The last year has been a particularly tumultuous one for Ukraine with the fight against Covid-19, a change of central bank governor, and most recently, the reinflammation of tensions with Russia.
While its economy has not crippled under the strain, Ukraine faces plenty of challenges. Amid growing inflation, Ukraine became one of the first emerging markets to tighten its monetary policy last month. The NBU hiked the key rate from 6% to 6.5% — the first increase since 2018.
But inflation jumped to 8.5% in March, driving a further 100bp rate hike on Thursday, putting the key policy rate at 7.5%.
That was the second rate hike of Shevchenko's governorship. He has been in the post since July, following the abrupt resignation of his predecessor, Yakiv Smoliy.
Smoliy left the post at the beginning of that month, claiming political pressure prevented him from doing his job.
Since then, Shevchenko has been tasked with bringing Ukraine’s economy out of a crisis while trying to prove central bank independence to international investors and multilateral lenders.
In recent days, tensions between Ukraine and Russia have risen to what some consider the highest point since the Crimea crisis of 2014, adding another obstacle to Ukraine’s recovery.
Shevchenko spoke to GlobalCapital about the range of challenges facing the country and what the central bank is doing to support the banking sector and the broader economy through the crisis.
GlobalCapital: The NBU’s recent rate hiking has proven popular with some investors. How much more can be expected in 2021? What is the long-term direction of monetary policy?
Kyrylo Shevchenko, NBU: We do have not a specific goal in terms of the key rate. Our goal is simply to avoid turning the current acceleration of inflation into a dangerous trend. We want to return inflation to our target of 5%, plus or minus 1%, by 2022.
The hike this week from 6.5% to 7.5% will help gradually slow down inflation in H2 2021 and return it to the 5% target in H1 2022.
In March, inflation accelerated steeply to 8.5% year-on-year, exceeding our initial forecasts. By the middle of 2021 we expect inflation to decline and return to 5% by the beginning of 2022. When the NBU raised the key rate to 6.5% in the beginning of March, it was a signal that we are not going to tolerate a long-term deviation of inflation from the target.
Several factors have led to the current inflation rate: the economic recovery in Ukraine and across the world has led to revival of economic activity, while global prices, including commodity prices, are high due to growing demand and limited supply. In Ukraine especially, we are seeing huge demand for agricultural products from China. All of these factors are speeding up inflation and will continue to do so until at least the end of summer.
However, the inflation trend will gradually reverse as new harvest supplies come to the market and the effect of a low comparison base fades for some products. If, in April, inflationary pressures increase by more than we expect, we are ready to tighten our monetary policy more decisively in order to ease underlying inflationary pressures, stabilise expectations, and bring inflation to the target.
The biggest uncertainty we still see is Covid-19. The lockdowns have had the most impact on GDP growth. We face two potential directions of monetary policy: either inflation will rise and we will react with all the tightening tools we have, or consumer demand will decrease as lockdowns continue, and similarly we will step in to support the economy with a looser monetary policy.
Your predecessor Yakiv Smoliy resigned last summer, blaming political pressure for preventing him from doing his job. Since then, central bank independence has come under scrutiny from international investors. Does the NBU continue to face political pressure?
There are three main parts of central bank independence: operational, financial and political independence. There may have been rumours around whether or not the bank is independent from the government, but I would say since 2020 I have proven that the bank will be sticking to the flexible exchange rate policy and inflation targeting.
Central banks should be technocratic and that is what the NBU demonstrates. The recent situation in Turkey clearly illustrates why a central bank should be a technocratic and independent institution. Loss of trust in the central bank due to the political interference dealt a heavy blow to Turkish lira exchange rate.
Of course we feel expectations from the government when it comes to inflation, but at the bank we stick to our policies of a floating exchange rate and a strict inflation target. Political pressure on central banks probably exists everywhere — but ultimately it is the NBU’s decision where the key policy rate moves to. Nothing is threatening NBU independence.
Since the start of the year, emerging markets have felt the fallout of volatility around yields and rising rates in the US. Does the NBU see this as a challenge?
The normalisation of the yield curve in the US is broadly a positive development for global markets. We do not see it as a challenge in terms of NBU activity.
Our focus is on hryvnia stability. However, we are not worried about our exchange rate. We have good foreign exchange reserves. We started the year at $28.8bn and it is now around $27bn.
Will the NBU’s crisis support continue over the next year? Which tools or measures will be used to help the banks in their recovery?
The NBU responded to the challenges posed by the coronavirus crisis and deployed a broad range of both conventional/traditional and unconventional tools in order to calm the financial market and support the real and financial sectors of the economy. We simplified access to finance for banks by increasing the frequency of tenders, extending the term of loans and expanding the list of collateral that banks can provide to take out loans from the NBU, for example.
Apart from conventional/traditional tools, the bank also introduced new instruments to support the economy, like long-term finance for banks for up to five years at an interest rate that equals the key policy rate, as well as interest rate swaps that enable banks to manage their interest rate risk. All of these measures are still in place.
Ukraine did not implement quantitative easing last year — fortunately, or perhaps unfortunately, we are not able to provide helicopter money.
One of our key priorities is the state-owned banks. Over 50% of the banking system is under some form of state-ownership and ensuring good corporate governance has been important for us over the last year. We have done a great job in decreasing the NPL ratios in state-owned banks.
Ukraine had the highest NPL level in the world in 2017 — they made up 58% of the loan portfolios of Ukrainian banks. Between 2018 and 2020, the overall NPL ratio has declined by 17.4 percentage points, reaching 40.4% of loan portfolios as of March 1.
The NPL ratio in state-owned banks has declined by seven percentage points since early 2020, to 57% from 64%. In money terms, the NPLs fell by 22%. Our goal is to bring the NPL ratio of the sector’s loan portfolio below 20% by 2025.
We are also expanding cooperation with the international community. In January, Ukrgasbank signed a loan agreement with the International Finance Corporation, paving the way for the IFC to become a full shareholder of in a few years’ time. This is a huge step in the acknowledgement of our banking sector’s compliance with international standards, and in reducing the government’s role in the banking market. Similarly, as a second step in the privatisation agenda, we are working to enable the European Bank for Reconstruction and Development to participate in the capital of Oschadbank, another of our state-owned banks.
We hope that in five years’ time, the state’s share of the banking market will have fallen from 55% to 25%. This process will assist the Ukrainian banking system in gaining greater independence and promote the banks’ operation according to market-driven principles.
Our banking sector holds significant potential for international investors. In the near future, we hope that international banking groups will take equity in Ukrainian state-owned banks. Under our plans, PrivatBank, Ukraine’s largest banking asset, will soon be put up for sale. We believe that the privatisation of PrivatBank — which holds 20% of the Ukrainian banking market — will draw the interest of the most prestigious international investors, including from the US and the EU.
Are you completely ruling out the introduction of QE?
Yes, we are ruling it out. QE usually starts to be used in the situation when all other standard instruments are exhausted. In the case of Ukraine, it is simply too early to talk about it.
What are the main risks in the banking system?
Covid-19 remains the biggest uncertainty, although there are two other main risks we are monitoring. Firstly, is Russia’s escalating aggression. We are monitoring any exchange rate fluctuations. Having absorbed the news about the most recent build-up of Russian forces at the border, we have only witnessed short-term fluctuations. We are grateful to our international partners — US president Biden and UK prime minister Johnson — for supporting the Ukrainian president throughout the crisis.
Secondly, although the liquidity of the banking sector is high enough to lend to both the government and private sector simultaneously, we have noticed that the ratio of banks' investment in government debt to deposits is growing. That ratio stands at around 40%. We have an expectation that the share of T-bills in the banking sector will normalise at below 35% to prevent the crowding-out effect.
In 2021, credit risk will also continue to be the significant risk faced by the banking sector. Some bank borrowers are still experiencing financial difficulties. This may affect the quality of loan servicing, forcing banks to make additional provisions. To get a better sense of the risks facing the banking sector we plan to do asset quality reviews and stress tests in the coming months. In addition, lower interest rates put the net interest income of banks at risk.
What is your outlook for economic growth and inflation in Ukraine in 2021/22? What are the challenges in returning to pre-pandemic growth levels?
Economic recovery will be constrained this year by Covid-19 and strengthening of lockdown restrictions. In January, we projected that in 2021 the Ukrainian economy would make up for losses from the coronavirus crisis and grow by 4% in 2022–2023.
We are ready to combine the tools used for financial system support in order to mitigate the crisis trends. We are also monitoring the risks; namely, escalation of the military conflict in the east of Ukraine, volatility in the global capital markets and a sharper worsening of the terms of trade.
The NBU is seen by international investors and the IMF as the most critical reform institution in Ukraine. Why has the IMF delayed the disbursement of funds from Ukraine’s $5bn Standby Agreement package?
The main assumption behind the NBU’s macro forecast is that cooperation with the IMF will continue. Given that negotiations are taking longer than expected, we are now aiming to receive two loan tranches in 2021, as opposed to the three we initially expected. However, it is rather difficult to classify when and how much these tranches will be disbursed.
As of today, $2.1bn of the $5bn IMF package has been disbursed. If the IMF in 2021 extends less credit than we project, additional funds may come from the issue of domestic government debt securities, which the January forecast estimated at $2.4bn.
The IMF is not only an important creditor that charges low interest rates, but also a vital strategic partner. Cooperation with the IMF is an important factor in shaping Ukraine’s investment climate, as well as a benchmark for relations with other international financial institutions and foreign investors. Our priority is to continue the dialogue with colleagues from the IMF in order to reach a staff-level agreement. We also prioritise taking measures to get the IMF Board to approve a review of the Ukrainian programme.
Ukraine will also benefit from the additional Special Drawing Rights allocations that are expected to be issued this year.
By performing its most important functions of surveillance, technical assistance, and lending through special programs, the IMF helps our country maintain economic stability and pursue economic priorities. In 2021, bilateral cooperation between Ukraine and the IMF will continue under the Stand-By Programme. Funds granted by the IMF are used to replenish Ukraine’s international reserves and support the state budget.
What is the contingency plan if Ukraine cannot access IMF funds? Will it tap the Eurobond market?
We are not even considering the scenario in which we do not get funding.
Cooperation with the IMF and other international partners is important to finance budgetary needs and provide additional incentives for the economy to grow. This will also enable Ukraine to maintain its international reserves at about $30bn. Postponing or suspending the IMF program may slow Ukraine’s economic recovery. Lack of external funding may increase the need to raise more funds in the domestic market. According to the NBU, the potential for these borrowings is quite limited.
Our concern is not that the money will not come. Aside from that, we do need to deepen the local market and we will also be monitoring the international markets to see if it makes sense for Ukraine to sell a Eurobond.
What are the main obstacles with the IMF? There are rumours that a lack of reform on the anti-corruption front has slowed negotiations.
It is true that discussions have continued around our anti-corruption framework and gas price cap. There are also discussions around our current fiscal figures.
The NBU plans to continue to promote the implementation of global best practices in banking. We have recently submitted for the Ukrainian parliament’s consideration an amendment to the law on improving corporate governance in banks, which we have developed together with IMF experts. The adoption of this law will also strengthen the institutional capacity of the NBU and its independence and bring governance standards closer to those seen in European bank regulation.
PrivatBank has been another source of concern for international investors. What are the latest updates regarding the bank’s nationalisation?
The NBU continues to support the legal strategy of PrivatBank. Our goal is to keep the bank in state ownership to save the Ukrainian taxpayers money and ensure that Ukraine’s financial sector remains stable. There are around 100 court processes ongoing right now just around PrivatBank — it is an exceptionally complex matter. The next important meeting is on April 14, during which there will be a high level meeting including the president’s office and IMF representatives around the recovery of assets.
As an important part of a stable and transparent banking system, the NBU believes that PrivatBank should continue to focus on resolving its NPL problems and press forward with efforts to return the misappropriated deposits.
These tasks are currently faced not only by PrivatBank, but also by the entire banking system, which must redistribute financial resources effectively and support economic growth.
How likely is it that the PrivatBank saga could be resolved by the end of 2021?
That is in fact our target. We hope that the court cases will have been resolved and we will be able to focus solely on recovering assets.
There is concern among international investors about the infighting at the NBU, seen most recently by an investigation into deputy governor Kateryna Rozhkova. What is your response?
We firmly believe in the independence of the central bank and one of the important parts of that is professionalism. The NBU’s team members and board members must all stick to the same professional policies, including a one-voice policy.
Those guilty of abuse should be held accountable for bringing Ukraine’s top bank to bankruptcy. Our international consultancy firm Kroll has played a significant role in uncovering all of the circumstances and facts of the large scale, coordinated fraud that took place at PrivatBank.
What are the key areas of concern for the NBU in 2021?
The escalation of Russia’s aggression in Ukraine is a big risk for economic growth, as I mentioned before.
The NBU will continue to promote the move away from a reliance on Russia, reorienting our economy to find new trading partners and ensuring we can compete in the global market.
Near-term prospects for the service sector remained subdued due to a new wave of Covid-19 infection and new lockdown measures in many countries, with tightened restrictions on travel and related services extending into the first quarter of 2021.
However, even then we have a really good level of FX reserves to react to any disturbance in the market. We have all contingency plans in place — although my expectation and hope is that the escalation with Russia will not continue. But if it does, we are ready for any scenario and we are in the position to prevent such a situation that we saw in 2014 with the invasion of Crimea.