclear whether the government can explicitly distance itself from the oligarchs (who retain substantial political power because they control all major media). Land reform is still being finalized, and has already been watered down. Similarly, tax and labor-market reforms – which are critical for reducing the size of the informal economy and boosting competitiveness – are still being formulated.

Ukraine's recent political storm highlighted the extent of the country's economic progress in recent years. But the new government still faces a difficult road ahead.

Sergei Guriev, a former chief economist of the European Bank for Reconstruction and Development and former rector of the New Economic School in Moscow, is Professor of Economics at Sciences Po.