How central bank’s policies undermine a troubled currency and exacerbate recession: the case of Ukraine

This is a short version of the article published by the journal Studies in Applied Economics of Johns Hopkins University’s Institute for Applied Economics, Global Health, and the Study of Business Enterprise. Please read the full text here:

There has been an ongoing academic and public debate as to whether central banks in developing countries with weak and corrupt governance live up to public expectations. In other words, whether they do more good than bad to the economy, households and businesses, especially during the crisis and various shocks hitting the economies. It may sound as a paradox but central banks, at least in some of the emerging market economies, can be more detrimental to financial stability than any exogenous or indigenous shocks altogether.

Professor Steve Hanke from Johns Hopkins University, a well known authority on troubled currencies and monetary policy and advisor to many governments, claims that “the Achilles’ heels of these countries are their crummy little central banks”. He believed that the central banks’ poor track record made clear that they could not be trusted to make prudent decisions, that they were susceptible to political pressures and poor judgment and tended to do more harm than good. [1] In this respect, it is difficult to disregard two arguments: one put forward by Nobel prize winner Joseph Stiglitz that Bretton Woods institutions provide loans to developing countries to force them open domestic markets and public wealth for looting by multinationals, [2] and the other made by prof. Richard Werner, a renowned author of the quantitative easing concept, who argues that in some cases “central banks intentionally impoverish their host countries to justify economic and legal changes which allow looting by foreign interests”. [3]

So, what does the most recent example of Ukraine, a country torn by deepest economic recession, show?

In the last two years, ongoing military conflict in the country’s East, deep economic recession and the downfall of national currency have become biggest shocks to Ukraine, its households and business enterprise. As a result, the country, one of the largest in Europe’s geographical centre, has quickly evolved into a geopolitical spot of extreme instability where internal and external shocks can trigger “snow slide” effects. Stakes are rather high. If Ukraine overcomes, both politically and economically, it may become a kind of Europe’s «Mannerheim» wall and possibly another European “tiger”. If it fails, already weakened dramatically by the undeclared war, domestic economic strife and persisting political corruption, the country could become, for many decades onwards, Europe’s only “hot spot” and biggest political and financial liability for the West. In such a critical situation, the only way out would be a proper implementation of genuine economic rescue and reform measures underpinned by a consolidated and well coordinated external assistance. And yet such prospects have recently been thrown into great doubt, mainly due to a continuing state capture by oligarchs and regional “elites”, growing domestic instability and rampaging political corruption.

Whereas a well coordinated and internationally supported implementation of comprehensive and genuine market reforms, including complete “de-oligarchization” and eradication of corruption, profound fiscal consolidation, streamlining of government expenditures and bureaucracy, complete overhaul of legal and judicial systems, strengthening private sector competitiveness, should be the right answer to Ukraine’s economic woes, important role in this process would have to be played by adequate and balanced monetary policy, effective foreign exchange regulation and transparent commercial bank supervision. Resulting financial stability, including predictability of foreign exchange movements in export- and import-dependent economy is a main pre-requisite for any sustained economic recovery.

As these functions in Ukraine are vested with its central bank, National Bank of Ukraine, the logical questions arise: Has the institution been up the standard and performed these functions well in the recent years? And if not, what were the policy miscalculations and implementation deficiencies? What other emerging market central banks can learn from these mistakes in order not to aggravate performance of troubled currencies and affect economic growth?

Ukraine’s central bank has had a mixed track record, of both commendable successes and regretful failures. In 1996, it attracted international acclaim for the «textbook» currency reform and exemplary introduction of Hryvna, for efficient conduct of hyper-inflation policy and resulting sustained financial stability. By early 2000s, the NBU had in place a well-developed, even by European standards, infrastructure for monetary policy and bank supervision. The Bank, again, coped well with financial instability during the 2004 “Orange revolution” and paved the way for subsequent 12% annual economic growth.

Against these successes, the NBU top management appointed during 2014 presided over serious policy miscalculations and misjudgements that dramatically undermined already troubled national currency, allowed for double digit galloping inflation, aggravated systemic bank sector crisis, undercut economic recovery prospects and completely destroyed public trust towards this important institution. Confirmation of these conclusions has been recently provided in various international publications, including Global Finance magazine, and by important country competitiveness ratings. [4] The WEF’s Global Competitiveness Report 2014-2015 ranks soundness of Ukraine’s banks as the worst in the world (140/140) and quality of public institutions in general as one of the worst (130/140). [5] Obvious institutional weakness in monetary and bank supervision policies has been accompanied by numerous mass media allegations about corruption and power misuse among the regulator’s top officials. [6]

During 2014-2015, Ukrainian currency had been massively hit by devaluation that reached almost 300%, which, due to a pass-through effect, gave strong momentum to so-called devaluation-inflationary spiral. Sharp increases in household utilities tariffs served as additional boost to accelerating inflation. In April 2015, year-on-year inflation topped 60%, the highest level since 1996 (fig. 2).

The start to unprecedented freefall of Hryvna and galloping inflation was given in early 2014, when the country’s central bank, under informal “advise” of the IMF that was preparing a decision on providing EFF loan to post-Yanukovich government, fully liberalised UAH exchange rate regime and committed to keep its refinancing facility fully open for commercial banks. In fact, these two policy actions were conditions precedent for the loan approval in March that year. There would be nothing wrong in these IMF conditions in normal circumstances as fixed exchange rate, against the background of continuous current account deficit, led to depletion of forex reserves and weak competitiveness for the exporters.

But those policy decisions were being made at the time when it was already evident that annexation of Crimea, spreading violence and military tensions in Donbas were creating unmanageable risks for economic and financial stability and that liberalisation of exchange rate and free access for banks to central bank liquidity would enormously intensify those risks and inflationary pressures rather than stabilise the banking system. This happened mainly due to the fact that free access to liquidity was used by poorly governed banks not so much to stop the run on their deposits as to increase speculative demand for hard currency on the forex market and thereby contribute to faster depreciation.

When it was clear, by autumn of 2014, that either complete bank holidays with freeze on deposits or massive forex interventions would save quickly depreciating national currency, the central bank, continued to act in the business-as-usual manner and, guided by the EFF conditionality, compounded devaluation pressures by regularly acting as a buyer of foreign currency on already speculative domestic forex market. The regulator’s lack of independent judgement and anti-crisis strategy were contributing to problems rather than addressing them. Incidentally, the IMF’s second tranche, which was due in autumn 2014 and which could have stopped the Hryvna freefall, was delayed until next year due to political uncertainty.

It’s worth to mention that devaluation and inflation unravelled against the background of downward trends in monetary aggregates and real wages. In 2015, negative rates of growth of all monetary aggregates, underpinned by restrictive fiscal policies, reached a historic maximum.  In other words, galloping inflation was accompanied by acute “money hunger” in the real sector. This type of inflation has atypical cost inflation nature. So classical anti-inflationary methods of cooling down demand wouldn’t be effective to meet the challenge.

A key problem in this case wouldn’t be so much excessive money supply but rather deficient management of monetary emission, i.e. wrong choice of channels, instruments as well as parameters of interventions. The core of the problem was that productive emission (the one with positive spill-over effects for the real sector) was highly insufficient while non-productive emission (the one that contributed to growth in asset bubbles) – too excessive. On one hand, unjustified expansion by the regulator of its overnight refinancing loans (standing facility) led to surge in forex arbitrage and additional speculative pressures on Hryvna (fig.4).

On the other hand, the NBU with its hands stimulated “financial bubble” by unwinding unprecedented sales of its own deposit certificates with high yields funded by surplus emission. These certificates, being rather profitable and risk free instruments, further demotivated commercial banks in their lending activity.

In August 2014, foreign exchange restrictions and capital account controls were substantially strengthened by the regulator, including introduction of 100% mandatory sale of export forex receipts and forced conversion of household currency transfers from abroad. The NBU’s rationale for introduction of further restrictive policies, which was to increase supply of foreign exchange and stabilize exchange rate, didn’t materialise.

On the contrary, the measures, accompanied by unacceptably poor public communications, led to a whole new range of negative effects: dramatic fall in export receipts (as exporters reacted to restrictions by hiding revenues offshore), surge in devaluation expectations, squeeze in official forex market activities, growth in shadow forex operations and general loss of confidence towards the regulator’s agenda. Balance of unrequited transfers, positive for many proceeding years, had dramatically fallen, official inter-bank and cash foreign exchange markets came to a standstill, while “grey” and “black” forex operations, so characteristic of early and mid-1990s, returned to the market and abounded. “Puzzled” by such market reaction, the NBU reversed a few months later: lowered mandatory sale requirement to 75% and cancelled mandatory sale of household currency transfers. But this policy correction failed to restore public trust and diminish inflationary and devaluation expectations.

The “miscalculations” in the NBU policy mix at that period of time stand out very clearly:

  • on one hand, controversial massive refinancing credit lines to selected banks, some of which later were declared insolvent and liquidated by the State Deposit Insurance Fund, contributed to further fragmentation of the inter-bank market and irreversibly undermined household and business confidence;
  • on the other hand, the focus of monetary policy had eventually shifted towards providing shorter term maturities and towards unprecedented expansion, from November 2014 to March 2015, of overnight refinancing loans to banks (fig.4). Obviously, such “super” short refinancing instrument couldn’t address the growing problem of the run on bank deposit. On the contrary, it created conditions for frequent speculative attacks against national currency;
  • very chaotic and illogical interest rate policy also encouraged the banks to lean heavily in favour of open-access standing facility operations (overnight refinancing). In this context, a characteristic episode took place in July 2014 when a “routine” NBU discount rate increase triggered increase in overnight interest rate (from 14.5 to 17.5%) that in a few days was lowered to 15%, then stayed at this level for 30 days and again shot up to 17.5%. This level of overnight rate was supported by NBU for almost six months (?!) despite growing devaluation and inflationary pressures as well as NBU discount rate increase. In December 2014, NBU overnight refinancing rate dropped below the level of inter-bank overnight interest rates, and that was a clear departure from principles of optimal liquidity policy management. A very dangerous financial destabilizer under the conditions of uncontrollable devaluation and huge inflationary expectations!

In other words, Ukraine’s central bank had willingly transformed itself into a massive-scale last resort supplier of super short-term liquidity that could NOT by definition address the problem of bank deposit flight. Such interest policy led to unprecedented growth (500%) in volume of overnight refinancing in just one month at the end of 2014. Moreover, the regulator provided free access to high volumes of super short-term liquidity at negative real interest rates to those banks whose instant liquidity coefficients exceeded the normative levels by more than 6-7 times. Such prudential “constraint” encouraged above banks to use the central bank funds as a “cushion” for speculative arbitrage against failing national currency. As fig. 4 shows, devaluation pressures grew exponentially during such periods. Devaluation trend was halted only after the sharp reduction in the volumes of overnight open market operations by NBU as well as introduction of further dramatic foreign exchange restrictions that particularly affected importers and businesses by substantially undercutting imports of goods, services and business inputs.

And, despite the obvious logic of higher interest rates as one of anti-devaluation measures, the central bank kept its interest rates on open market interventions unchanged during the peak pressures on the forex markets. And only three months later, in early March 2015, when Hryvna slightly appreciated, the Bank management approved a decision to raise a discount rate to 30% and overnight rate – to 33%. Again, timeliness and adequacy of the regulator’s policy reaction comes into question. On top of all this, such late and inadequate interest rate measures have been accompanied by active expansion of central bank’s liquidity sterilisation operations conducted through the sale of NBU high-yield deposit certificates. In 2015, average monthly interest rate for this instrument reached the level of bank lending rates and thus demotivated banking sector for lending to the real sector.

During 2014, volumes of liquidity sterilisation operations by the NBU amounted in volume to the country’s GDP – an unprecedented record in the history of Ukraine’s monetary policy! And all this was against the background of massive flight of bank deposits and bank liquidity crisis. These disproportions are also characteristic for 2015 when the NBU sales of deposit certificates exceeded the GDP level.

In other words, instead of facilitating the consolidation of inter-bank market and its “business-as-usual” operation, instead of stimulating bank lending to corporate sector, the central bank with its own hands has created and inflated a risk-free high-yield instrument (overnight NBU deposit certificate) that created for the state a super costly “financial bubble” – a spiral of structural liquidity surplus propped by obstacles for the banks to expand credit operations. In fact, instead of monetary regulator role Ukraine’s central bank assumed the role of inter-bank financial broker thus distorting competition and allocation of liquidity in the banking system.

On top of this, in 2014, Ukraine’s central bank had become the single most important investor into the domestic public debt – the scope of budget deficit monetisation grew exponentially and exceeded in volume the monetisation for all proceeding years altogether. Despite evident and substantial bank liquidity disproportions, this instrument was used by central bank to predominantly finance deficits of the public sector enterprises, mainly the state-owned oil and gas holding NAK “Naftogaz”. On the whole, this practice had continued throughout 2015 when holdings of T-bills on the central bank’s balance sheet grew by almost UAH 72 billion exceeding the total of UAH 390 billion. [7] By the end of 2015, the share of T-bills in the central bank’s asset portfolio reached a historical 75 per cent level (fig. 18).

Deep and sustained devaluation of Ukraine currency triggered a sharp increase in Hryvna-denominated external debt, enhanced real risk of the country’s default, caused a massive deposit flight from the banks, worsened banks’ toxic asset problems and distorted radically bank balance sheets. All this provoked a full scale banking crisis accompanied by a sharp drop in household real incomes (by more than 30%) as well as increased social and political tensions.

Several key lessons can be drawn for other emerging market economies from Ukraine’s central bank performance.

First and foremost: genuine and true independence of the central bank’s top management from domestic politics and control of “big money” as well as proper corporate governance are an absolute must for emerging economies plagued by institutional corruption, profound state capture by corporate “moneybags” and deeply vested political interests. [8]

In Ukraine’s case, the obvious institutional deficiency lies in the constitutional and legal framework governing the NBU top appointment, who, as a rule, is chosen among loyalists, former business partners or associates. And such a system creates a fertile ground for using central bank as an instrument for insider windfall profits through foreign exchange arbitrage, huge volumes of proprietary T-bill operations, for using bank supervision as anti-competition tool or bank asset stripping facilitator, saying nothing about ample opportunities for illegal profiteering from in-house procurement schemes. In Ukraine, non-transparent, biased and allegedly corrupt central bank supervision, on the one hand, «cleaned up» more than a third of banking system (63 banks) but, on the other, contributed to much deeper mistrust towards the regulator, further financial instability and fast deleveraging in the real sector economy.

Most recent events in Ukraine’s parliament when no-confidence vote to discredited and highly unpopular government was torpedoed by MPs loyal to the head of state and to most powerful oligarchs led to gruesome conclusions made in the Foreign Policy magazine: “…after two years of empty promises, neither Ukrainians nor their foreign partners should be satisfied. In Ukraine, it doesn’t matter who runs the government or the General Prosecutor’s office. …the alliance of oligarchs and corrupt officials will stand strong…” [9]  And it is, indeed, the alliance of top office holders with oligarchs that in reality shapes the hidden agenda of the central bank. Something that is incompatible with the whole idea of central bank as an independent regulator and credible monetary policy maker. Similar situations might create for any emerging economy irreparable financial and reputation risks, especially when a weak national currency fully reflects a country’s institutional immaturity and dwindling international competitiveness.

A logical question arises: why the corporate governance (i.e. supervisory board, the Council of the National Bank of Ukraine) that has existed at Ukraine’s central bank almost since its establishment failed to improve the situation and make its own contribution to improved policy making capacity of a regulator?  The answer to this question is rather simple. Despite formal existence, the supervisory board has not been vested, until very recent amendment to the Law on the National Bank, with any real power to control the NBU top management or its policies. The mentioned amendment, approved at the insistence of the international donors, fundamentally reshapes the regulator’s supervisory board on a more professional and politically neutral basis. But the main channel of the Bank’s political dependence, a direct linkage to the political institution of the country’s president, remains intact.

Second: importance of highly professional judgement on domestic economic situation as well as of independent and well-grounded position vis-à-vis international official lenders. The latter, as was Ukraine’s case in early 2014, “recommended” a very arguable action to the country’s central bank (full float of the currency and unlimited access to refinancing for commercial banks against the rise in military operations and related instability and risks), which later led to bank deposit flight, deep devaluation and outburst of inflation, highest since hyperinflation in 1992-1994.

Third: consistency of banking sector laws and regulations. The central bank’s main mandate should be clear and unequivocal. The laws should be consistent in setting the CB main policy anchor – whether it be a stability and purchasing power of national currency (exchange rate) or inflation targeting. Ukraine’s example should be avoided at all costs whereby the country’s Constitution defines stability of the national currency (stability of its exchange rate) as the main NBU function while the Law on the National Bank of Ukraine adds up another three priorities (in the order of importance) to the central bank mandate: price stability (inflation targeting), financial stability, including stability of the banking sector, as well as a support to the government’s policy aimed to achieve sustainable economic growth. Such legal ambiguity exposes central bank to political speculations and manipulations, public relation failures, policy indecisiveness and useless internal debates. A lot of frictions that hampered effective anti-crisis response by the NBU were due to heated and futile arguments over interpretation of the NBU mandate between its management and supervisory board. Responsible authorities in any emerging country should make sure that mistakes and misjudgements in monetary and foreign exchange policies by a central bank during the crisis do NOT become one of the key factors in conserving or even aggravating economic recession at the grass roots level. A lot of success in central bank’s activities depend upon such intangible public capital as trust. The latter is extremely difficult to accumulate but very easy to lose. Without trust, implementation costs of any central bank’s monetary policy quickly escalate resulting in additional inflationary expectations and financial instability.

One could argue with bold “anti-central-bank” statements by prof. Steve Hanke and conclusions by prof. Richard Werner about some central banks intentionally impoverishing the host country to allow for looting of domestic assets but, unfortunately, Ukrainian central bank’s case provides a very strong argument, at least, in favour of “impoverishment”: intentional actions and/or unintentional policy blunders by the country’s regulator in 2014-2015, which resulted in unprecedented devaluation-inflationary spiral, wiped out, by modest estimates, more than 30% of households’ real incomes and savings as well as most of corporate profits in the enterprise sector and thus contributed to further impoverishment of the host country. Unprecedented devaluation in 2014-2015 of already troubled national currency, Hryvna, became a powerful factor in exacerbating systemic crisis of Ukraine’s economy triggered by combination of many shocks and factors and that still persists despite domestic efforts and sizeable international assistance. [10]

So, what are possible ways forward? The obvious solution is to turn the central bank into a truly professional, efficient, highly reputable and politically independent market regulator, which, provided the current circumstance in Ukraine, seems a rather unlikely scenario.

Or, according to prof. Hanke, to enforce more radical solutions: either to introduce a currency board, which would take control over the exchange rate and money supply away from corrupt politicians (i.e. introduce de facto hard budget constraint), or implement full “dollarization” of the financial system, which would abolish the need for a central bank and replace a troubled national currency with a strong foreign one, for instance US dollar. [11]

Whatever is the outcome, but it is increasingly important that central bank’s policies become an important part of overall solution within a sensible package of reforms rather than a significant part of the overall problem.






[6]–sina-u-Delta-Banku; ;

[7] In comparison, the monetary base at the end of 2015 was estimated at UAH 336 billion.

[8] These interests are concentrated on the very top of the country’s political hierarchy. See latest article in The Economist


[10] See:

[11] See: Steve H. Hanke. Currency Boards. –; Steve H. Hanke. On Dollarization and Currency Boards: Error and Deception – Policy Reform, 2002, Vol. 5(4), pp. 203-222.

Yuri Poluneev