Last week brought into the spotlight an important topic that’s been overlooked somewhat in debates surrounding the Russian military buildup around Ukraine – the destabilizing economic effects of the ongoing threat.
Propelled by rising geopolitical tensions, the Ukrainian hryvnia fell by almost 7% in January – from about 27.2 hryvnias to the US dollar to almost 29, though it regained some ground on the last day of January. The National Bank of Ukraine has spent $1.5 billion from its foreign currency reserves, with more than $700 million spent last week alone.
Meanwhile, the rates on Ukraine’s Eurobonds trading on foreign markets have risen to the point where the country can effectively only raise funds internationally from international financial organizations and foreign governments, with private financing unavailable.
This situation has even provoked some tension between Ukraine and its Western allies, with Ukrainian President Volodymyr Zelensky calling on them to tone down the rhetoric on the crisis to avoid panic.
So what’s going on and how risky is the situation?
It’s important to understand what kind of financial outflows are actually happening. According to the data from market participants, only about one-fifth of the outflow was actually driven by foreign investors leaving Ukraine.
The population is behaving calmly; ordinary people aren’t withdrawing deposits from banks en masse, nor are they queuing at foreign exchange offices to buy up dollars and euros.
Rather, most of the outflow is due to the re-adjustment by Ukrainian businesses, with exporters hoarding their foreign-denominated income and importers rushing to buy foreign currency in the face of a falling hryvnia.
This kind of re-adjustment is to be expected in such a situation – and is rather sensible from a business perspective. Nevertheless, it is unlikely to persist, as businesses don’t seem to be shoring up their activity.
In fact, in a recent poll by the European Business Association, half of the companies polled said they’ll continue operating even if the invasion happens. Rather, it seems, the businesses are hedging their risks and adjusting to operating in a new and more dangerous reality – but not completely halting their operations or fleeing Ukraine.
This, in turn, implies that capital outflows in their current form are unlikely to persist. Once Ukrainian companies adjust to heightened geopolitical risks, the pressure on the currency – and the need to spend National Bank reserves to support it – will abate. The reserves are still relatively large – around $30 billion, which is sufficient to cover almost half a year of imports to the country. Thus, the National Bank has quite a lot of resources to keep the economy and financial system stable and functioning.
Another issue is the Ukrainian budget’s funding needs, with the country effectively locked out of international financial markets. While this year’s payment schedule on foreign government debt is relatively light (about $4 billion), the country still relies heavily on foreign financing. In these circumstances it’s vital for international financial organizations and partner countries to step in and provide financial assistance. The EU pledged 1.2 billion euros in a new macro-financial aid package on January 24.
If enough official financial assistance is provided, this should offset the unavailability of market access and keep Ukraine’s funding needs covered throughout 2022.
Of course, all this doesn’t mean there’s no threat to economic stability.
First, an actual invasion by Russia, even on a limited scale, would provoke further capital outflow and potentially cause financial panic. This would have to be countered by the NBU burning its reserves and foreign official donors quickly topping up financial assistance packages. The resources are available, but they would have to be used quickly and efficiently.
Second, Ukraine is still vulnerable to the Russian economic weapon of choice – energy.
In February, the Ukrainian electricity grid is slated to be disconnected from the Russian and Belarusian grids (having been connected since Soviet times) and tested in isolated mode.
Successful completion of this important test would enable Ukraine to proceed quickly with integrating itself into ENTSO-E, the system of transmission operators, and so reducing Ukraine’s dependence on Russia and Belarus. The risk is high that Russia will try to do something on this front – like suddenly cutting energy supplies.
Third, rising food prices will be a destabilizing factor at global level this year, and Ukraine is no exception. There is no doubt Russia will try to use this in its relentless information warfare to destabilize the domestic political situation in Ukraine. It’s quite important for the authorities to take mitigating measures now, while there’s still time. These include targeted help for the poor and temporarily lowering consumption taxes on critical foodstuffs.
Finally, it’s vital to remember that Ukraine is not the only one to suffer. The Russian economy and financial system are also feeling the heat, with the ruble’s value dropping by more than 10% since the start of the military buildup in October. Russian stock markets are falling and major international investment banks are selling off Russian assets.
The Russian financial system is more developed than Ukraine’s, so, arguably, Russia is actually getting hurt more by financial outflows and destabilization. It is not a given that this will by itself deter the Kremlin from further aggression – but it’s definitely a signal to the Russian leadership that the costs of such aggression would be quite high.
Op-ed disclaimer: The Kyiv Post is not responsible or liable for any content in this article, which expresses the personal viewpoint of the author only.
