The National Bank of Ukraine (NBU) has officially declared the end of the 18-month-long fixed-exchange-rate regime and introduced a "managed flexible" exchange-rate system, effective from October 3.

The central bank has slowly been easing its tight controls over the financial system as pressure on the war-torn economy recedes. Ukraine put in its first growth since the war started 19 months ago expanding by 19.5% in the second quarter y/y, driven partly by low base effects. Inflation has also started to fall allowing the regulator to start cutting interest rates.

Now the currency controls are being lifted. Under the new FX framework, the official exchange rate will undergo daily fluctuations, with the NBU actively overseeing bidirectional fluctuations. This transition marks a significant shift in Ukraine's monetary policy, Ukrainian investment bank ICU said in a note.

“The NBU announced it has abandoned the fixed exchange rate of the Ukrainian hryvnia vs the dollar starting today. The new, flexible, exchange-rate regime implies the official exchange rate will fluctuate daily depending on market rates. The NBU will, effectively, remain the key player in the market.,” head of research at ICU Vitaliy Vavryshchuk said in a note.

Forecasts suggest that the hryvnia exchange rate is likely to experience minimal changes in the immediate months ahead. (chart) However, it is important to note that over the longer term, particularly in 2024 and 2025, a managed and gradual depreciation of the hryvnia is expected, Vavryshchuk says.

“Our projection for the exchange rate by the end of 2024 remains at UAH42 per US dollar. Despite the expected depreciation, yields on hryvnia deposits are expected to provide sufficient compensation for potential currency risks,” says Vavryshchuk.

The NBU's decision to abandon the fixed exchange rate is a pivotal development, symbolising a shift towards a more market-driven exchange rate regime. In this new flexible system, the official exchange rate will be influenced by market dynamics, with the NBU retaining a significant role in shaping exchange rate movements.

The central bank’s room for manoeuvre has been improved after it has built up record volumes of international reserves thanks to the support of the country’s international partners’ support. Ukraine has recorded its highest volume of international reserves in July that reached nearly $39bn.

The fixed exchange rate, which was initiated on February 24, 2022, at UAH29.25 per dollar in response to Russia's full-scale invasion of Ukraine, played a crucial role in providing stability during a tumultuous period. It served as a nominal anchor for the economy, offering reassurance to businesses and households. Furthermore, this policy contributed significantly to reining in inflation, which had climbed into single digits since August 2023. However, maintaining this fixed rate required substantial interventions by the NBU, amounting to an average of $500mn per week in 2022 and the first nine months of 2023.

“While the fixed exchange rate was effective in stabilising the economy, it resulted in an overvaluation of the hryvnia,” says ICU. “This, in turn, led to imbalances in external accounts, including a substantial trade deficit of goods, which is expected to reach an unprecedented 16-17% of GDP in 2023.”

Factors contributing to this deficit include stagnant Ukrainian exports and increased imports due to robust domestic demand. Additionally, expenditures on refugees abroad and significant withdrawals of foreign currency by the population, both domestically and abroad, added to the pressures on the balance of payments.

Ukraine lost around $1bn in reserves as Ukrainian refugees in EU countries and elsewhere used their Ukrainian bank cards to withdraw foreign exchange from bank machines in their host countries, while those that remained in the country also changed money into dollars to protect against devaluation risks.

The NBU has indicated that it does not plan to address external account imbalances by adjusting the exchange rate in the near term. However, their intention to do so over the longer-term horizon remains uncertain, with no specific timeline provided, Vavryshchuk says.

“The NBU has emphasised its commitment to maintaining exchange rate stability in the short term, with minimal deviations from the current rate,” says Vavryshchuk.

To alleviate structural foreign exchange deficits, the NBU intends to maintain a presence in the FX interbank market and conduct significant FX sale interventions. However, the exact size of the structural deficit and the acceptable level of FX interventions under the new exchange-rate regime have not been disclosed.

“In the immediate future, the NBU is expected to prioritise hryvnia stability to prevent excessive depreciation or volatility in the official exchange rate, which could erode market confidence and trigger substantial FX purchases,” says Vavryshchuk. “As a result, any weakening of the hryvnia exchange rate by the end of the year is expected to be marginal, posing no significant risk to macroeconomic stability.”

In the coming weeks, the market may experience some uncertainty as it adapts to the new exchange-rate regime. Cash exchange rates could exhibit higher-than-usual volatility, and FX demand in the interbank market may temporarily rise, necessitating increased FX sale interventions by the NBU. However, this situation is likely to stabilise within a few weeks.

“Looking ahead to 2024 and 2025, we anticipate a gradual, managed depreciation of the hryvnia, aligning with yields on hryvnia deposits,” says Vavryshchuk. “This approach aims to maintain the attractiveness of hryvnia-denominated instruments and discourage massive conversion of hryvnia savings into foreign currency. Consequently, the NBU is expected to maintain a relatively high real policy rate in the coming years. Our end-2024 exchange-rate projection remains unchanged at UAH42 per dollar.”

The NBU is well-prepared to manage the FX market situation, boasting substantial reserves that stand at nearly $40bn, significantly higher than pre-war levels,” says Vavryshchuk. This reserve level equates to over five months' worth of future imports, providing a strong buffer. While potential disruptions to international financial aid inflows from the US could impact further reserve accumulation, it is unlikely to result in a significant reduction in existing reserves, as long as inflows from other allies remain intact.

Regarding FX liberalisation measures, the NBU is expected to proceed cautiously in the coming quarters, taking incremental steps to facilitate cross-border trade operations. Rapid liberalisation of flows related to external private debt and foreign direct investment (FDI) is viewed with scepticism.