How the NBU's actions are provoking the destruction of the country's monetary system.
They wanted the best, but it turned out as usual. This latest Russian proverb is all too often true in Ukraine. Especially when it comes to reforms that, while being carried out according to the best international models, fail to take into account domestic specifics.
A striking example is some of the reforms being implemented by the National Bank of Ukraine. Most competent economists, including international ones, agree that the regulator's actions are generally necessary and appropriate, and that it is at the forefront of reform among government bodies. However, the NBU often operates rudely, resulting in significant public losses and creating a solid foundation for successful speculation by those seeking political gains.
Intentions versus reality
The National Bank recently announced a gradual transition to inflation targeting. Now, the regulator will focus its monetary policy not on the exchange rate, which it would otherwise try to maintain at a certain constant level, but on a specific inflation rate—5% over a long period—and will do everything possible to ensure that annual price growth does not deviate significantly from this target. What does this mean?
The main thing that will change is that the economy will no longer accumulate imbalances over the years (which led to subsequent collapses—of the exchange rate, the banking sector, and GDP—with all the consequences for Ukrainians' lives). Now, it will mitigate these imbalances daily with a number of "shock absorbers," the most important of which will be a flexible exchange rate. And the National Bank will try to smooth out these shocks so that average annual inflation remains low and does not hit Ukrainians too hard. This would seem like a good and necessary reform, were it not for a few "buts."
To implement inflation targeting, it's necessary to abandon the fixed exchange rate and move to a flexible one. The NBU is gradually doing this. However, this poses two problems.
First, the shadow economy ceases to operate in the hryvnia (previously, during periods of exchange rate stability, operating in the national currency was quite common among shadow operators), as high-amplitude currency fluctuations lead to unnecessary losses. Gradual dollarization of the shadow economy occurs, and the National Bank, as the issuer of the hryvnia, loses its already insignificant influence over the shadow economy.
Because the shadow economy in Ukraine is quite large and continues to exist, it shapes trends and expectations that have a significant—now effectively uncontrollable—influence on key macroeconomic indicators, especially inflation, which the NBU will target, and the exchange rate, which significantly influences price levels under the current economic structure.
Thus, the National Bank's achievement of its inflation targets will be hampered not only by external economic shocks, which are now cushioned by the exchange rate, but also by internal shocks, those originating in the informal sector and subject to poor control. Whether the regulator's policy will be effective in such a case is a rhetorical question.
Secondly, since the shadow economy in Ukraine is so large (by some estimates, around half of GDP) and is a social norm, many businesses are operating at their limits. When the country's real GDP fell by 14,8% in 2009, some economists noted that between a third and half of that figure, or 5-7% of official GDP, simply went underground. The situation is similar now.
Entrepreneurs who operate openly, according to law, must conduct transactions in the hryvnia. But if operating in the national currency results in losses, they will shift to the shadow economy and begin to use the dollar to survive. Between 2014 and 2015, real domestic product contracted by 15,8%. How much of this decline is due to the shift to the shadow economy, which has undoubtedly increased in scale?
Having allowed the hryvnia to float freely to transition to inflation targeting, the NBU was forced to impose a number of restrictions on the foreign exchange market to prevent a too-sharp collapse. In our economic system, administrative restrictions are the only effective mechanism for preventing the hryvnia from depreciating sharply during a crisis (one can only guess what the dollar exchange rate would have been if the NBU had not imposed any restrictions). However, given the realities of the informal sector, this supposedly necessary step is now backfiring.
Black currency
The National Bank happily reports that the long-standing outflow of foreign currency from financial institutions has turned into an inflow. But this data bears no resemblance to the actual market situation. After the NBU capped the amount of foreign currency that a commercial bank could sell to an individual per trading day at UAH 3 in September 2014, a full-fledged black market emerged nationwide within a few days. The logic is simple: the NBU's restrictions didn't eliminate the shadow economy's need for foreign currency, so the latter resorted to the black market in search of it, effectively shaping it through its demand.
By November of that year, the volume of household foreign currency purchases from banks had fallen threefold: from almost $600 million to less than $200 million. And that wasn't the limit: in the first months of 2016, it had already reached $39 million per month. According to official figures, everything seemed to be in order: household foreign currency purchases were falling, easing the pressure on the balance of payments and the hryvnia exchange rate. But these amounts simply disappeared from official statistics and migrated to the black market.
It's impossible to measure, but judge for yourself: in 2015, imports of goods and services to Ukraine fell by 33% in monetary terms, and nominal GDP (a proxy for income) in dollar terms fell by 32%. Meanwhile, the average annual volume of cash currency purchased by the population from banks plummeted by 91%. Does anyone really think that the shadow economy, now more motivated to operate in foreign currency, suffered such a loss of income? Moreover, The Week has repeatedly reported on the recent surge in smuggling.
Clearly, these losses aren't attributed to the shadow economy, but to official statistics. We're talking about $250-300 million per month, based on 2014 currency market figures and taking into account the decline in business activity in 2015. This is five times greater than current official figures.
If we consider market turnover up to and including 2013, the decline would be several times greater, but the mechanisms at work back then were radically different, making the comparison inappropriate. This is likely the order of magnitude of the amounts that now flow monthly through the black market for cash currency. The NBU has no influence over them, which could be reflected in the implementation of inflation targeting policies and, in general, in maintaining macroeconomic stabilization (the mechanisms involved should be discussed separately).
It's clear that such volumes of currency were bound to appear on the black market. Initially, there was a real shortage of foreign currency. For several months, while the black market was still in its infancy, lines formed daily at bank tellers, eager to earn a few hryvnias by buying a hundred dollars and then selling it immediately to a money changer waiting outside, giving people the opportunity to "earn."
Subsequently, the black market began to compete with the official one and offer higher prices: the dollar was, on average, 5-10% higher than in banks, and on some days, it reached 20% or more. As a result, most people who previously deposited currency at banks switched to shadow services. Official statistics confirm that the average volume of cash currency sales by the population to banks last year did not exceed $200 million, more than half the amount in 2014. This should be supplemented by the currency from confiscated deposits (the balances of foreign currency deposits are still declining). Therefore, foreign currency is no longer sufficient to meet the needs of the black market.
Yes, the flows of currency entering and exiting the black market have more or less balanced out. It has become established, matured, and taken on a life of its own. The strength of this market is evidenced by the fact that last year, in February and March, when the hryvnia was heading for the abyss, it was there that oil traders found the currency they needed to import fuel. The scale of the imported fuel market in Ukraine is well known. If oil traders could satisfy their own demand for currency on the black market, then one can imagine the volumes circulating there.
But that's not all. The black market not only siphons off hundreds of millions of dollars monthly. It turns out it's also a profitable business in its own right. This can be seen by the proliferation of currency exchange offices, both shady and otherwise, in Ukraine. At least in Kyiv, for every old one, one or even two new ones have sprung up. There are cases where an exchange office has taken over the premises that once housed an entire branch of a bankrupt bank.
It's probably unnecessary to explain where this outlet gets the money to even pay rent (and that's with a small margin—the difference between the buying and selling rates). It's highly likely that the rapid development of this new "branch" of the economy has not left those accustomed and skilled at "protecting" any shadow business indifferent, creating an irresistible temptation for them to "help" these new entrepreneurs. This creates additional factors of shadow economy, corruption, and the like. Was this what the National Bank had in mind when it changed its principles and made them transparent?
The black market has now entered a new phase of development. It has become so self-sufficient that its bid and ask prices are very close to those of banks. Perhaps the money changers are anticipating a slight decline in the dollar exchange rate, which is why, since around mid-February, the difference between their prices and the official ones has been no more than a few tens of kopecks.
But it's doubtful they'll react to the NBU's increase in the daily limit on foreign currency sales per person from UAH 3 to UAH 6. This measure will have a very limited impact, as money changers have taken over the bulk of the country's cash currency turnover. And this isn't 50% of the total turnover, as some experts estimate, but significantly more. The clientele is already established, and for now, there's no economic incentive for them to emerge from the shadows.
The operation of the spot foreign exchange market over the past year and a half demonstrates how good intentions, which certainly include the introduction of inflation targeting in Ukraine, when confronted with our realities, create a chain of actions and events that ultimately pave the road to hell with those same intentions. At best, it's a road to nowhere, far from genuine economic development and overcoming the country's problems.
The foundation of the Ukrainian shadow
In this context, it's crucial for the state to listen to the shadow economy and try to understand why this is happening and what can be done to make life easier and better for everyone. Our authorities maintain the Soviet tradition of treating anyone who does anything against the state as a criminal, with the only difference being that in Soviet times, people were jailed for crimes, whereas now they demand bribes. This approach can be seen in the actions of the current leadership of the State Fiscal Service and other officials. It's completely wrong, counterproductive, and anti-reform. This is especially true when you consider the reasons for the existence of the shadow economy in Ukraine. And there are only two—at least two key ones.
The first is distrust of the government. For decades, if not centuries, Ukrainians viewed it (which at one point or another historically it was) as alien, and often hostile. During the years of independence, this was exacerbated by the fact that the state performed its functions very poorly, and taxpayers' money disappeared in well-known ways. How, under such circumstances, can a Ukrainian emerge from the shadows and start paying taxes voluntarily? Why would they? Unfortunately, this attitude toward the state and the government is ingrained. And, it should be noted, the government (including the current one!) is doing nothing to change it.
For the supposed, illusory government, which may one day become real, to become truly Ukrainian and restore their trust in itself and in state institutions as a whole, corruption must be combated (so that citizens' interactions with government agencies don't end in bribery alone), and action must be taken for the people (roads, effective education and healthcare, etc., effective reforms) and at their request (for example, punishing those guilty of crimes). People must earn trust through their actions. The same applies to the state, from which it is very difficult to expect genuine action in these areas. In fact, they won't happen as long as private interests prevail in politics, and the public's trust in the state is undermined.
The second reason is perhaps more compelling than the first. It concerns the low efficiency and structural quality of entrepreneurship in Ukraine. According to the State Statistics Service, in 2014, of the nearly 1,6 million registered individual entrepreneurs, 56% worked in trade (repairs). These people wanted to become engineers, but instead, they turn to bazaar trading out of desperation, not because they have a better life.
They operate in the shadows and don't pay taxes not out of stinginess, but because they can't survive otherwise: physically, not in business. Engaged in entrepreneurship in other fields (besides trade), they lack the experience, professional knowledge, and management skills to ensure the kind of business efficiency that would allow them to operate transparently (meaning generally, which, however, does not exclude notable exceptions). Moreover, bribes must be paid everywhere...
Under these conditions, many of the government's reform initiatives simply don't work (for example, even after the reduction of the unified social tax, those who didn't pay wages transparently because they had nothing to pay them with are still not paying them), and are even perceived among entrepreneurs as an outright "harassment" and an attempt by the state to dig into their already shallow pockets.
This is why small and medium-sized businesses became the socioeconomic backbone of both revolutions and the initiators of the tax Maidan during Yanukovych's reign. They simply reacted painfully to state oppression, but they have nowhere to retreat because there is no alternative.
Economic persecution not only fails to solve this problem, but actually exacerbates it, ultimately leading to uncontrollable consequences. It must be addressed in a completely different way. At best, the country should foster entrepreneurship at the state level: from education, starting in schools and ending with courses on effective management, to support for starting and running a business through targeted government programs (but in any case, without disbursing funds, otherwise we will have a new source of corruption) and the creation of entrepreneurial platforms that will make starting one's own business significantly easier.
In the worst-case scenario, the state should simply facilitate job creation. Because then Ukrainians will have an alternative—a job with decent pay, rather than clinging to low-productivity entrepreneurship. People must have a choice, because without it, they focus on survival rather than development. Under such circumstances, the state becomes an opponent, and its transformational initiatives are viewed with hostility.
Until the government finds a tool that addresses both of these factors, entrepreneurs, who mostly suffer from low productivity and zero trust in the state, will be physically and psychologically unable to operate transparently. The scale of the shadow economy will be enormous. In such a case, economic reform is like trying to flip the tip of an iceberg: as soon as you grasp it and begin to tilt it toward the water, the hidden 90% of the volume will suddenly emerge from the depths, making the task impossible, and with its own weight, it will restore the original position.
The consequences of this are truly dire. Although reforms are ongoing, the failure to take into account internal specifics during their implementation results in significantly worse results than expected, and the effectiveness of the measures adopted is achieved far beyond the planned schedules. Moreover, the vast majority of implemented reforms have a common side effect—a sharp rise in social discontent, which populist politicians skillfully exploit. To prevent this, true reformers must deeply study internal specifics and take them into account when implementing reforms. Then populists will have no chance, and the population as a whole will support the changes, seeing real results, not just their own patience.
Lyubomir Shavaliuk, published in the publication Tyzhden.UA
Translation: Argument
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