National Bank of Ukraine (NBU) Governor Kyrylo Shevchenko’s column about the risks of continuing the monetary financing of the state budget and how to minimise them.

The monetary financing of the budget deficit will not stabilise the economy in the long run. We should seek other ways to minimise the fallout from the war.

At the onset of the full-scale war, Ukraine’s only option was to let the NBU conduct the monetary financing of the state budget deficit so that the country’s critical needs could be met.

Compared to other ways of meeting budget objectives, the printing of money is a rapid response that makes the burden of the war easier for the people and businesses – in the short run.

In the long term, however, taking the monetary financing approach cannot keep the economy afloat. To mitigate the adverse economic and social consequences of the war, the authorities should use methods that optimise the state’s finances.

Time is of the essence

As Russia unleashed its full-scale invasion of Ukraine, a combination of factors expanded Ukraine’s budged deficit: Tax revenues decreased due to the physical destruction of enterprises and the occupation of territories, the disruption of production and logistics chains, and a drop in economic activity, income and consumption.

Significant defence, humanitarian and social needs led to an increase in budget expenditures.

Initiatives to reduce the tax burden on businesses also played a role.

This has led to a situation in which the possibilities of financing the state budget from traditional sources are minimal, and the need for funding grows with each day of the war.

Desperate times require desperate measures. All available means of financing must be mobilised. The NBU is in the thick of this process.

To repel Russia’s military aggression, the NBU has deployed the monetary financing of the state budget deficit, providing funding for critical government expenditures in limited amounts. This has made it possible to support Ukraine’s defence capabilities and ensure the uninterrupted operation of critical infrastructure and the public finance system overall.

Had the NBU, in this time of hardship, decided against financing the budget deficit, the state’s financial system could have come to a halt.

Monetary financing, however, is an option that can buy Ukraine some time but that cannot resolve its economic and budgetary problems. Yet the government has actually been increasingly relying on the NBU to issue money to meet the budget’s needs, and this type of financing has gradually turned into the main source of covering the budget deficit.

Despite having slowly shifted into wartime operation mode, the economy has developed a chronic craving for more and more monetary financing: The UAH20bn that was issued in March turned into UAH50bn in April and May each, and another UAH105bn was provided in June.

Not the best model

The state’s economic policy is currently faced with a clear task: redistribute the economy’s resources to meet the priority objectives of a country at war. The monetary financing of the budget cannot ensure such a redistribution.

By issuing money, the NBU does not create new economic resources but only moves available resources around through the inflation tax. This burden is shouldered by those earning hryvnia incomes as their value declines in real terms (retirees, recipients of fixed salaries). This directly increases poverty.

High inflation has the potential to quickly erode the value of the incomes and savings of broad swathes of the Ukrainian population. Owners of real assets, foreign currency and other valuables reap short-term benefits, as do exporters of goods and services.

The state budget may also experience a short-lived relief: the inflationary growth in the tax base will for the time being exceed the need for financing fixed hryvnia-denominated expenses.

But in the end, everybody loses, because an economy without a reliable unit of currency has no way of growing, let alone recovering.

Exporters will have to buy production inputs at higher prices, and pressure to raise the wages of their workers will rise.

The government will struggle with unrelenting pressure to have its expenditures indexed as the amount of money required to meet the same needs grows.

So, how is monetary financing working so far? Increasing batches of the “issued” hryvnias are finding their way into the FX market, driving up pressure on the exchange rate. The NBU is taking some of this pressure off the market by making FX interventions.

Specifically, the central bank in February-May had to sterilise, through FX interventions, about 70% of the “issued” hryvnia injections. Meanwhile, the ratio between interventions and issuing reached 1:1 in May, up from just 2:3 in April. In other words, 1:1 means that the NBU in May “printed” as many hryvnias as it then took out of the FX market by selling foreign currency.

The NBU sells foreign currency it takes from international reserves, which are limited. The depletion of international reserves leads to the deterioration of exchange rate and inflationary expectations, which feeds into the next wave of demand for foreign currency and imported goods.

As a result, an increasingly large volume of hryvnia liquidity drives up FX demand through the government spending channel and the worsening expectations channel.

The real yield on hryvnia instruments, primarily deposits and domestic government debt securities, is going deeper and deeper into negative territory, incentivising economic agents to look for ways to safeguard their savings, in particular by purchasing foreign currency and imported goods, including those unrelated to their primary needs.

As a consequence, each round of “money printing” only acts to reinforce the dollarisation of the economy and the withdrawal of savings from the financial system.

The longer this trend persists, the greater the pressure on the hryvnia to depreciate and on the international reserves to decline, and the higher the risk of households gradually losing confidence in the government, the hryvnia and the NBU. The farther out that the negative expectations spread, the faster the price growth.

The non-linearity of the growth in the inflationary risks associated with a monetary expansion within the limits of monetary financing is corroborated by the IMF’s research.

Unfortunately, the world’s and Ukraine’s experience shows that the loss of control over inflation is far from being the only possible consequence of large-scale monetary financing.

Learning from the mistakes of others is always a good idea

We are already making plans for our economy’s post-war recovery, which is the right thing to do as we ponder the risks associated with the stepping up of the monetary financing effort.

The past episodes of fiscal dominance are still fresh in our memory. Ukraine’s efforts, in particular in the 1990s, to ensure the financing of state expenditures and the needs of enterprises by issuing money, had catastrophic consequences for both the economy (inflation in 1992-1994 galloped to 2,000%, 10,155% and 401%, while real GDP plunged by 9.7%, 14.8%, and 22.8% respectively) and the well-being of households.

The monetary financing of public debt in 2014-2015 had a similar fallout, with inflation accelerating to almost 25% and 43.3% respectively.

The experience of economic revivals in the aftermath of the wars that raged in the past century reveals a multitude of facts about the adverse implications of printing money to cover budget deficits.

Let’s take a look at a few cases that stand out the most. After the Second World War, the Bank of Japan actively bought bonds issued by the government in order to accumulate funds for the restoration of production facilities destroyed during the war.

Monetary financing was precisely what experts believe sent Japan’s inflation sky-rocketing into the triple-digits. What is more, it took almost five years for inflation to return to moderate levels.

In a more recent example, the Serbian central bank financed the growing budget deficit after the end of the war. In addition, the regulator and private banks extended direct loans to state-owned companies and agricultural businesses in order to keep prices for food and housing services low.

As a consequence of this grand-scale monetary financing splurge, inflation in the 2000s ended up surging past the 100% year-on-year mark.

Monetary financing experiments often result in the dollarisation of the economy, the loss of domestic currency and the forfeiture of monetary independence.

During the active phase of the war (1991-1993), the Croatian National Bank also tried to patch the fiscal deficit with monetary financing, which triggered rampant inflation. However, the deterioration in the economic situation and the looming hyperinflation prompted the government to take decisive action by conducting a rapid fiscal consolidation and rolling back the central bank’s financing of the budget deficit.

The joint actions of the government and the Croatian National Bank contributed to the achievement of macroeconomic stability, a rapid slowdown in inflation, stabilisation of inflationary expectations, and transition to sustainable economic growth.

What options are on the table?

What should Ukraine do if the government’s needs for meeting budget expenditures grow as the central bank insists on cutting back on the monetary financing of the budget deficit? Option one is the simplest solution, but it will cause a crisis in the long run. This option is to do nothing. This means continuing to rely more and more on the issuing of money by the NBU to finance the budget deficit.

The justification seems to be obvious: the nation is at war. But then we have to visualise the consequences of this scenario. After public confidence evaporates, the authorities may eventually lose control of the economy, social inequality will deepen, and the country’s defence capability will suffer a major blow, as will its monetary sovereignty.

Option two requires difficult decisions to be made, but it is effective. The economy has a limited resource. Given political will, it is realistic to redistribute this resource to meet priority needs (after all, this is supposed to be the goal of macroeconomic management).

On the one hand, there is a need to cut expenses by sequestering the budget and curtailing non-core spending, a task the government has already begun to accomplish.

The alternative is that if monetary financing is allowed to continue, the inflation-depreciation spiral will not make it possible to prioritise budget expenditures, and government expenditures will depreciate in real terms, making it impossible to achieve the set goals.

On the other hand, there is the need to increase revenues. Doing it by putting a greater tax burden on businesses and workers is not the best choice. Businesses need to recover.

Taxes should be an incentive to limit the indiscriminate spending of resources necessary for continued defence. This can be done by raising taxes on consumption, imports, assets and rent.

It is vital to ramp up domestic borrowing, including by increasing the rates on hryvnia domestic government debt securities to the market level. This will increase the appeal of hryvnia assets and allow the government to raise market resources to cover the budget deficit and, accordingly, reduce the need for the issuing of money by the NBU.

This will also safeguard households’ incomes and savings from inflation and reduce FX demand, which will prevent the further accumulation of imbalances, ease pressures on Ukraine’s international reserves and gradually resolve the issue of multiple exchange rates.

In addition, all representatives of the authorities should make maximum diplomatic efforts to increase the amount of international aid. We have already received unprecedented amounts of official funding. However, they remain dwarfed by the magnitude of the losses that Ukraine suffers with every day that the war drags on.

Of course, option two will in the short run take a more painful toll on the population and businesses. But at least it is straightforward and honest. It will make it possible to take pressure off the hryvnia and avoid a speed-up of inflation and a drawdown of international reserves. After all, such adverse processes will by no means contribute to the stability of public finances.

This will allow the authorities to retain control of the financial system and the economy as the war rages on, and will also facilitate a quicker return to the market-driven operation of the economy and financial markets after the war.

How monetary financing impacts the European dream

Large-scale financing of the public sector by the NBU can significantly prolong or even hinder Ukraine’s accession to the European Union.

The possibility of accepting a new country into the EU is provided for in Article 49 of the Treaty on the European Union. Any European country applying for EU membership must also meet what is known as the Copenhagen criteria, which require the candidate country to comply with certain requirements.

The eligibility criteria in the field of economic and monetary policy, in particular, contain clear rules that, among other things, require: ensuring the independence of central banks of member states, bans on direct monetary financing of the public sector by central banks, and prohibition of privileged access of the public sector to financial institutions.

On the way to full accession to the EU, these elements of monetary policy are the benchmarks for the candidate countries and are subject to annual evaluation. Failure to meet these requirements can hinder European integration or drag out the process of Ukraine’s joining the EU for decades, as has happened to Turkey.

Finally, it is worth noting that Ukraine and its economy are currently undergoing many traumas and trials. However, in overcoming these trials and tribulations, there is a chance to emerge stronger.

Overcoming the reliance on monetary financing can strengthen the country both economically and institutionally. And then the “post-traumatic” recovery will be more stable and more rapid.

This column first appeared on Ekonomichna Pravda’s website and was republished on the NBU’s website.