"Given Ukraine’s substantial foreign exchange reserves, this is in principle a good time for the country to move to a more flexible currency regime," says Martin Raiser, economic adviser in the World Bank country office for Belarus, Moldova and Ukraine in Kiev. "Assuming the current political uncertainty is quickly overcome, Ukraine has an opportunity to introduce more flexibility from a position of strength and so problems are less likely."
The hryvna is pegged to the US dollar and its value has been rigidly maintained in a narrow band between 5.00 and 5.06 since May 2005. The average January exchange rate was 5.0495. As a result, the hryvna has not been allowed to weaken against the dollar to the same extent as other eastern European currencies, such as the Czech koruna. Over the past five years, the koruna has gained 20% against the dollar, while the hryvna has risen by just 5%.
This has come at some cost to the country and has inevitably resulted in an accumulation of foreign currency reserves. By the end of 2006, these stood at more than $22.4 billion. However, there is debate about whether politicians are just paying lip service to recommendations of advisers, such as the World Bank. On one side are those people who believe that currency stability is good for locals and for economic growth for incoming investors and local exporters. On the other are advisers at the IMF and World Bank, which continue to try to push for a managed floating rate and a loosening of the central bank’s control.
"The long-standing position for the IMF is to suggest that Ukraine gradually move towards a more fluctuating exchange rate," says Jeffrey Franks, senior resident representative of the IMF in Ukraine. "Although the currency peg has worked well in the past to help anchor expectations of the economy, as they came out of the 1990s’ crisis time, we think that it has now outlived its usefulness,"
But the path to a more flexible exchange rate is complex. One suggestion is to move to a basket of currencies, including the euro, especially as Ukraine is encouraging trade with the European markets as talks start for EU accession. Also, there remain fears about sudden gyrations if greater liberalization is allowed. In April 2005, when the central bank attempted to loosen the peg, the currency rose by 5% against the dollar in its first 24 hours of trading, resulting in uproar from exporters and dollarized households alike.
Since the 1998 crisis, locals have tended to continue putting their savings into US dollars, rather than trust the hryvna. They have kept these savings "under the bed" rather than placing them on deposit with local banks. "The current level of dollarization isn’t good for the economy," says Raiser. "It complicates monetary policy management and increases risks in case of an external shock. I think that if the peg was widened it could be the trigger that would make people realize that the exchange rate isn’t a one-way bet and therefore they would start to move away from the dollar."
Dollar weakness has resulted in inflationary pressures. In December 2006, inflation averaged 11.6%. For 2007, the prediction is that inflation will come in at around 10%. "At the moment wages are depreciating every day because inflation is so high. There is a trade-off – you can get lower inflation but risk a sharp appreciation of the currency. I think the inflation risk is stronger than the effect an appreciation will have on the economy overall," says an analyst in Kiev. Ultimately, this may be what drives greater currency liberalization.