Ukraine’s allies must dig deep to save its economy now

Continuing failure to release international finance as grants in a timely manner will trigger an economic crisis in Ukraine which would hugely damage the war effort.

Expert comment Updated 4 October 2022 Published 3 October 2022 3 minute READ

Remarkably, despite ongoing conflict in close to one-quarter of Ukraine’s territory, basic economic functions in the country are still working, and working well.

Transport, infrastructure, telecommunications, banks, and the financial and monetary system are continuing to function and although the Ukrainian hryvnia (UAH) has devalued by around one-third since the invasion, it has not collapsed.

There have been no bank runs and, even in the heart of the conflict zone, banks continue to provide cash and transaction services. In many respects this reflects reforms instigated since 2014, such as the cleaning up of the banking sector and the reform of the National Bank of Ukraine (NBU).

The move to an orthodox monetary and exchange rate regime with a floating exchange rate system and inflation targeting has also helped, allowing the NBU to have built up a foreign exchange (FX) reserve buffer of close to $29 billion – six times the level it was in the period just after Euromaidan.

Economic destruction is on the horizon

But, despite this resilience, the war has collapsed Ukraine’s GDP and devastated its infrastructure. Data from the Ukrainian ministry of economy suggests real GDP has contracted by as much as 40 per cent in the second quarter of 2022, and expectations are the full year decline will be one-third in terms of lost economic output.

If this continues, Ukraine will be saddled with an unsustainable debt burden upon the war’s conclusion and could well end up going through another disruptive debt restructuring just when it will need speedy market access

The destruction of infrastructure is huge, and ongoing. Estimates from early September suggest the damage in physical assets to be as much as $349 billion, close to double the pre-war GDP.

War is also expensive, and Ukraine’s defence spending increased five-fold to $17 billion for the first seven months of the year. With the GDP contraction hitting budget revenues, the budget deficit has ballooned and, for the full year, it could top $40 billion, equivalent to 30-40 per cent of GDP.

Funding such a huge budget deficit has put enormous pressure on Ukraine. The war effectively closed market funding channels and, in the early months of the war, international donors were slow to pledge and even slower to disburse funding. Only $7-8 billion, around one-third of the budget financing needs, was forthcoming in the first five months.

The ministry had some modest access to war bond issuance but during this period most budget financing came from NBU issuance – effectively just printing money which put additional pressure on the exchange rate and inflation.

The NBU felt compelled to support the currency initially to anchor confidence but lost around one-third of its FX reserve buffer in the process. Needs must, but this policy risked and indeed still risks the hard won macro-financial stability delivered in the period before the invasion.

The war effectively closed market funding channels and, in the early months of the war, international donors were slow to pledge and even slower to disburse funding

This fiscal dominance and jettisoning of the NBU’s flexible exchange rate and inflation targeting regime is not sustainable long-term as it brings risks of currency collapse and hyperinflation.

Recent improvements cannot hide bigger issues

Ukraine’s financing position has thankfully improved recently and, for the period from 24 February 24 to 20 September 20, Ukraine’s ministry of finance secured $33.9 billion in financing, but still only $19 billion of this was provided by international donors. And in reviewing this international financing, a few glaring concerns are evident.

Quite clearly the burden seems to be disproportionately shouldered by the US, which has provided $8.5 billion in financing to Ukraine mostly in the form of grants. The European Union (EU) and European bilateral creditors have provided just over $5 billion so far – the EU did promise nine billion euros in financing but has only disbursed around 2.4 billion.

In addition, just more than half of the $19 billion international financing provided to date has been in the form of loans. If this continues, Ukraine will be saddled with an unsustainable debt burden upon the war’s conclusion and could well end up going through another disruptive debt restructuring just when it will need speedy market access to ensure the private sector fully participates in the country’s huge reconstruction needs.

Ukraine’s allies must dig deep to save its economy now 2nd part

Assuming the war continues to the end of 2022, Ukraine’s financing needs will likely reach more than $12 billion but how this will be funded is unclear. Donor commitments are there but if monies are not disbursed in a timely manner the result will be even more resort to NBU financing and printing more money, creating more pressure on the exchange rate and inflation.

As the UAH continues to weaken, the danger is that macro-financial stability is threatened, with the risk of bank runs and a broader loss of confidence in the currency and financial system.

Ukraine needs to focus on fighting the war. Its international allies need to pull their fingers out and remove at least one headache for policymakers in Kyiv by funding a war budget and maintaining macro financial stability. Ukraine is partly fighting this war in defence of the values of its allies and yet is being charged for its efforts. This is not right and must not continue.