The war in Ukraine is starting to look like it might last a long time and that means putting the economy onto a war footing. For the first six months of fighting, running the economy has been little more than crisis management, but if Ukraine is going to fight for another six months, or longer, it needs a plan. Simply printing money to pay soldiers’ salaries and buy more ammo is not going to work for much longer.

A team of very distinguished economists from the Centre for Economic Policy Research (CEPR) that includes Kenneth Rogoff, the author of the much talked about “This time it’s different: Eight centuries of financial folly,” have released a paper outlining policy recommendations for putting Kyiv’s financial house in order to be able to pay for the defence of its country. That is not going to be easy.

“The government is mobilising as many resources and as much revenue as it can, having reinstated import taxes suspended at the outset of the full-scale invasion. It has cut non-military spending to the bone. Yet independent estimates, such as that of Moody’s, project a budget deficit of 22% of GDP, or $50bn, for this year,” the CEPR team said in its report.

Ukraine needs money, but the authors of the report say that expecting the West to provide enough cash to support the budget is “wishful thinking”.

Approximately one-third of government spending is covered by tax revenue, loans and grants from international organisations. Ukraine’s allies cover another third, and the central bank prints money to cover the rest.

“In short, with limited reserves, the central bank cannot at the same time print money, defend the hryvnia and maintain macroeconomic stability. Continuation of the current policy will result in a crisis (high inflation, a currency crisis or a banking crisis),” the authors wrote.

As bne IntelliNews has reported, Ukraine is running out of money and the stress is beginning to show. Timothy Ash, the senior sovereign strategist at BlueBay Asset Management in London, wrote in a recent opinion piece that the West has been complacent in its financial support of Ukraine, which is not “in sufficient scale and in a timely enough manner.”

Since the start of the war international donors have given Ukraine a total of $12.7bn, or about $2.5bn-$3bn a month. As things get increasingly desperate the US has promised another $4.5bn in financial aid (and another $1bn in military aid) to arrive in August and the EU will match this with €8bn in September. The US money is welcome, but it is still only half of the $9bn Washington promised to send, and even the $4.5bn will only cover the shortfall for a single month. The Western financial aid has been dogged by bureaucratic delays and fears of corruption.

“To avert economic calamity, Ukraine’s allies should disburse larger amounts immediately. Given debt sustainability concerns, grants are strongly preferred, but if the choice is a loan versus no money, then a loan should be given and taken,” the CEPR team writes.

Ash complains that because most of the money being given to Ukraine is in the form of interest-bearing loans, Ukraine is “being charged to fight this war for us” and calls for more of the aid to be given as grants that don’t have to be paid back. According to the Kiel Institute for the World Economy, the share of grants in the EU aid programme is only 1%, whereas the corresponding share for the US is 87%, according to CEPR.

Sovereign and private investors have also pitched in, recently giving Kyiv a 1- to 2-year debt repayment holiday and the resulting $6bn in savings for the government and state-owned enterprises over 2022-2023 will be helpful, but this will go only a small way towards closing the fiscal gap, the CEPR authors said.

Things are coming to a head as the government starts reversing one policy after the next as it increasingly focuses on husbanding what dwindling resources it has.

The government was adamant since the Russian onslaught began that it would honour all its obligations and pay its bonds off on time in the hope that the international markets would reopen for Ukraine and it could raise some of the money it needs with Eurobonds.

But those hopes are dead now. The state-owned gas company Naftogaz was forced into default on a $335mn redemption on July 26 after the government ordered the company not to pay in order to “preserve cash”, despite the fact that the company had the money and the management were willing to pay.

The NBU also did an about-turn and abandoned its efforts to defend the currency. It spent $3.4bn and $4bn of its foreign exchange reserves in May and June respectively to defend the exchange rate to retain the public’s confidence in the currency. Faced with the realisation it was going to burn through all its cash very quickly, the regulator abandoned that policy in July and devalued the hryvnia by 25% on July 21 to align the official exchange rate with the cash rate in the market. The currency has since slipped further and the NBU may have to devalue again, as there is still a gap between the official rate of UAH36.6 to the dollar and the cash rate of about UAH40, although the rate seems to have stabilised in the last few weeks.

Both the international and domestic bond markets remain unavailable for raising funds. The banking system is actually saturated with liquidity, but government bonds offer below-inflation interest rates, which makes domestic bonds impossible to sell.

With little access to international funding and almost no access to bond markets, that leaves the government with a handful of alternatives: raise taxes, print money or tap into domestic savings.

Policy recommendations

The situation is bad, but not impossible, says the CEPR team. There are several things the government needs to do to be able to raise the resources it needs from within its own resources.

First, the government must mobilise more resources to improve its fiscal position so that the country can fund huge military expenditures and maintain basic public services in an economy ravaged by the war.

Raising tax revenues involves three basic elements. First, a stronger, larger economy provides more resources for taxation. High military spending already gives a powerful demand-side stimulus and CEPR recommends exploring more supply-side policies. Second, the government can broaden the tax base, by introducing new (ideally, easy to administer) taxes but also eliminating exemptions. For example, with zero import duties in April-June 2022, Ukraine imported light vehicles worth about $1bn, which cost the government budget approximately UAH25bn in lost tax revenue – a loophole that has been closed in the meantime.

One obvious change is the government should introduce progressive income taxes, as Ukraine has a flat personal income tax with a rate set at 18% and the existing military levy (introduced in 2015) is also a flat 1.5% of income. The story is the same for corporate profit taxes.

“The aim should be to increase the collection of tax revenues and for remaining shortfalls to be financed primarily through non-monetary means: preferably through external aid, but if not, through domestic debt issuance, with much less reliance on seigniorage (printing money),” says CEPR.

The way you can do that is to restore some credibility to the government, and that means first and foremost bringing inflation down.

“There is an urgent need for a durable nominal anchor. Heavy reliance on money printing to finance government deficits has been unavoidable in the first months of the war but if the current reliance on money finance is sustained, inflation, already over 20%, could easily drift much higher,” says CEPR.

Classically the way to kill inflation is to hike interest rates, but the NBU has already tried that, more than doubling rates to an extraordinary 25% on June 2, with little effect. Annual inflation in Ukraine accelerated to 22.2% in July, according to the State Statistics Service of Ukraine. Earlier in July, the National Bank of Ukraine said that inflation in Ukraine will reach over 30% in 2022, despite the rate hike.

The government is currently printing roughly UAH30bn per month, while a sustainable level of printing would be less than 2% of GDP, says CEPR. “This is a relatively small sum that is extracted at the price of a high and accelerating inflation as well as regressive taxation and greater misallocation.”

Increasing interest rates further will not have any effect. The other way you can bring inflation down in times of crisis is to float the currency. The NBU took several emergency measures to stabilise the financial system and cushion it from the shock.

·    Banks: To protect domestic credit and payments, the central bank introduced capital controls and eased macroprudential regulations.

·    The government raised the maximum insurance limit threefold and, for the duration of the war, insured all retail deposits.

·    Social support: The government suspended some taxes (or substituted existing taxes with alternative taxes; for example, smaller businesses were allowed to switch from VAT to a sales tax) and introduced holidays for various payments (e.g. mortgages, utility bills) to provide households and businesses with liquidity to sustain their operations

·    Funding: The law was changed to allow NBU to print money and directly fund the government, by buying Ministry of Finance bonds on the domestic market.

·    FX: The NBU fixed the exchange rate at the pre-war level to forestall panic and provide a nominal and temporary anchor.

“The government should aim to enhance national savings rather than rely on monetary financing from the central bank. In co-ordination with fiscal authorities, the central bank should implement a flexible framework to support macroeconomic stability. A managed float of the exchange rate is consistent with this goal,” says the CEPR team.

Central Bank of Russia (CBR) Governor Elvia Nabiullina did the same thing in the 2014 crisis when oil prices collapsed, leading to a very sharp fall in the ruble, which dropped from around RUB36 to the dollar to RUB80 in a matter of weeks. The CBR was already moving towards freeing the ruble by gradually expanding the trading band for the ruble, but she accelerated the process and freed the ruble completely. The exchange plummeted but acted as a brake on the crisis and absorbed the shock, as well as allowing the central bank to preserve its reserves.

Today, despite the problems caused by the war, the situation is not as volatile or panicked as it was in Moscow in November 2014 and so the NBU has the luxury of being able to move more cautiously.

CEPR suggests a managed float of the hryvnia that strikes a balance between the costs and benefits of these polar cases of floating and fixing. Market forces will guide the exchange rate, but the central bank can limit daily fluctuations to something small like plus/minus 0.1% in a day. The NBU could also limit participants to just importers and exporters and let the market set the demand for FX trades.

“External imbalances should be addressed through a combination of strict capital outflow controls, restrictions on imports, and some flexibility in the exchange rate to avoid jeopardising internal macroeconomic stability in the face of huge fiscal needs. A comprehensive standstill on external debt payments is essential,” recommends the CEPR team. “There is a need for a durable nominal anchor. The aim should be for relatively low inflation and low seigniorage (money printing).”

CEPR seems to harbour the same mistrust of the government that the US and EU do, which is reportedly holding up their disbursements of more fiscal support. CEPR recommends that much of the spending of government resources should be done by the private sector.

“Although wartime governments usually take over the allocation of resources, Ukrainian circumstances call for more market-based allocation mechanisms to ensure cost-effective solutions that do not overburden the state capacity, exacerbate existing problems (such as corruption) or encourage (untaxed) black market activities,” CEPR wrote. “To this end, the aim should be to pursue extensive radical deregulation of economic activity, avoid price controls, and facilitate a productive reallocation of resources.”