The war will last. The most influential people in the world keep repeating this statement. NATO Secretary General Jens Stoltenberg alone mentioned this at least five times in his public statements. Even if someone refuses to believe this, still harboring the dreams of going back to February 23, three things are enough to look at to make reality crystal clear.
Firstly, the analysis of the Kremlin’s goals in this war signals that Russia will fight until victory. However you look at it, this is Russia’s only chance to hop on the last train of time that is rapidly taking its “glorious” past into oblivion. Military defeat is the only thing that can stop it. Secondly, nobody in the world is willing to reach deep enough into their pockets in order to speed up Russia’s defeat with the noose of sanctions. While Europe is quitting Russian fuels, the Kremlin is shifting supply to Asian markets. Even with the addends regrouped, the sum of the numbers will remain the same. Thirdly, the world is willing to give Ukraine as much weapons as it needs to avoid a quick defeat. But it is not willing to give Ukraine as much as it needs to quickly win militarily. The world is afraid of nuclear bombs. It is willing to wait for Russia to get exhausted. Yet, as the statements of the key suggest, it has no idea of how much time that would take. Therefore, time — not the number of victims among Ukrainians — is de facto the key factor of efficiency in the West’s support for Ukraine as it holds a golden share in this war through its huge assistance to Ukraine. The longest possible time of war and Ukraine’s military resilience, and — unfortunately — the greatest possible losses among Ukrainians.
So, the war will last. Even if it did not, all spheres of public and private life in Ukraine should be fully prepared for a lasting war, continuously stay alert to make victory happen as soon as possible. Otherwise, Ukraine could experience a domestic social explosion at one point — if that happens, nothing will save it from defeat. A lot has been published about this in the past months. But these have mostly been theory and emotions rather than invaluable practical reflections. As a result, all the declared by the Ukrainian Government “2,500 experts” who worked on Ukraine’s National Recovery Plan already live in a virtual world of victory because they do not even start to think about what economy makes that victory real rather than virtual. They believe that all it takes to win this war is for the West to supply enough weapons and money to Ukraine. This is wrong!
The economy of a country at war is the foundation of its capacity to wage war. Even if Ukraine is flooded with money and weapons, what morale will the soldiers have if they know that their wives are losing their minds without jobs; their family members in business are losing money as customs and tax officers are doing whatever they want to, and business is losing money as a result of failing economic policy; their children cannot study because teachers have left and there are no textbooks after the state failed to find the funding to publish them, and their retired parents cannot afford medicines or food even if they are paid pensions on a regular basis? What will the soldiers fight for when they see that the government is failing on the economic front while they are defending the military front? Finally, how will Ukrainians rebuild the country if they get used to living on external assistance over the months of war? These questions make one think about how to make sure that Ukraine’s economy develops, even if slowly, right now.
After four months of war, the government knows enough to be able to build economic policy properly to optimize the resilience and of the national economy and its capacity to work for the victory amidst the war. All key economic trends are obvious, budgets are known, and statistics is available to serve as the basis for analysis. All it takes is to do the homework: draw the accurate conclusions and apply proper economic policy measures. In doing so, the following two principles should be taken into consideration. First, the economic cycle should be split into two sectors — military and civilian — separating war-related financial flows into a standalone system so that they do not distort the signals and incentives of the civilian sector. Second, the civilian sector should be kept in a permanent resilience macroeconomic balance. Without it, the economy will not be sustainable or dynamic, nor will it provide reliable support to the Army.
Fiscal policy
Ukraine has low budget revenues caused by the economic downturn, high defense and security spending, and a serious budget deficit that is partly covered with money printing. This is not balanced. Under normal circumstances, it would be extremely dangerous and unacceptable for the economy. However, society is following wishful thinking whereby this is not for long, hoping that financial support from the West will soon increase to the amount Ukraine needs and solve all of Ukraine’s problems at the expense of the developed world. This is a misleading if not disastrous approach. Ukraine has suffered many times when it relied on hopes without learning any lessons.
Fiscal policy should be built differently. In the cumulative budget, war spending is concentrated in two sections, Defense and Civilian order, Security and Judiciary. According to Ukraine’s Ministry of Finance (MFU), Ukraine spend UAH 92bn on these two sections in March and UAH 135bn in May. Even if we think of the May indicator at the fixed exchange rate of UAH 29.25 to US $1, Ukraine needs USD 4.6bn to wage the war — or less in reality as the market exchange rate is higher than the fixed one, and part of this spending has nothing to do with war. This is not US $5bn that Ukraine’s greedy officials have spoken about. They should probably start by speaking the truth in their communication with Western partners — to make it easier for them to give Ukraine as much money as it actually needs.
Secondly, the cumulative budget deficit was UAH 80bn in March, UAH 84bn in April and UAH 99bn in May. This shows that, though all the three months of war where statistics is available, the deficit was far below what Ukraine spent on war. This means that — if the spending on the war and the deficit that covers that spending is separated into a standalone military money turnover — the civilian sector will end up with a surplus budget. Surplus budget is a hard fiscal policy instrument that is used when the economy needs to be made leaner, taken out of the overheated phase. But Ukraine’s economy needs to be stimulated, not restrained! Therefore, such budget proportions are fundamentally wrong at the current moment as they kill economic growth.
Thirdly, after the NBU introduced currency exchange restrictions in the wake of the war and loosened them in May, it has been burning nearly US $1bn of its currency reserves through interventions in the interbank market (the total monthly shrinking of reserves is smaller thanks to the support of foreign partners that goes directly to the reserves bypassing the currency market). As a result, monthly spending on currency interventions amounts to nearly US $4.0-4.5bn. This is de facto much higher than the currency spending on the war (much of it is not spent to buy weapons and ammunitions abroad); budget deficit or the amount of money the NBU prints to cover that deficit. Plus, Come Back Alive, one of Ukraine’s biggest war charity funds, reports spending hundreds of millions — or billions — hryvnia monthly. These amounts make it hard to explain the current rate at which Ukraine’s currency reserves are being burnt. This means that foreign currencies are flowing out of Ukraine to cover consumer needs — and that is unaffordable in wartime.
All this means that the formula of the wartime economic cycle is not working, whereby budget deficit equals war spending, and war spending equals currency intervention to tie in the hryvnia printed to cover the deficit, or the currency spent is the one received from foreign partners. The problem is that the deficit is too small in this formula, and interventions are too high. If the formula is so distorted, the wartime economic cycle will deform the civilian cycle — which will eventually damage or kill economic growth. Obviously, this is a sporadic result of the government’s motivation to work with available economic resources under the current restrictions. But if things stay as they are, Ukraine’s economy will grow weaker and will not be able to handle lasting wartime pressure. In fact, we are already seeing it grow weaker. So, this scheme needs to be fixed.
The external sector
Weekly interventions worth billions that rapidly exhaust Ukraine’s significant, if not unlimited, reserves are not the only problem. If reserves are burnt at the June pace, they will not last longer than 10 months — and the war will not necessarily end by then. Another huge problem is that every billion of dollars burnt by the NBU takes UAH 29-36bn out of Ukraine’s economic turnover — those who buy foreign currency must get hryvnia somewhere to pay for the dollars and euros they buy. If the budget draws the money out of the civilian sector, and the banking system barely lends to it — loans to legal entities grew a mere UAH 19bn over March-May — where will it get the money for development? The civilian sector is simply drying up, “aided” by both the state and by the external and financial sectors. Add to this the policy by Danylo Hetmantsev, Chair of the Verkhovna Rada Tax Committee, and you will see why Ukrainian business is lamenting in despair. If we want Ukraine’s economy to develop — otherwise it will not survive in the war — the civilian sector must get systemic liquidity injections from somewhere. This is the focus of this analysis.
The currency exchange rate is another problem. The NBU has fixed it to restrain inflation expectations and support purchasing power of the budget and charity funds that buy weapons and ammunitions abroad. This may have been a correct short-term step in the past. It is now producing side effects. Below are the three reasons why.
Firstly, Ukraine’s imports of goods shrank 24.5% compared to 2021 in May, according to NBU data. GDP decline is estimated anywhere between 30-50%. This means that economic activity is plummeting in Ukraine and people continue to buy goods produced abroad. This is an imbalanced situation that undermines the balance of payments — contributing to the huge amount of interventions, among other things — and helps build crisis potential in the country.
Secondly, Ukraine imports 115% more services than it did in 2021. The key contributor is from traveling, i.e. the money Ukrainians — mostly refugees — spend abroad. Paradoxically, the way the NBU’s currency restrictions work is that Ukrainian refugees can spend their money abroad at a better rate than the market rate in Ukraine. Ukraine’s care of its citizens who have left and might not return is understandable. But they are not hearing explosions, and are better off in the destination countries than those who stayed — so Ukraine does not necessarily need to help them in this way. Finally, Ukrainians can find jobs abroad, so Ukraine does not need to spend over a billion dollars from the NBU’s reserves on them on a monthly basis.
Thirdly — and most importantly, — the real effective exchange rate (REER) for the hryvnia that shows its relative value compared to the currencies of Ukraine’s trade partners, it was 1.08 in May when restrictions were partly lifted and the official exchange rate had not yet changed. This is higher than 0.92-0.94 in the months before the EuroMaidan Revolution and slightly under the historic record of 1.19-1.24 before the 2008-2009 crisis. It was 0.54 at the lowest point of the 2014-2016 crisis and 0.87 at the lowest point of the 2008-2009 crisis. All this shows that hryvnia is extremely expensive now and has the potential to lose at least 25-30% of its value. The difference in inflation rates between Ukraine and the world objectively devalues hryvnia, but reality does not reflect this after the NBU introduced the fixed rate. This results in unjustified import growth boosted with zero tax rate that was only abolished recently; huge problems for exporters that are primarily caused by the relative priciness of their products rather than the blocked ports as they are required to sell their revenues in foreign currency at the official NBU rate of UAH 29.25 per US $1; and capital outflow from Ukraine that continues through unconventional channels as some BOP items illustrate despite the NBU’s efforts to block it. Ukraine’s BOP is bleeding and this is incompatible with economic development.
Financial sector and public debt
The situation in the banking sector can be briefly described as follows: banks are not lending (loans to corporations increased by UAH 19bn over March-May and household loans shrank by UAH 12bn) and not funding the state (banks purchased government bonds at UAH 13bn over March-May and the amount they currently hold is lower than it had been before the war), while cleaning up the losses caused by the war and showing off available liquidity worth UAH 163bn as of late May in NBU deposit certificates. Ukrainian banks are essentially not helping the state or the economy, even though they have the resources to do so. The only way in which they work for the victory is that they are dealign with their problems independently and are fairly resilient which prevents panic in the population on the financial front. They increased the amount of all deposits by UAH 89bn over March-May (hryvnia-denominated deposits increased by UAH 101bn), which shows that the banking economy is working to take money out of the economic cycle, and thus stifles the development of the economy and its resilience in wartime. We can praise banks for not failing, standing strong and continuing operations as normal. Unfortunately, however, their contribution to Ukraine’s victory is disproportionately smaller compared to their potential.
For this analysis to be relatively full, it has to take into account public debt. The huge budget deficit calls for a rapid increase of public debt. I am not a fan of suspending public debt payments now, especially when it comes to external debt: Ukraine is getting generous support, so it should fulfill certain obligations, including financial ones, in return. But we need to understand what resources are available in order to know what strengths Ukraine has if anything goes wrong. In March, April and May, the cumulative budget spent UAH 15, 9 and 28bn respectively. Not paying these amounts will not help Ukraine much. Obviously, even doubling these sums with growing interest rates would not be critical for the budget. So Ukraine can increase the yield of its government bonds. Over these months though, Ukraine spent UAH 19, 30 and 32bn to pay domestic debt from the cumulative budget. These are more serious amounts. If they are delayed, the state will not draw new funds from the banking sector, including private banks. And two more numbers for comparison: the cumulative budget received UAH 155bn from foreign borrowings — almost all of that came during wartime — over five months of 2022; and UAH 42bn through official transfers, i.e. free nonrefundable grants. This shows that Ukraine’s partners are willing to give money to Ukraine but would prefer to get it back eventually with an interest, even if low. Clearly, Ukraine will be able to discuss the revision of its debt burden when the war ends, and possibly write it off partly. But these conversions should be left for after the war.
What can we do?
This analysis shows that Ukraine’s economy is now in extremely unfavorable conditions. The key reason for this is probably not the destruction caused by the war, but the poorly balanced macroeconomy that creates artificial barriers to economic development. This weak foundation, coupled with inadequate policy solutions passed thoughtlessly, kills the prospects of surviving economically, thus diminishing Ukraine’s chances of winning the war. But this is not a desperate situation. Balance can be restored, resilience strengthened and development boosted. This calls for a number of steps.
First, currency exchange rate restrictions should be lifted for it to reach the market rate and for multiple exchange rates to disappear. As a result, the foreign sector will stop squeezing the juice out of the national economy. A sharp increase of interest rate by the NBU is a good move to anchor down inflation expectations and prevent a currency panic when the exchange rate is loosened. When the regulator said a, it forgot to say b. The sooner it does that — lifts currency exchange restrictions — the sooner it can start the cycle of bringing the interest rate down, meeting the MFU halfway in its attempts to decrease interest payments on debt. A cheap hryvnia will boost exporters that see external markets as the only reliable mark amidst high uncertainty on the domestic market (with the current problems in logistics, the industries with high added value and high value of a ton of export will benefit from this incentive the most); decrease non-productive consumption of imports within the country and make domestic goods more affordable than their imported equivalents on the shelves. This will boost the support of domestic producers by Ukrainian consumers. Ukrainian households will grow somewhat poorer, but what they lose will go to the business as a boost for its development and to the state that will be able to spend more on defense. If the NBU wants to support the purchasing power of budget spending on the war, it can sell foreign currency to the Defense Ministry and some charity funds at a subsidized rate to purchase weapons and ammunition abroad. It will be impossible to fully avoid all kinds of scamming in this situation. But this will not be too critical for the currency reserves if it amounts to some UAH 50bn a month (or less — this requires extra calculations).
Second, the budget has to increase spending on non-military purposes to stimulate total demand, thus boosting economic activity. Winter is coming and Ukraine needs to buy fuels. Apart from that, it needs to boost construction and public work. That requires anywhere from billions to tens of billions of hryvnia. The domestic market should be filled with money, otherwise it will see no economic growth. Budget spending offers a way to do this directly and as fast as possible. Avoiding embezzlement is the main thing about it.
Third, the state should reduce tax pressure dramatically. It is now or never. When Western partners say that they are willing to provide funding to Ukraine and Ukraine needs to justify its needs, there is no better need than stimulating economic activity with a serious multiplication effect. This should be coupled with tax exemptions linked to the creation of jobs. And with the engagement of Western technology and investment. Obviously, this and the point mentioned above will make budget deficit larger. But Ukraine will be able to fund it if it manages to justify it well to the Western partners. As a reminder: the civilian sector of the budget should have a deficit in order to boost business activity, otherwise there will be no-one else who can pump the money into the civilian sector. Finally, one important thing to keep in mind is that people are the foundation of any business. Ukraine has lost millions as refugees, but a lot of people have stayed who have profound knowledge and expertise in some productions. All they need to resume production is to get together and replace the capital that may have been destroyed or left somewhere in an area of active fighting. Stimulating the resumption of production with such fragments of resources is one way for the state can accomplish a serious economic effect with little funding.
Fourth, the state can expand subsidized lending for the business amidst loans with high interest rates and a de facto inactive banking sector. This will allow it to pump money into the economy and to boost investment. The main thing here is to start building the mechanisms to prevent embezzlement of public funds now. Otherwise, foreign partners could simply stop funding it at one point.
The main purpose about the measures offered above is to restore the macroeconomic balance and a systemic inflow of money to the domestic market. Without this, any state policy will bring questionable results and the economy will not become sufficiently resilient or dynamic. And Ukraine will not win the war without a strong economy, however heroic its warriors are.