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How Ukraine could smooth out exchange rate fluctuations?

Author : Oleksiy Kushch

New models of exchange rate stability should be sought in the experience of European countries, which at one time had already had "childhood diseases" associated with any economy that integrates into a stronger environment
21:27, 16 July 2019

Open source

The National Bank announced the beginning of “constructive uncertainty” era. The term "constructive" means the fact that market agents inside our economic test tube are fully aware of the possibility of the National Bank at any time to switch the selector of the foreign exchange market. The reason is simple: the market is small, and the regulator is large. On the other hand, the uncertainty factor suggests that the majority of market participants do not know when this will happen. The impossibility to predict the action of the NBU, according to officials, is the main "highlight" of the central bank's market game held today in Ukraine. The complex behavioral models that arise at the micro level generate millions of individual investment and financial decisions, which form the unique relief of our internal market environment. This is how it should be in theory and in the minds of the managers. But this does not happen in practice. In reality, such an environment becomes ideal for financial speculators and margin trading in financial instruments and currency.

Investors from the real sector of the economy just need clear forecast parameters and indicators to form clear outlines of the future of a particular economy. Such indicators can be the projected exchange rate, GDP, inflation. Excessive volatility of forecasts discourages investors, especially since most developing countries are already able to provide a sufficiently deep horizon for planning complex business cycles designed for 3-5-year payback. The value-added strategy and the likelihood of embedding the national economy in global technological chains also depend on the adequacy of the monetary policies of the central bank. If it is over, we are not talking about a commodity economy that is firmly tied to the  world prices for raw materials and semi-finished products.

That is, system investors need "constructive certainty." The promise of beautiful figures of GDP growth, moderate inflation and a stable exchange rate should be confirmed by the real operational capabilities of the economy in general and the central bank in particular. Obviously, we are not talking about a fixed rate. By the way, the floating rate in fact means only the refusal of the NBU from any forms of constructive monetary policy.

New models of exchange rate stability should be sought in the experience of European countries, which at one time had already had "childhood diseases" associated with any economy that integrates into a stronger environment. After all, now Ukraine is actively going through a painful period of adaptation to the European market for goods, services, labor and capital, the standards of which are disproportionately higher than ours. Under these conditions, pressure on the hryvnia is inevitable. In particular, domestic capital will go to more reliable "harbors", and the trade balance with the EU market for Ukraine will be zero at best.

Even at the dawn of the European integration processes, European countries came to the need to establish a special currency regime, which was mentioned in history as the "European currency snake" or "snake in a tunnel". The essence of this exchange rate model was as follows: in the conditions of the integration of a significant number of countries into the general capital market, their economy represented by weak national currencies, will be in a state of long-term exchange rate shock, which in turn will destructively affect the economic condition and financial sector in particular. To smooth out peak exchange rate fluctuations (in the absence of a common European currency), the six countries of the Common Market agreed to define "gold points", that is, limiters of the exchange rate corridor for their currencies relative to the dollar parity. The deviation of six national currencies against the US dollar was allowed within plus / minus 1.125%, that is, the total range of fluctuations was 2.25%.

Let’s consider this model on the example of the hryvnia. The basic rate is 28 UAH/1 USD. The size of exchange rate fluctuations in relation to the hryvnia can be expanded to 5%. In this case, the upper point of hryvnia devaluation will be 29.4, and the lower - 26.6.

The model of the European currency snake did not last long and later led to the creation of a single European currency. But in the 90s of the last century, in certain aspects of its operation, it was “re-energized” and was actively used to smooth out exchange rate fluctuations of the national currencies of the new EU members from the former socialist camp (Central European and Baltic countries).

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That is, to reduce devaluation expectations and the level of interest rates, Ukraine (until it became a member of the EU) needs effective exchange rate mechanisms that would dampen contact with a more powerful and dynamic capital market, such as Europe. The "snake in a tunnel" for this fits just perfect. But smart people will reasonably argue - who will fund the National Bank? After all, our regulator emits the hryvnia, not the dollar or the euro. To smooth the exchange rate curve, taking into account the seasonal fluctuations of our national currency, it is necessary to spend about $ 1.5 billion and up to one billion euros (autumn / winter). These negative NBU interventions can be fully or partially compensated in the spring-summer period, when there is a surplus of currency in the market. In the event of a crisis exacerbation due to falling prices in the international commodity markets or sharp turbulence in the financial markets, the volume of interventions to smooth out the “exchange rate peaks” and straighten the exchange rate curve will have to be increased several times. Given that the seasonal factor will bring a surplus of supply in the spring and summer, the National Bank only needs to find a source of compensation for cash gaps. But where to get the starting resource for launching this model, because in order to sell dollars, you need to buy them at the beginning, and we have no money ...

In fact, we have the tools to implement the “exchange snake” model, and for this it is not at all necessary to spend our gold and foreign exchange reserves, especially since there are few of them. A currency swap is in simple words a currency exchange between two participants (a simple swap) or several ones (designed swap). The exchange can occur at fixed and floating rates, with the payment of the difference by the base interest rates for a particular currency or without it. In this case, we have a classic swap line between two central banks, providing for the exchange of national currencies at a fixed rate.

To form a stable exchange rate trend for 3-5 years within a clear NBU corridor, it is necessary to conclude swap agreements with the Fed (dollar) and the ECB (euro) in the amount of $ 2 billion and one billion euros respectively (minimum). These resources can be provided to us as compensation for structural deficits in the balance of payments with the obligation to restore the limit within 2-3 years.


In fact, this model is not unusual. In the world there are several system pools of swaps in the form of a conglomerate of countries that are concentrated around the issuer of the world reserve currency.

The swaps of the US Federal Reserve liquidity line have been actively studied by world monetary science. The activation of these studies coincided with the global crisis of 2008, that is, at the moment when the need for instruments to compensate for lost currency liquidity was more acute than ever. A start was made in 2007, when, in accordance with the decision of the Open Market Operations Committee, the US Federal Reserve decided to open a swap line with the ECB and the National Bank of Switzerland. In the future, the list of countries was significantly expanded and the central banks of such countries as Australia, Great Britain, New Zealand, Canada, Mexico, South Korea, Singapore, Japan, Sweden, Denmark, Brazil were included. After a few years, there was no need for swaps, but they played a role in stabilizing local currencies. As we see, not only system players, but also “kids”, as well as developing economies, are among the countries.

The ECB also had its own conglomerate of swap clients who needed to feed liquidity in euro: Denmark, Latvia (before the euro was introduced), Sweden, Poland, Hungary, Japan, Switzerland, the Fed, the United Kingdom, Canada.

There is a network of swaps in Asia. It emerged as the Chiang Mai Initiative in response to the Asian crisis of 1997–1998. It includes a group of ASEAN + 3 countries (where +3 is China, Japan and South Korea). All participants in the network pool were merged by a system of swap agreements between their central banks. Subsequently, Brunei, Vietnam, Cambodia, Laos and Myanmar joined the agreement, and the sum of the limits of swap agreements increased to $ 120 billion, with China, Japan being the main donors, and South Korea a little less.

China not only limited itself to participation in the Chiang Mai Initiative, but also created its own “grid”: Australia, the United Arab Emirates, Pakistan, Argentina, New Zealand, Turkey, Uzbekistan, Kazakhstan, Mongolia, Belarus and Ukraine.

Yes, back in 2012, the NBU signed with the People’s Bank of China an agreement on currency swap for 15 billion Chinese yuan or 19 billion hryvnia, which at that time was equivalent to 2.36 billion dollars. The transaction itself was filed as a serious breakthrough in providing opportunities for economic entities of the two countries to carry out export-import operations in national currencies. In former times, foreign economic agreements in both China and Ukraine were funded in dollars and the need for a swap was zero. But starting in 2010, China began to move harder to reduce the level of dollarization of its foreign trade and developed a comprehensive program for concluding swap agreements with central banks representing countries that are its trading partners. In addition to swaps with China, the National Bank of the times of Yanukovych planned to conclude similar agreements with Russia (ruble-hryvnia) and Belarus.

The agreement on the Chinese swap, by the way, was last year re-signed by the current head of the NBU, Yakiv Smoliy, during his visit to Beijing: it will last three years, the amount is the equivalent of UAH 62 billion.

If the NBU already has experience of “swapping”, then why is it not trying to expand this tool through the relevant agreements with the ECB and the Fed on euro and dollar? This requires the proactive policy of the National Bank. As the experience of other countries shows, without effective damping mechanisms, moving along the path of integration into complex and more competitive markets will turn into wandering around the Mobius strip, which, as we know, is a symbol of infinity.

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