Waiting for the next IMF tranche: will it be possible to reach an agreement without devaluation of the hryvnia and tax increases?

The other day in world mass media it was said that the International Monetary Fund may require Ukraine to accelerate the devaluation of the hryvnia, lower the discount rate and ease monetary policy in order to receive the next tranche of financial assistance.

Ukrainian officials are preparing to meet with IMF officials this week to discuss faster devaluation of the hryvnia, lower interest rates and increased tax collection to cover the budget deficit. It is expected that the IMF mission in Kyiv will, under any circumstances, try to “convince” Kyiv to resort to these unpopular measures in order to continue financial support from the international regulator. They are conducting the fifth planned review of the credit program in the amount of 15.6 billion dollars.

They help those who help themselves

The result of the review may unblock the allocation of $1.1 billion to Ukraine if the fund’s staff conclude that Ukraine is meeting program goals and has sufficient resources to meet its financial needs.

The National Bank of Ukraine, however, does not want to allow further weakening of the hryvnia. The currency has already lost more than 10% since October, in a process of currency liberalization that saw the expiry of a fixed exchange rate imposed after a full-scale Russian invasion. This move will call into question the Central Bank’s ability to maintain price stability. A devaluation of the hryvnia and an increase in taxes could have negative political consequences, as the population is already suffering from the war with Russia.

The IMF, the central bank and the Ministry of Finance of Ukraine refused to comment on the situation. After the meeting with the IMF team, the head of the National Bank, Andriy Pishnyi, posted on Facebook that it is important to find the “optimal” monetary and fiscal policy, without going into details. He also noted that the domestic debt market will play a significant role in financing the government.

Ukraine relies on international support in the form of weapons and funding to counter Russian aggression. The unexpected offensive of the Ukrainian military in the Kursk region did not change the course of the war, since the aggressor has gained a foothold in the east of Ukraine and continues to launch massive missile attacks on the country.

Although Ukraine received about $122 billion in international aid from the US, the EU, the IMF and other international partners, it still faces a budget deficit of $15 billion for next year. And this deficit, for in words of Prime Minister Denys Shmyhal, is not yet covered by financial guarantees from donors.

To help close this deficit, the IMF plans to urge the National Bank of Ukraine to quickly devalue the hryvnia and ease monetary policy, given moderate inflation in the country. It is expected that these measures will increase budget revenues in hryvnias and reduce the cost of borrowing for the Ministry of Finance.

Why the IMF considers Ukrainian tax policy too soft

The IMF criticizes the Ukrainian government’s plan to raise taxes, considering it too soft. They called on the government of President Zelensky to increase the range of tariffs. One possible proposal is to increase the value added tax from the current 20%.

On Tuesday, the Verkhovna Rada failed to pass a draft law on increasing the “military levy” on the income of individuals and extending it to entrepreneurs. This testifies to the unpopularity of such measures among Ukrainians, the resource of strength of which has already been exhausted. Faced with mobilization, fears of government corruption, regular blackouts due to airstrikes, and rising electricity and food prices.

In addition, it is planned that Ukraine will receive additional financial support in the form of loans in the amount of 50 billion US dollars. These funds will be financed by profits from the frozen assets of the Russian central bank. The Group of Seven countries leading the effort aim to secure the funds by the end of the year, although the US and EU are still working out the details.

Possible consequences of implementing unpopular financial measures recommended by the IMF

The aforementioned financial measures, the implementation of which is being pedaled by the IMF in Ukraine, can have both potential benefits and risks for Ukrainians. Their impact will depend on how they are implemented and what additional measures are taken to support the economy and population.

As for the devaluation of the hryvnia, a faster devaluation of the hryvnia may lead to an increase in import prices, which will increase the cost of living for ordinary citizens. However, it can also make Ukrainian goods more competitive in international markets.

Easing monetary policy, i.e. lowering interest rates, can reduce the cost of credit and thus stimulate business activity and investment. However, it can also lead to an increase in inflation, which will negatively affect the purchasing power of the population.

An increase in taxes, especially the war levy, could cause discontent among citizens already facing economic hardships due to the war. This can reduce consumption and economic activity.

Additional loans and financial assistance from the international community can help stabilize the economy and finance important government programs. However, it will also increase the country’s external debt, which will have long-term consequences for the economy.

In addition, the increase in financial flows will increase the risks of corruption, which can reduce the efficiency of the use of funds and the trust of citizens in the government.

Of several evils, one should choose the lesser one

Obviously, there is no easy way out of this situation. It is likely that the government and the National Bank will decide on such an unpopular measure as devaluation of the hryvnia. But this measure will not improve the economic situation in the country. Those who consider hryvnia devaluation beneficial both for the state budget and for Ukrainian exports probably do not take into account several possible consequences.

First, imports will become more expensive, in particular, the prices of fuel and weapons will soar. Secondly, devaluation of the hryvnia does not mean an immediate increase in imports. In particular, because even though the Ukrainian sea corridor has been restored, it is still very risky logistics. And it is not yet known whether a reliable infrastructure will appear for increasing exports.

Devaluation of the hryvnia may help exports, but only in the short term. Because prices for domestic export products abroad leave much to be desired. In essence, the devaluation of the hryvnia is a redistribution of capital between those who receive income in hryvnia and those who earn in the currency. That is, the teacher’s salary, while remaining unchanged in hryvnia, will decrease from 200-300 to 150-200 dollars per month in currency, and will make the poor teacher even poorer, while the one whose work is paid in currency will become richer in the short term.

Regarding the reduction of the discount rate, many experts try to compare the level of devaluation and the discount rate. But in Ukraine, the foreign exchange market is not free, but fixed, and all players are oriented towards it. If you plot the interest rate curve and the devaluation curve on the same graph, it will become obvious that the profitability of the country’s discount rate is already quite low, and a decrease in the rate can undermine it.

The IMF calls for a rate reduction allegedly for domestic obligations. But at this time, the rate on OVDP in the auctions of the Ministry of Finance is already lower than the rate of the NBU. It is worth considering another three-month deposit certificates, which can also be sent to the OVDP, but this is impractical. Players of the financial market consider the rate for decertificates to be balanced.

It is worth noting that it is impossible to maintain the exchange rate and the discount rate at the same time. And a simultaneous decrease in the exchange rate and interest rate can have very negative consequences for the country’s economy.

Probably the least of the evils is an increase in the VAT rate. Since such a measure will also affect the shadow market, and inflation from its implementation should be short-term.

Tatyana Morarash