Looks can be deceiving.

Photographer: Vincent Mundy

Ukraine's Economy Is Worse Than It Looks

Leonid Bershidsky is a Bloomberg View columnist. He was the founding editor of the Russian business daily Vedomosti and founded the opinion website Slon.ru.
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The world's worst-performing currency this year, the Ukrainian hryvnia, has bounced back 47 percent since last week's precipitous plunge. It's tempting to conclude Ukraine has pulled back from the brink of financial disaster. In reality, the Ukrainian central bank and government are just sweeping their problems under the rug to make them less obvious to the International Monetary Fund as it prepares a decision on a rescue package for the country on March 11. After the IMF money arrives, Ukraine will probably resume its previous monetary policy -- the most disastrous and Soviet-like pursued anywhere in Europe since the early 1990s.

This chart of the hryvnia's exchange rate to the U.S. dollar may look depressingly like a dead bird lying on its back, but, in theory, it shows progress in recent days:

Bloomberg

The hryvnia has now approached the 21.7 per U.S. dollar level stipulated by the IMF program. That would be great if it weren't just the meaningless official exchange rate. Though the hryvna was officially floated last month, it is propped up by Wednesday's refinancing rate hike to 30 percent from 19.5 percent and by currency controls. These include a ban on foreign exchange sales of more than 3,000 hryvnias to individuals and on foreign currency deposit payouts of more than 15,000 hryvnias, limits on currency purchases by banks for their own accounts, a requirement that exporters sell 75 percent of their foreign receipts for hryvnias and the ceaseless harassment of importers trying to make payments outside Ukraine.

These draconian measures might seem reasonable given that Ukraine's international reserves at the end of February were down to $5.6 billion, the lowest level since June 2003. There's also the fact that the National Bank of Ukraine spends about $1 billion per month despite all the present restrictions, half on debt servicing and half on interventions to prop up the hryvna's official rate. With the coffers running empty, National Bank governor Valeria Gontareva had to do something to convince the IMF that Ukraine would be able to repay it.

The problem is that the harsh foreign exchange regulation, which makes it nearly impossible to travel abroad or conduct cross-border business, and the interest rate, which pretty much precludes domestic investment through bank funding, are driving much of the economy into the shadow sector. Ukraine has long had one of the biggest shadow economies in the world. Before last year's "revolution of dignity," the IMF estimated it at about 50 percent of output, and it is probably bigger now, because private citizens' foreign exchange transactions have moved almost entirely to the black market, and the corporate ones have gone offshore. 

At the same time, the National Bank is not independent by any measure. It is printing money to finance public spending: Last year, according to Gontareva, the National Bank funded 40 percent of the country's consolidated budget. This is being done through the direct -- non open-market -- purchase of domestic bonds issued by the government. The National Bank has promised the IMF to stanch this flood, limiting the direct funding of public expenditures to 90 billion hryvnias this year. But between Jan. 1 and Feb. 26, 2015, it has already bought 20.3 billion hryvnias of government bonds. 

Gontareva insisted in a speech to parliament today that the country's monetary base has actually shrunk in the last two months, but that's hardly what people believe. The black market exchange rate (this being tech-savvy Ukraine, you can follow it on the Internet) is now more than 27 hryvnias to the dollar, about 25 percent lower than the official one. More than half of the Ukrainian economy likely runs on this basis, outside the regulators' reach.

As Gontareva spoke today, parliament deputies, led by radical populist Oleh Lyashko, shouted her down until it was impossible for her to finish the speech. The National Bank eventually published her full remarks on its site, which is the only reason I know what she planned to say. The legislators never heard the central bank governor announce that she expected a rate of 20-22 hryvnias to the dollar would eliminate Ukraine's current account deficit and that new IMF loans would be used to replenish the country's international reserves to $17 billion by the end of this year.

But this is no panacea. If the planned increase in foreign reserves prompts the National Bank to relax its currency controls, the hryvnia will inevitably sink at least to the current black market level unless the National Bank intervenes and depletes the reserves again. 

Ukraine today faces a rare paradox. Its citizens are fervidly patriotic and energized by the need to resist Russian aggression, but they are so deeply mistrustful of the authorities they elected by a landslide last year that they do everything to escape their watch. They are drawing down their bank deposits and moving most of their economic activity to the shadow sector: Last year, banks lost 126 billion hryvnias in deposits, and in the last two months, another 18 billion hryvnias. The enormous volunteer infrastructure supporting Ukraine's ragtag military also exists off the government's radar. 

Strictly speaking, the IMF shouldn't approve the bailout package next week. Recent events have shown that the government and the national bank are losing control of the economy. Yet the Fund will probably make a political decision to fund Ukraine anyway. Any other decision will ruin the country and hand Russian President Vladimir Putin an easy victory.

There are indications that once the bailout is all set, Kiev will see a massive government reshuffle, in which Gontareva and a number of ministers may lose their jobs. This game of musical chairs, however, is unlikely to increase trust in President Petro Poroshenko and Prime Minister Arseniy Yatsenyuk. As long as there's no significant decrease in corruption levels and scant evidence that the government knows what it's doing, the possibility of a coup by the battered, angry military will grow. Ukraine has wasted time, and now not even the IMF may be able to help.

This column does not necessarily reflect the opinion of Bloomberg View's editorial board or Bloomberg LP, its owners and investors.

To contact the author on this story:
Leonid Bershidsky at lbershidsky@bloomberg.net

To contact the editor on this story:
Cameron Abadi at cabadi2@bloomberg.net