To peg or not to peg: A suitable exchange rate regime for the Ukrainian hryvnia in times of war


December 23, 2022

In his recent article “No Fear of Floating for the Hryvnia” Mr. Gorodnichenko called for limited exchange rate flexibility of the Ukrainian hryvnia, enumerating several problems with its present peg to the US dollar. For instance, he argues that the nominal hryvnia depreciation in July was not sufficient to preserve the competitiveness of the economy, largely because of the outdated peg to the dollar which has in the meantime appreciated significantly vis-a-vis the currencies of Ukraine’s main trading partners. It also laments the political travails which accompany a change in the level of the fixed exchange rate in the current environment and which make the regime inflexible in responding to changing economic circumstances. He also suggests that preserving the foreign exchange (FX) reserve cover should be paramount for the current stage of the war and points out that the fixed exchange rate is in any case a temporary solution as Ukraine will need to revert to flexibility and Inflation Targeting (IT) sooner or later.

These are good points and have recently been raised by other analysts regarding the current exchange rate policy in Ukraine. Nevertheless, these critical voices do not quite explain why a flexible exchange rate should be a preferred arrangement at the current juncture, and fail to credit the present regime for its success in maintaining monetary stability in Ukraine since the beginning of the full-scale war. Nor do they propose any alternative nominal anchor for the war economy.

First, in highlighting the virtues of a flexible exchange rate in balancing market forces, the critics of the present exchange rate policy fail to appreciate that there is practically no unified FX market in Ukraine to speak of today. The National Bank of Ukraine (NBU) is the main supplier of FX to banks and the rest of the economy, the interbank market is practically non-existent, and the cash market is under heavy influence of NBU regulation. A vast majority of FX transactions are trade-related, not financial, transactions. There is therefore not much demand and supply equilibration that a flexible exchange rate could achieve. Making the exchange rate more flexible would therefore hardly make the exchange rate market-determined, unless some controls are relaxed and private sources of FX supply are restored. A flexible exchange rate would not help much in shoring up competitiveness of Ukrainian production either, considering the current energy and production constraints, and physical disruptions of basic logistical channels (e.g., for grain exports).

Second, the critics often hail a flexible exchange rate as a safeguard against the drainage of FX reserves whose preservation is critical for the success of long-term war efforts. However, currently, much of the drainage is simply unavoidable, financing imports critically important for continuing the war and production in the rest of the economy. Much of disposable consumer import demand has already been tamed by falling incomes and depreciation. Financing of the needs of refugees outside of Ukraine will also continue. It is not clear how a flexible exchange rate could materially help in reducing the amount of FX outflows. In contrast, a flexible exchange rate, if not properly executed, carries the risk of more FX drainage by damaging the credibility of the regime, sowing seeds of distress, and raising devaluation expectations. Demand for FX assets by the population and businesses would be a natural response to the un-anchoring of expectations.

Third, a flexible exchange rate is also viewed as a way of eliminating the FX-cash market premium which distorts the allocation of resources. However, the premium results not from the fixed exchange rate per se, but from capital controls designed to prevent FX outflows. Most of the critics of the present policy admit that capital controls will need to remain in place even if a more flexible exchange rate regime is adopted. As long as they are in place, there will always be a case for a cash/black market premium.

Fourth, in calling for a regime with limited exchange rate flexibility, the critics make reference to how well a similar regime functioned during the Covid crisis. However, that comparison is misleading – the financial system, the monetary transmission mechanism and market forces functioned fully back then and there were no substantial capital controls. Moreover, a “managed float” is difficult to implement, and is far from a simple solution.  Under the present structural deficit of FX supply in the market, any managed float arrangement would result in a forced, artificial volatility of the exchange rate, not reflecting market forces and mechanisms.  

Finally and most importantly, the critics of the present policy do not propose any alternative nominal anchor for the war economy that could credibly replace the role the fixed exchange rate plays in Ukraine today as “a measure of inflation, purchasing power, and the overall health of the economy.”

The fact is that the present regime has served the Ukrainian economy well in extremely difficult conditions. Crucially, it has helped safeguard monetary and financial stability since the beginning of the war. Inflation has increased but is in check and not far from levels of some other European economies. The banking system continues to operate. Domestic residents as well as refugees have access to their savings. The cash FX market is functional, and the cash market premium is not large given the circumstances. Paul Krugman, the Nobelist, in a recent op-ed had this much to say about the inflation numbers in Ukraine: “That’s all?”  

Mr. Gorodnichenko and others make a very good point that the fixed exchange rate arrangement is in any case a temporary solution and Ukraine will need to revert to exchange rate flexibility and IT in the future. A flexible exchange rate will better underpin the reconstruction and structural changes expected in the Ukrainian economy along its EU transition path. However, targeting inflation seems overly ambitious in the present circumstances of a broken interest rate transmission channel. The credit channel of transmission will remain frozen because of the risks of the war, and fiscal policy will determine much of the investment for some time to come. Capital controls, not interest rate policy, will continue to govern practically every aspect of FX movements for the foreseeable future.

We fully agree that it will be important not to get habituated to the current regime or maintain it for too long – fixed exchange rates can lead to misallocation and are addictive. Nevertheless, we question if now is the right time to abandon the peg and whether the benefits of exchange rate flexibility outweigh its costs in terms of un-anchoring expectations and potential financial and monetary instability. In our view, such risks are too high now and the conditions are not yet in place to reap the benefits of a flexible exchange rate. We do not operate in a “normal” market economy environment.

We firmly believe that whatever regime is chosen, it should help the NBU in upholding monetary and financial stability. Such stability is easy to lose and difficult to gain. It would therefore be imprudent to put it at risk unnecessarily. The NBU has good control now, using the combination of an exchange rate commitment, high interest rates, and capital controls. With lending activity constrained by the realities of the war, the fixed exchange rate commitment is the most transparent and effective tool that the NBU has to preserve nominal stability. High interest rates are a complementary instrument working through savings decisions. At least for now, we believe this is a better solution than an eclectic managed-float kind of regime without a clear nominal anchor for expectations.