Monetary system of Ukraine

    There were a lot of arguments about European Monetary System:

• The European Monetary System was important in ensuring currency stability in the European Community at a time when international markets were very volatile.
• Without the EMS the completion of the single market project would have been more difficult.
• Fixing exchange rates is dangerous because unless the correct rate is set and changed appropriately, a national economy can be forced to pursue policies that are not best suited to domestic conditions simply in order to maintain international stability.
• EMS established the principle that one monetary policy can suit all member states. The events of 1992 proved that this was not the case.

    Let’s now consider Economic and Monetary Union (EMU). A monetary union is an arrangement where several countries have agreed to share a single currency amongst themselves. The European Economic and Monetary Union (EMU) consists of three stages coordinating economic policy, achieving economic convergence (that is, their economic cycles are broadly in step) and culminating with the adoption of the euro, the EU's single currency. All member states of the European Union are expected to participate in the EMU. The Copenhagen criteria is the current set of conditions of entry for states wanting to join the EU. It contains the requirements that need to be fulfilled and the time framework within which this must be done in order for a country to join the monetary union. An important element of this is the European Exchange Rate Mechanism ("ERM II"), in which candidate currencies demonstrate economic convergence by maintaining limited deviation from their target rate against the euro.

    All member states, except Denmark and the United Kingdom, have committed themselves by treaty to join EMU. Sixteen member states of the European Union have entered the third stage and have adopted the euro as their currency. Denmark, Estonia, Latvia, and Lithuania are the current participants in the exchange rate mechanism. Of the pre-2004 members, the United Kingdom and Sweden have not joined ERM II and Denmark remains in ERM without proceeding to the third stage. The five remaining (post-2004) states have yet to achieve sufficient convergence to participate. These eleven EU members continue to use their own currencies.

    First ideas of an economic and monetary union in Europe were raised well before establishing the European Communities. For example, already in the League of Nations, Gustav Stresemann asked in 1929 for a European currency against the background of an increased economic division due to a number of new nation states in Europe after WWI.

    A first attempt to create an economic and monetary union between the members of the European Communities goes back to an initiative by the European Commission in 1969, which set out the need for "greater co-ordination of economic policies and monetary cooperation" (Barre Report), which was followed by the decision of the Heads of State or Government at their summit meeting in The Hague in 1969 to draw up a plan by stages with a view to creating an economic and monetary union by the end of the 1970s.

    On the basis of various previous proposals, an expert group chaired by Luxembourg’s Prime Minister and Finance Minister, Pierre Werner, presented in October 1970 the first commonly agreed blueprint to create an economic and monetary union in three stages (Werner plan). The project experienced serious setbacks from the crises arising from the non-convertibility of the US dollar into gold in August 1971 (i.e. the collapse of the Bretton Woods System) and from rising oil prices in 1972. An attempt to limit the fluctations of European currencies, using a snake in the tunnel, failed.

    The debate on EMU was fully re-launched at the Hanover Summit in June 1988, when an ad hoc committee (Delors Committee) of the central bank governors of the twelve member states, chaired by the President of the European Commission, Jacques Delors, was asked to propose a new timetable with clear, practical and realistic steps for creating an economic and monetary union^[1]. This way of working was derived from the Spaak method.

    The Delors report of 1989 set out a plan to introduce the EMU in three stages and it included the creation of institutions like the European System of Central Banks (ESCB), which would become responsible for formulating and implementing monetary policy.

    The three stages for the implementation of the EMU were the following:

    Stage One: 1 July 1990 to 31 December 1993. On 1 July 1990, exchange controls were abolished, thus capital movements were completely liberalized in the European Economic Community. The Treaty of Maastricht in 1992 establishes the completion of the EMU as a formal objective and sets a number of economic convergence criteria, concerning the inflation rate, public finances, interest rates and exchange rate stability. The treaty enters into force on the 1 November 1993.

    Stage Two: 1 January 1994 to 31 December 1998. The European Monetary Institute is established as the forerunner of the European Central Bank, with the task of strengthening monetary cooperation between the member states and their national banks, as well as supervising ECU banknotes. On 16 December 1995, details such as the name of the new currency (the euro) as well as the duration of the transition periods are decided. On 16-17 June 1997, the European Council decides at Amsterdam to adopt the Stability and Growth Pact, designed to ensure budgetary discipline after creation of the euro, and a new exchange rate mechanism (ERM II) is set up to provide stability above the euro and the national currencies of countries that haven't yet entered the euro zone. On 3 May 1998, at the European Council in Brussels, the 11 initial countries that will participate in the third stage from 1 January 1999 are selected. On 1 June 1998, the European Central Bank (ECB) is created, and in 31 December 1998, the conversion rates between the 11 participating national currencies and the euro are established.

    Stage Three: 1 January 1999 and continuing. From the start of 1999, the euro is now a real currency, and a single monetary policy is introduced under the authority of the ECB. A three-year transition period begins before the introduction of actual euro notes and coins, but legally the national currencies have already ceased to exist. On 1 January 2001, Greece joins the third stage of the EMU. The euro notes and coins are introduced in January 2002. On 1 January 2007, Slovenia joins the third stage of the EMU. On 1 January 2008, Cyprus and Malta join the third stage of the EMU. On 1 January 2009, Slovakia joins the third stage of the EMU.

 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 

CHAPTER III. MODERN TENDENCIES IN MONETARY SYSTEM OF UKRAINE 

1. Current situation in monetary system of Ukraine

    For better description of current situation in monetary system of Ukraine let me adduce analytical report for year 2009. March-April macroeconomic data revealed early signs of stabilization in Ukraine’s economic situation. However, the magnitude of the economic downturn means that the economy is still in a difficult situation. Although the government is still reporting an over-fulfillment of budget revenues, deeper fiscal data reveals a worrisome picture. Being reluctant to revise the 2009 budget, the government has been seeking measures to increase budget revenues and secure sufficient financing for the planned budget deficit.

    In mid-May, the IMF Board agreed to relax fiscal budget requirements for Ukraine to a deficit of 4% of GDP. Moreover, according to the revised program, a portion of the IMF funds will be used to cover the fiscal gap. Inflationary pressures continued to ease; the annual consumer-price index (CPI) declined below 15% in May.

    Following sharp depreciation in the fall of 2008 and high volatility in the first three months of the year, the Ukrainian Hryvnia stabilized during April and gained 5.3% in May. While regular NBU interventions and administrative controls have contributed to the stabilization of the forex market, we believe that the rapid adjustment of the current account and improved sentiments over Ukraine’s ability to serve its large short term debt obligations in the near term were the most crucial.

    March-April 2009 data showed that the pace of economic decline in a number of sectors (e.g., industrial production, construction, and passenger transportation) has slowed. Inflation has notably decelerated, the national currency has stabilized and even started to appreciate during April-May, and the current account gap narrowed dramatically in 1Q 2009. The recent risk-appetite reversal on global financial markets and the resumption of the IMF stand-by program to Ukraine were reflected in the sharp decline of CDS spreads for Ukraine (from more than 5000 basis points to less than 1800 points at the end of May) and revival of the Ukrainian stock market. By the end of May, the PFTS stock market index had gained 120% since March’s bottom, although this growth was achieved on relatively low trading volumes and on a very low base.          Although this news might create the feeling that Ukraine has already reached the bottom, the severity of the economic downturn over the first four months of 2009 does not provide much comfort. In particular, industrial production fell by almost 32% yoy over January-April 2009. According to various estimates, real GDP shrunk by more than 20% yoy in 1Q 2009. The magnitude of the downturn compared to the worst years of economic depression during the early 1990s, which was caused by a difficult transformation from planned to market economy.

    The disproportionately high impact on Ukraine may be attributed to slow and piece-meal reforms, the lack of a broad-based and comprehensive program to diversify, modernize and to make the Ukrainian economy more efficient and thus more competitive on international markets. Such a sharp contraction may be one of the main reasons why Ukrainian authorities have decided to delay the release of the first quarter national accounts data for the beginning of July 2009. With the previous economic growth heavily hinged on external demand, Ukraine’s export-oriented sectors continued to suffer from the sharp decline in commodity prices and economic woes in the Ukraine’s main trading partner countries. Thus, production in metallurgy, the chemical industry and machine-building fell by 44% yoy, 36% yoy and 54% yoy respectively over the first four months of 2009. At the same time, the impact of the crisis on domestic demand has strengthened since the beginning of the year. Retail trade turnover and the value of passenger transportation works declined by more than 14% yoy and 10% yoy respectively over January-April. Food processing production fell by almost 9% yoy over the period.

    Meanwhile, the output decline in many domestic-market-oriented industries and sectors slowed during March-April, which may be explained by two major reasons. First, during almost a decade of fast economic growth, Ukrainian households saved enough to mitigate the crisis’ impact for a few months. Moreover, farming, which employs about one-fifth of the total workforce, continued to expand. Actually, agriculture was the only sector that demonstrated an increase in output, growing by 2.1% yoy over January-April. Second, sharp Hryvnia depreciation at the end of 2008 gave new impetus to import-substituting industries. At the same time, this competitiveness gain is hampered by banking sector weaknesses, depriving the economy of credit resources. The credit dry-out and weak demand have already resulted in a 40% yoy decline in investments in fixed assets. However, assuming a gradual recovery of world commodity and financial markets in the second half of the year, a successful bank recapitalization program and prudent fiscal policy despite the coming presidential election, we project the economy to contract by 8% yoy in 2009.

    A steep decline in economic activity over the first four months of the year should have caused a notable deterioration in budget revenues. However, the government is still reporting above-target proceeds to state coffers. In particular, the government reported that the general fund of the state budget was over-fulfilled by 1.3% and 5.7% in March and April respectively.

    Moreover, in April, proceeds to the special fund of the state budget were almost 34% above the planned amount. As a result, according to the Minister of Finance, total consolidated budget revenues amounted to UAH 65.7 billion in 1Q 2009 and were 6.5% yoy higher in nominal terms. Thanks to tight control over expenditures, the consolidate budget was reported with a small deficit of UAH 74 million ($9.5 million) in the first quarter of the year. Information on both budget revenues and expenditures is quite scarce and often contradictory. The government releases budget execution data with a several month lag. Moreover, it appears that any other source of budget sector information but the Ministry of Finance is suppressed. Thus, since early April, the State Treasury has stopped publishing the cash balance on the unified state treasury account, which was usually used to assess current budget performance.

    Budget reviews, regularly published in the analytical reports of the Ministry of Economy and other government institutions, were eliminated. The revenue targets announced at the beginning of the year and those actually reported suggests that the plans have been corrected downwards, although the new targets were not announced.

    According to the presidential secretariat, proceeds collected to the general fund of the state budget were 0.3% lower than the target for the first four months of the year, while the government reported an almost 4% over-execution.

    The sustainability of the state budget revenues raises serious concerns as the government has relied heavily on one-off revenues and early payments of tax bills and other charges. According to the presidential secretariat, early payments to the budget grew from less than UAH 4 billion ($0.5 billion) at the beginning of the year to almost UAH 12 billion ($1.6 billion) at the beginning of May 2009. Moreover, during April the NBU transferred UAH 3.4 billion as the positive difference between the NBU’s revenues and expenditures in 2008. According to the 2009 Budget Law, these funds were planned to be received in equal installments of about UAH 1 billion on a quarterly basis. However, the annual target for the NBU payments was already met in April. Excluding the NBU advance payments, revenues to the general fund of the state budget turned out to be under-fulfilled by 12% in April. Even excluding other advance tax payments and one-off transactions (e.g., VAT proceeds from the customs clearance of 11 billion m3 of natural gas imported last year by RosUkrEnergo), this estimate indicates that state finances are indeed under significant strain. Despite worrisome developments, the government is very reluctant to revise the 2009 budget. The revision would likely mean a necessity to revise downwards government expenditures on public wages and social transfers. At the same time, such a move looks quite problematic for the government ahead of the upcoming presidential election.

    Alternatively, the government has been seeking measures to increase budget revenues and secure sufficient financing for the planned budget deficit. In particular, in mid-April, the government raised a number of excises (on alcohol, tobacco, etc.), confined maximum pensions, increased deductions to the Pension Fund of Ukraine for entrepreneurs who chose a simplified taxation system, etc. Observing these measures, the IMF resumed its financing to Ukraine under the stand-by program at the end of April. Moreover, the IMF relaxed its original fiscal deficit requirements for Ukraine from a balanced budget to a deficit of UAH 40 billion (about $5.2 billion), or 4% of GDP (excluding expenditures on bank recapitalization). This larger deficit was accepted considering the relatively small public debt ratio and the past record of low deficits. Moreover, the IMF agreed to direct $1.5 billion (1.2% of GDP) from the second tranche to finance the fiscal budget deficit in 2009. The latter reflects the shift in the government approach towards external financing of the targeted budget deficit this year. Initially, the targeted fiscal deficit of 3% of GDP was expected to be financed primarily by domestic financial sources. According to the 2009 state budget law, funds from issuance of domestic debt securities, privatization proceeds and accumulated cash balances on the unified treasury account should have been sufficient to cover almost 80% of the budget gap. The 20% remaining was planned to be raised from external markets. But given the sluggish privatization process and weak domestic borrowing market, now the government plans to raise about 60% of the state budget financing needed from external sources. Ukrainian authorities have been working to secure external financing from a number of international financing institutions (the World Bank, EBRD, etc.) as well as bilateral financing. So far, however, the talks on the latter have not been successful and the government has relied on the issuance of domestic debt securities. At the same time, domestic debt securities saw little demand from the commercial banks due to unattractive premiums and tight liquidity in the banking system. Though the dubious clauses that obliged the central bank to buy-out the government securities from commercial banks in three days upon request were removed from the state budget law in mid-March 2009, the NBU remained the principal buyer of government bonds in April. Over the month, the government bonds portfolio of the NBU grew by 31% to UAH 23.9 billion ($3.1 billion) at the end of April. At the end of April, the NBU held about 65% of total government securities compared to less than one third at the beginning of the year. The NBU financing of government expenditures may not bear inflationary pressures in the short-term. However, with a slow domestic supply response, the deficit monetization may have serious inflationary consequences as the crisis abates.

    Ukraine’s consumer price inflation slowed to 0.9% month-over-month (mom) in April and 0.5% mom in May. In annual terms, CPI growth fell to 14.7% in May, down from more than 22% yoy at the beginning of the year and 31% yoy in May 2008. The reduction in inflation is attributed to weaker consumption affected by lower incomes, major reduction in money supply growth and tighter credit. In addition, global recession depressed demand on industrial products and drove down world commodity prices. As a result, Ukraine’s domestic producer price inflation decelerated sharply from more than 20% yoy in January 2009 to less than 2% yoy in May 2009. In addition, April-May’s CPI developments were favored by a high statistical base effect. On the back of resumed growth of world crude oil prices, Ukraine’s fuel prices also gained 3.7% during April-May. Affected by an increase in excises, prices on alcoholic drinks and tobacco rose by 5.4% during these two months, while the scheduled tariff adjustments drove up the costs of transportation and communication services by 1.9% and 2.3% respectively. The upward pressure on total CPI from the price growth on these commodities and services was partially compensated for by declining food prices, which account for more than half of the consumer basket. Thus, during May, monthly food price growth fell to 0.3% mom, down from a 1.8% mom increase on average during January-April. In annual terms, food inflation eased to 9.3% in May compared to 23% at the beginning of the year and almost 50% in May last year. Stabilization of the foreign exchange market and moderate Hryvnia strengthening with respect to the US Dollar also contributed to disinflation during April–May. In particular, during May 2009 the exchange rate appreciated by 5.3% to UAH 7.63 per US Dollar. Market stabilization occurred thanks to regular NBU interventions, administrative measures and special auctions on foreign currency sales.