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Coordinated Macroeconomic Policy in Wartime is Key to Victory

The fight with russia is going into longstanding war of attrition mode. To win this war, it is vital that we hold the economic frontline not only in the short run, but also for as long as it takes Ukraine’s Armed Forces to expel the enemy from our land.

The aggressor’s blitzkrieg effort came to nothing. In a dignified defense effort that caused Ukraine significant losses, it repelled the enemy forces both in the battle zone and on financial frontlines. In the earliest months of the war, the government aimed to prevent the economy from plunging into meltdown. We successfully came through this period even as the war posed more and more challenges. Meanwhile, we have grown accustomed to taking for grated our smoothly functioning banking system and minimal losses to the hryvnia’s purchasing power, while many international partners still perceive this as nothing short of a Ukrainian miracle.

But as the war has dragged on, the state’s economic policy priorities have shifted towards measures to enable the economy to operate in conditions of a protracted standoff. One practical implication is that resources must be allocated in a way that will fortify Ukraine’s defenses while also laying the groundwork for businesses to generate even more resources. Put another way, we are switching from a sprint to an endurance run (in what I hope will not turn out to be an excruciating marathon), so that we can, first and foremost, correctly space out our energy over time.


The primary instruments in this effort are fiscal policy and the state budget.

Since the full-scale war broke out, the budget deficit has expanded significantly, consistently with the defense effort, and, excluding international aid, stands to hit 25% of GDP by the end of the year. Over the past 20 years, a wider budget deficit has been observed only in a handful of cases: in Iraq in 2004, in Eritrea for several years in a row, in Ireland in 2010, in Libya in 2014–2016, and in Venezuela in 2018. Fiscal gaps of such magnitude do not lend themselves to closure through regular financing efforts and are evidence of grave problems with public finances and severe policy miscalculations.

Unlike the countries noted above, Ukraine has been pursuing a balanced fiscal policy and conducting monetary and financial reforms for years, meaning that such a huge deficit is exclusively the consequence of the war and its tremendous impact on both budget revenues and defense expenditures, including those to support households and businesses. This does not, however, relieve the authorities of the job of finding an optimal solution to this problem to avoid the collapse of the public finance system and to adequately finance critical expenditures to ensure the country’s defense capability.

Unfortunately, despite all measures the Ukrainian government and its partners have taken to raise international military and financial assistance, this aid can only partially cover the budget deficit.

How do we finance the rest of it? That’s the overpowering question that macroeconomic policy makers must answer. Several options come to the fore:

1. Using previously accumulated reserves. Yes, I mean international reserves. The drawdown of international reserves occurs when a central bank’s efforts to close a budget gap through monetary financing generate additional demand for foreign currency as economic agents buy it in order to purchase imported goods and services. To meet this excessive FX demand and ward off depreciation, the regulator takes foreign currency out of international reserves and sells it in the FX market. The war caught Ukraine with USD 31 billion in international reserves, as of early 2022, a sum that is far from unlimited. Seven months into the year, we are down by USD 8.5 billion. This will not last long. We also need to have a margin of safety put away for the worst-case scenario. What is more, the sharp depletion of reserves will fuel more demand for foreign currency and speed up the arrival of a full-blown balance of payments crisis.

2. Borrowing against the future. This means raising credit financing in the domestic market. This requires hiking interest rates on domestic government debt securities, which means shifting the burden of financing the deficit to post-war years.

3. Transparently redistributing towards top priorities whatever resources the economy is generating. This amounts to curtailing the budget deficit in a controlled manner by cutting nonpriority expenditures and raising taxes, with the least adverse effects on economic recovery and thus on the economy’s ability to drum up resources going forward.

4. Pressing forward with monetary financing, thus robbing the public of their savings and hryvnia incomes through depreciation. In other words, if the NBU continues to issue money, the hryvnia will lose value because of depreciationand inflation. This outcome can, up to a certain point, be prevented by drawing down international reserves (see option one above), but not forever.

On the surface, this solution seems like a no-brainer: the public would see it as the easiest path to take, from a short-run perspective at least. After all, monetary financing by central banks imposes a hidden inflation tax on society. In the short term, this may even reduce the budget deficit to acceptable levels if budget expenditures are “frozen” and nominal incomes rise with inflation.

In the long run, however, this approach may result in extremely adverse, if not disastrous, consequences:

First, inflation tends to persist. A range of theories explain away inflation’s endurance by attributing it to various factors, from the pass-through of price increases for some goods to the cost of inputs that go to produce other goods, to the role of inflation expectations, which are in and of themselves capable of stoking inflationary pressures. When expectations are set in motion, it takes a very strict kit of measures to stop them, which causes even greater damage to the economy and puts a significant drag on economic recovery, or worse yet, deepens and prolongs recessionary processes.

Second, inflation exacerbates social inequality by primarily affecting the least well-off sections of the population. Owners of assets (real estate, foreign currency) suffer less from inflation because the value of these assets also increases as prices rise. Retirees, on the other hand, are made worse off due to the fixed nature of their pensions. With prices rising, people in such income categories can afford increasingly fewer goods and services.

Third, inflation can easily trigger a vicious cycle of rising nominal social standards, depreciation, and a new wave of price growth. This unleashes the so-called inflation-depreciation spiral, a scourge that has previously been the exclusive feature of Latin American countries and that has eventually plunged them into permanent financial meltdowns. As it happens, the breaking of this vicious circle in countries such as Chile, Colombia, Brazil, and Mexico has been seen to drive a significant improvement in macroeconomic management and rapid economic growth. But we don’t have to relive their negative experiences when in fact the correct recipes for macroeconomic stabilization without going into a crisis are readily available.

The vicious circle can easily result from attempts by politicians to overcome the negative effects of inflation on the population by raising social standards. Ultimately, this will lead to where more monetary financing is needed to pay the revised wages and pensions. Payments will therefore depreciate even faster than they are revised higher. This implies the loss of social stability, which amounts to having to fight another war, within a country at war.

Fourth, the loss of confidence in the domestic currency. Trust will take years, even decades, to regain, and only if and when economic policy is back to normal. With high inflation, money first loses its capacity as a means of saving (as people switch to foreign currency savings) and then ceases to be a measure of value (as businesses charge prices in foreign currency). Eventually, it comes to the point where the domestic unit of money no longer serves as a means of exchange. Marketplaces and stores resort to foreign currency or barter transactions. Normal redistribution of resources is rendered impossible as the economy falls into meltdown.

Fifth, the collapse of financial stability and the loss of control over economic processes become a reality. The banking system steadfastly withstood the challenges of the earliest months of the war. However, significant depreciation, liquidity outflows, and the loss of confidence are the inevitable attributes of monetary financing when done on a large-scale. When the economy migrates to barter and foreign currency and largely goes into shadow, the government generally loses the leverage to accumulate and redistribute resources, because control over the financial system is gone. An out-of-control financial system cannot provide a foundation for winning a war.

A major takeaway from the discussion above is therefore that a macroeconomic adjustment through inflation can only happen on a very limited scale. Making such an adjustment on a large scale will lead to a drop in the incomes of broad sections of the population below the poverty threshold, the destabilization of the financial system, and ultimately the loss of the country’s defense capability.

We must clearly understand that even the current 22.2% rate of consumer inflation per year is a significant reduction, almost by a quarter, in the real disposable income of households. At the same time, to prevent a greater loss of income due to inflation, we have been forced to spend a significant part of our reserves and greatly increase the key policy rate.

Our baseline macroeconomic scenario assumes that, overall, inflation will exceed 30% this year and hover around 20% next year. Only in 2024 will it retreat to single digits. It means that the hryvnia’s purchasing power will almost halve over the three years.

And even this scenario will require great efforts to be implemented (otherwise, the outcome can be much worse). This scenario assumes the following monetary financing schedule: the NBU will purchase up to UAH 30 billion of domestic government debt securities per month until the end of the current year, to reach a total UAH 400 billion in such purchases, an amount agreed upon with the government; the monetary financing volumes in 2023 will be half the 2022 level and will cease completely in 2024.

This will require decisive measures to cut the budget deficit. No matter how unpopular they may seem, their mindful and controlled application is the most effective option for adapting the economy to a war of attrition and providing the basis for victory. The authorities therefore need to take responsibility and make unpopular decisions, while honestly explaining to the public the need for appropriate steps.

And it is paramount not to delay this, because the longer that these imbalances are allowed to accumulate, the more difficult and painful that future decisions will be.

Ideally, of course, the necessary, albeit painful and difficult, steps should be taken in advance, before the situation turns from a looming crisis to a full-fledged meltdown scenario.

We are not giving specific recommendations here. We have repeatedly voiced our stance on possible measures in our previous publications. However, we are aware that the Ministry of Finance, the government in general, and the Verkhovna Rada have much more expertise in finding optimal ways to manage the reduction of the budget deficit.

Buffers (international reserves) accumulated in the past and the resources of the post-war generations can relieve pressure from these measures on the current generation. The first resource is limited, and a large part of it has already been used.

The second resource involves funds raised by issuing war bonds on market-driven terms. We understand that this measure will increase the government’s public-debt-servicing expenditures going forward. In addition, this path will narrow the possibilities for recovery, as more taxpayer money and budget revenues from other sources will have to be allocated not for the post-war reconstruction but for debt repayments. However, (a) this process can be controlled by building a yield curve without creating a peak debt, reducing the debt burden on future generations; (b) buyers of bonds will have more resources that they can use for investment or consumption; (c) the other way will be much more complicated.

Furthermore, monetary financing will not save the country, because when the NBU purchases domestic government debt securities, the government ends up paying interest on them.

Without raising interest rates now and borrowing more from market players, the adverse effects from monetary financing and inflation mentioned above will be considerably worse. If the country slides into the chaos of uncontrolled monetary financing, depreciation, inflation, the collapse of the financial system, and the loss of defense capability, it will be much more difficult for future generations to pull the economy out of this abyss.

Moreover, the point is not just to increase monetary transmission, meaning to enhance the effects of raising the NBU’s key policy rate on yields on government securities, a process that had been automated in pre-war times. At the moment, raising the interest rates on domestic government debt securities will allow households to safeguard their hryvnia savings and income from sharp depreciation and avoid poverty.

The mechanism for domestic borrowing therefore needs to be significantly improved, although not without control. However, even if the cost of servicing hryvnia-denominated government bonds approaches the current key policy rate, it will remain below the expected average growth rate of nominal GDP over the next two years. From this perspective, the threat to debt sustainability from the unfolding of what macroeconomists call a Ponzi scheme is therefore minimal. In contrast, considering that the share of FX public and publicly guaranteed debt exceeds 60%, uncontrolled hryvnia depreciation is posing a much bigger risk to debt sustainability.

The conclusion would seem obvious: monetary financing and the inflation tax need to be curtailed (through the controlled reduction of the budget deficit and an increase in its market-based financing). Then why do countries so often fall into the hyperinflation trap? Let’s look at what was done in the interwar period by governments in Germany, Hungary, Serbia, Croatia, Israel, Venezuela, some countries in Latin America, and in the 1990s in Ukraine itself.

The answer to the hyperinflation question is found in the formal distribution of powers between the government, which is responsible for the execution of the state budget, and the central bank.

In Ukraine, as well as in many other countries, the responsibility for domestic currency stability, meaning inflation, falls to the central bank. However, the tool with which to influence it is in the hands of the government. After all, it is the government that makes decisions about the level of the budget deficit and the sources of financing it. Because of the war, the NBU has to cover the gaps in public finances by issuing money. The central bank is actually “held hostage” by the war’s effects on the budget and the fiscal authorities’ response.

At the moment, issuing money is like keeping a critical patient, which our economy is, on a ventilator. Failure to finance the budget deficit will result in the collapse of public finances, when expenditures on defense, social support, and pensions come to a halt.

I, however, would like the patient to recover and breathe deeply without artificial ventilation. But it is not going to happen by itself. Decisive steps are needed to revive our budgetary and monetary systems.

The NBU currently agrees to deploy the “ventilator” machine of temporary and restricted monetary financing.

At a certain stage, however, the adverse effects of monetary financing will begin to put at risk the stability of our country’s money, defense capabilities, and monetary sovereignty. What is more, if such a means of support is used for too long or in too significant amounts, addiction will occur, and the patient (country) will no longer do without artificial ventilation of the lungs and will lose the ability to breathe independently (that is, the capability to run the budget without resorting to monetary support).

The war cannot be used as an excuse for not taking action. On the contrary, desperate times call for desperate measures. Despite the unpopularity of such difficult decisions, it is now more important than ever that the government takes political responsibility and finds a means of reducing the budget deficit and minimizing monetary financing of the budget deficit.

This is the only way to ensure macrofinancial stability in our country. It is fundamental to our ability to fight back in this war of attrition. Only by standing united and by understanding the necessary, albeit difficult, steps that need to be taken, and only through the joint responsibility of all branches of government in the face of the enemy onslaught can we ensure that victory on this frontline will be ours to claim.

Kyrylo Shevchenko, NBU Governor
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