What a Ukrainian Financial Meltdown Might Look Like
On top of all its other problems, Ukraine is at risk of a financial meltdown. A question remains, however: What form would it take? Presumably it would be reminiscent of the Russian financial crash of August 1998—with default, high inflation, a frozen banking system, falling output, and panic. The three critical factors at play in the country today are shrinking international reserves, a falling exchange rate, and a collapsing banking system. These factors would unleash high inflation and plunging output, which would devastate the economy and standards of living.
The crucial concern is the level of international reserves. A critical moment occurred in October, when reserves plummeted from $16.4 billion to $12.6 billion. The cause of the fall was that Naftogaz paid back a bond of $1.67 billion and was compelled by the European Union to pay $1.45 billion of arrears to Gazprom, although Naftogaz is disputing this debt in the Stockholm Arbitration court. Ukraine also repaid the IMF $233 million.
The European Union also wants to force Naftogaz to pay another $1.65 billion to Gazprom by the end of December. The European Union's position is self-serving and impermissible. Such a payment would ensure that Russian transit of gas continues through Ukraine to Europe throughout the winter. The European Union should finance both these payments to avoid a Ukrainian financial meltdown resulting from the fact that no international financing for Ukraine is likely until the end of January. JP Morgan forecasts that Ukraine's international reserves will fall to only $7.4 billion at the end of 2014.
As a consequence of the crisis over reserves, the market has lost confidence in the Ukrainian hryvnia, whose value plummeted from 13 to 16 hryvnia per dollar in early November. A year ago, the exchange rate was 8 hryvnia per dollar, so the value of the hryvnia has fallen by half. As the international reserves decline further, everybody who can do so is exchanging hryvnia for dollars or euros and taking the money out of the country. Ukraine has extreme currency regulations, and no dollars seem to be available for business or individuals. Yet, the thinner the market becomes, the faster the currency can fall.
The third factor in the financial meltdown is the banking system. The banks are suffering from currency mismatches, making huge losses on the falling hryvnia. The more the hryvnia depreciates, the greater the bank losses will be. In September, the National Bank of Ukraine (NBU) estimated that half the banking system was bankrupt. The NBU has been busy closing one bank after the other. In October, it carried out a stress text of the 15 largest banks, and found that only five of them had sufficient capital. Two of these five are Russian-owned, two are owned by Ukraine's biggest oligarchs, and one by Austrian Raiffeisen International. All the state-owned banks had insufficient capital.
The NBU and the Ukrainian government face a severe dilemma. Should they close or recapitalize the failing banks? If they close these banks, credit will dry up and output will contract. If they recapitalize the banks, the budget deficit will expand perilously, and the only financing available would be monetary emission, or printing money. The NBU and related state banks financed by the NBU already hold 60 percent of Ukraine's public debt. The exchange rate of the hryvnia falls with every announcement of further bank recapitalization. An additional issue is that related lending is standard in large parts of the Ukrainian banking system. It even happens that more than 80 percent of the lending one particular bank has gone to enterprises belonging to its main owner.
Last July, the IMF assessed Ukraine's total budget deficit at 10.1 percent of GDP, including the large Naftogaz deficit of 4.3 percent of GDP. Given a larger than expected output contraction, a budget deficit of 12 percent of GDP appears more likely. Bank recapitalization could add a large amount to the deficit. Because of the sharp currency depreciation and the large budget deficit, the public debt is skyrocketing from 41 percent of GDP at the end of 2013 to 75 percent of GDP or more at the end of this year.
The scenario is all too clear. Ukraine has entered a depreciation-inflation cycle. As the exchange rate falls, more banks are collapsing. As long as the government recapitalizes them, the budget deficit will increase, and monetary emission will rise. Inflation has already risen from nothing last year to 20 percent in October. JP Morgan forecasts 24 percent inflation by the end of the year. But inflation can surge far higher if the exchange rate collapses. Because of the extreme currency regulations, foreign payments barely work, and as this vicious cycle evolves it appears only a matter of time before the banking system freezes. Output and the standard of living would plummet.
The meltdown can still be prevented, but what can and should be done? When a financial crisis becomes sufficiently rampant, the answers become all the more lucid, because most alternatives fall by the wayside. First, Ukraine should close the truly insolvent banks rather than recapitalize them. The new government must not allow its reserves to just run out. It should call on its creditors to agree to a standstill on its foreign payments. In particular, it must not pay the remaining $1.65 billion to Gazprom for disputed arrears. For Ukraine, money is in far more short supply than natural gas. The government needs to cut public expenditures by 10 percent of GDP—as the Baltic governments did in 2009—to save the country and convince foreign creditors that it can manage the nation's finances. The main expenditure cut should come from a unification of Ukraine's domestic energy prices, which would cut energy subsidies as well as the rampant corruption in the energy sector. After having proven its reform acumen, the government should call for sufficient international financing through a renewed IMF program, expanded EU financing, and a Marshall Plan for Ukraine.
The new Ukrainian rulers have no choice but to act fast and hard, because Ukrainians are likely to show very little understanding if they do not.