UKRAINIAN CURRENCY IN SLIDE

UNCLAS SECTION 01 OF 02 KYIV 001995 SENSITIVE SIPDIS DEPT FOR EUR/UMB, EB/OMA TREASURY PLEASE PASS TO TTORGERSON E.O. 12958: N/A TAGS: EFIN ECON XH UP SUBJECT: UKRAINIAN CURRENCY IN SLIDE REF: KYIV 1959 SENSITIVE BUT UNCLASSIFIED, NOT FOR INTERNET DISTRIBUTION ¶1. (SBU) Summary: Ukraine's external vulnerabilities - including a substantial slowdown in capital flows, worsening terms of trade, and a large current account deficit (reftel) - have caught up with the economy, leading to a swift hryvnia (UAH) depreciation in recent days. Although the National Bank of Ukraine (NBU) surprised observers with a token effort to stabilize the situation, it appears the government has not taken any coordinated steps to respond to the broader economic causes of the currency slide. End Summary. ¶2. (SBU) Since June 2008, the NBU's official policy has been to maintain a midpoint-based exchange rate. Set at 4.85 UAH per dollar, with 4 percent flexibility in either direction (4.65-5.05), the currency is, in theory, allowed to move within a fixed range. In practice, however, market forces have pushed the currency's value beyond the prescribed deviation. Last summer, for example, the UAH appreciated below 4.65, and in recent weeks it has traded above 5.05 UAH at Kyiv exchange kiosks. (Note: On October 7, Kyiv vendors are selling dollars for as much as 5.39 UAH. End Note.) ¶3. (SBU) As the currency has depreciated, embassy contacts and news reports stated that the NBU would not intervene under any circumstances. Then, on October 3, the National Bank announced it had sold $342 million in reserves at the rate of 5.0 UAH to the dollar, in order to stave off speculation and change the "psychology" of the market. Bankers now say the intervention did little to reverse the UAH slide and raised more questions about the competence of NBU policymakers. In response to criticism, NBU Council Chairman Petro Poroshenko stated unequivocally that the National Bank would not engage in further currency intervention to support the hryvnia. However, representatives from the arguably more powerful NBU Board have been largely silent. ¶4. (SBU) Ukrainian consumers are subject to the risks of further UAH depreciation, because many have taken on debt in UAH fixed to the dollar exchange rate. This is also the case for corporate borrowers whose loans in foreign currency (through syndicated loans, Eurobonds, etc.) are repaid from UAH revenues. As the dollar appreciates relative to the UAH, repayment schedules become more expensive. These borrowers may soon face problems meeting loan obligations, and banks that made loans for cars, vacations, and home mortgages will also be in jeopardy, especially if defaults on devalued assets occur in appreciating currencies. In addition, Western banks (holding roughly 70% of the country's external banking debt) remain focused on their home markets and liquidity of their parent banks. One financier suggested that, other than funds to roll over maturing foreign debt, little new capital is likely to flow into Ukraine; rather, the trend could be in the opposite direction. ¶5. (SBU) Ukrainian Finance Minister Viktor Pynzenyk recently acknowledged concerns about the effects of financial volatility on the Ukrainian economy. His was one of the first public statements on the "crisis" uttered by a ranking government official. More typically, however, bureaucrats, politicians, and the general public exhibit a lack of interest or capacity to deal with the emerging problems. One observer noted that the situation is worse than "heads in the sand," since no one, perhaps outside of Pynzenyk, acts as if there were an impending emergency. Another commented that only three people - NBU Governor Volodymyr Stelmakh, Prime Minister Yulia Timoshenko, and President Viktor Yushchenko - have the wherewithal to pull needed economic levers, but a lack of coordination among them has stalled any relief. In addition to not addressing the broader causes of a currency slide, the NBU has been silent on how to deal with bank solvency. Furthermore, the collapse of the governing coalition in parliament (Verhovna Rada) has made coordinating economic policy more difficult. ¶6. (SBU) Comment. A real devaluation of the hryvnia is needed. Ukraine's real exchange rate may not have been overvalued before the global economy fell apart, but mounting external vulnerabilities, exacerbated by the worldwide financial crisis, are now forcing the UAH downwards. It remains unclear whether the National Bank will attempt to further defend the exchange rate corridor at its current level, given the NBU's intervention of the past week. More prudent policy might argue for saving the NBU's $37 billion in reserves for bank bailouts or as a shock absorber for future economic needs. ¶7. (SBU) Should the NBU allow the UAH to stay outside its established corridor, depreciation would have different affects on various stakeholders in the economy. Exporters, like Ukrainian steelmakers who complained recently about their lack of competitiveness at current global commodity prices, should benefit if inflation is controlled. Other Ukrainians, especially local KYIV 00001995 002 OF 002 bankers, importers, and those holding highly exposed or hard currency-linked loans, will likely not find UAH depreciation so palatable. End Comment. TAYLOR