Standard & Poor`s Ratings Services said that the National Bank of Ukraine`s decision to permit the Ukrainian hryvnia to fluctuate within a wider corridor is an encouraging move towards greater monetary flexibility. According to Financial Mirror, the weighting of tradeables in the Ukraine`s consumer price index is slightly above 50%. A shift towards greater monetary flexibility will partially help to reduce inflation`s role in driving appreciation of the real exchange rate.
The departure from a strictly fixed exchange rate regime should also help to strengthen the interest rate channel, giving the central bank`s greater latitude to influence domestic demand. It is important for economic agents to recognize, however, that the exchange rate can weaken as well as strengthen depending on economic fundamentals, which are no longer unambiguously supportive of a stronger hryvnia. We expect the Ukraine`s current account deficit to double from 4.2% of GDP in 2007 to 8.4% of GDP in 2008, although the uncertainty of this forecast is considerable given the uncertain outlook for the price of metals and chemicals, which together make up 60% of Ukraine`s exports.
The key endogenous drivers of very high inflation in the Ukraine remain in place.
Nominal general government expenditure growth--which averaged 30% year-on-year (y/y) in 2007 and is set to increase 33%y/y in 2008--is very high. It is also heavily weighted towards wage and pension increases, which will feed directly into higher food and consumer goods prices. The risk is therefore that rising inflation will feed upon itself, as expectations of inflation push the prices of goods continuously higher.
Consumer inflation in the Ukraine is currently approaching 30%, a level that is extreme enough to change economic behavior. In particular, by eroding the real value of private savings, double-digit inflation could reverse the recently promising pace of fixed investment growth. We no longer believe that inflation will decline significantly below current levels this year, largely due to our expectation that fiscal stimulus will continue ahead of the 2009 presidential elections.
