The hryvnia is all right

December 5, 2013

The fate of Ukraine’s hryvnia currency hangs by a thread. Will that thread break?

The hryvnia’s crawling peg has so far held as the central bank has dipped steadily into its reserves to support it. But the reserves are dwindling and political unrest is growing. Forwards markets are therefore betting on quite a sizeable depreciation  (See graphic below from brokerage Exotix).


The thing to remember is that the key to avoiding a messy devaluation lies not with the central bank but with a country’s households. As countless emerging market crises over decades have shown, currency crises occur when people lose trust in their currency and leadership, withdraw their savings from banks and convert them into hard currency.  That is something no central bank can fight. Now Ukraine’s households hold over $50 billion in bank deposits, according to calculations by Exotix. Of this a third is in hard currency (that’s without counting deposits by companies).  But despite all the ruckus there is no sign of long queues outside banks or currency exchange points, scenes familiar to emerging market watchers.

So what are the reasons?  First, households and businesses seem confident of a muddle-through scenario (this view is shared by most, though not, foreign analysts). Possibly, the optimism is based on the central bank’s  track record this year on defending the hryvnia. It also seems likely that with some foreign aid (bits and bobs garnered from Russia, China and the EU) and by using the remaining reserves, Ukraine can hold it together until 2015 elections are past and the government can finally knuckle down to the rigours of an IMF aid programme.

Second, people will not find it easy to turn their backs on the 14-25 percent annual rate they can earn on their bank deposits. In smaller, lower quality banks, bank deposits might earn up to 27-28 percent a year.  Inflation meanwhile is running below zero.  David Hauner, head of EEMEA fixed income strategy at BofA-Merrill Lynch Global Research, says:

Households  tend to take these decisions looking in the rear view mirror and they have had relative currency stability so far. Also, for households and corporates it is a very negative carry trade to be long dollar and short hryvnia, you would be giving away a huge amount of interest, around 25 percent a year.

Hauner says it’s hard to judge the exact catalyst that could tip households’ sentiment but escalating political turmoil is clearly the main risk.

While the central bank was forced into a 40 percent devaluation back in 2009, today’s picture does not seem as bad. Ukraine’s economy contracted 15 percent that year and the rouble of trade partner Russia too had weakened, Exotix economist Gabriel Sterne points out:

On a Richter scale there is a massive difference between today and 2009. NDFs (non deliverable futures) may be pricing 18.5 percent depreciation in a year but if you are Ukrainian, your income is in hryvnia and savings are in hryvnia, the depreciation will make your imported goods more expensive but otherwise it’s not so bad. It only really works against you if you are in a pseudo carry trade like the Hungarian Swiss franc mortgages, the currency falls and you take a hit. That’s not really the case in Ukraine.

So what stresses will a devaluation inflict on Ukraine’s economy? Sterne says the IMF’s view is the economy and banks can easily take a 10 percent devaluation, and the step will give the big Ukrainian metals and agro exporters a much-needed boost.

Those are the positives. The problem is that a controlled depreciation is unlikely in circumstances such as these — if the central bank allows the currency to float amid the political turmoil, it is more likely to sink by up to 30 percent. That will torpedo the banking sector of course but also President Viktor Yanukovich’s political career. All the more reason to believe the authorities will do all they can to hold the hryvnia’s exchange rate until times are a bit calmer.

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