Verkhovna Rada speaker Vladimir Lytvin during his meeting with representatives of Kherson shipbuilding yard on Aug 12 made a harsh declaration that the real level of consumer inflation exceeds 2-fold data of state statistics committee (SSC).

According to Lytvin, inflation makes up 15% ytd whereas SSC in the beginning of August put it at just 6.7% y/y in Jan-Jul. Such a declaration by the speaker may be regarded as a political move, taking into consideration the informal start of March 2006 parliament election campaign.

But there is one thing that gives extra credence to Lytvin's words. Speaking actual real inflation, the speaker just repeated a conclusion of the IMF mission that worked in Ukraine on Jul 25 - Aug 2. After examining the current economic and financial situation, the mission named two major problems.

They are the decline of GDP growth from 12% y/y at the beginning of the year to 4% y/y in Jul 2005, and the rising inflation. IMF declared inflation is main problem of the Ukrainian economy.

NBU's FX interventions trigger increase of monetary base
IMF's statement caused broad reverberations, first of all among participants of the local FX market. The latter stated the currency policy of National Bank of Ukraine (NBU) had created all preconditions for inflation acceleration. We should note that NBU keeps a ban on arbitrage transactions, i.e. banks during one day can only buy or sell foreign currency.

At the same time, banks are forbidden to exceed the purchase or sale volumes that are indicated in the list which banks must fill and transfer to NBU before trading.

Banks tried hard to meet currency exchange demands of its clients and at the same time make transactions for its own needs. The major clients of Ukrainian banks that possess large amounts of foreign currency are exporters traditionally accounting for the largest part of the country's GDP.

Thus, on the FX market supply in most cases exceeded demand. NBU attempted to prevent FX oversupply in interbank trades via every day interventions (buying up excess FX). Only in Jul 2005, NBU bought USD 397.3mn. Since year-start, purchases made up USD 5bn. The interventions helped banks to keep a stable UAH/USD rate of 5.05 during the last few months.

But by buying FX surpluses, NBU spurred increase of the monetary base. Over Feb- Jul, the indicator soared UAH 10.6bn (19.3%) to UAH 65.5bn (almost USD 13bn).

By not participating in interbank trades on Aug 8-9, NBU causes near-panic among market players 

IMF criticized the monetary base upsurge and NBU's interventions. This caused government to pressure NBU to clean up its act. We cannot say for sure what kind of pressure government put on NBU, but on Aug 8-9 the bank did not purchase as usual FX surpluses in interbank trades.

This led to a near-panic on the market because of uncontrolled oversupply of USD. According to some dealers, UAH/USD rate on these days strengthened as far as 4.60. Banks rushed to sell USD at any rate because they had obligations toward their clients. In their turn, clients needed UAH to make current payments.

As a result, on Aug 8 the UAH/USD rate on the interbank market reached a 5-year high at 4.99. This was very unfavorable for exporters, who lost part of their earnings due to a weaker USD.

NBU raises interest rate from 9% to 9.5% to curb inflation

On Wednesday, Aug 9 NBU made several steps to calm down market players. FIRST the bank took part in interbank trades, but bought only FX revenues of
exporting companies. It was reported that the bank acquired USD 80-100mn during this day. Moreover [SECOND] the NBU raised the refinancing rate by 0.5pps to 9.5% from 9%. The rate was kept at 7% since Dec 2002.

Then [THIRD] the NBU raised it by 0.5pps to 7.5% in Jun 2004, by 0.5pps to 8% in Oct 2004, and by another 1pp to 9% in Nov 2004. According to NBU's
head of FX reserves department Mykola Melnichuk, the bank intends to take measures to prevent sharp fluctuations of the UAH/USD rate.

Dealers interpreted the move more as NBU's desire to show it would become more active on the FX market rather than a real anti-inflation measure. Indeed, the bank resumed active purchases of foreign currency (but only from exporters). The UAH/USD reached 4.98 on Aug 12.

Also, [FOURTH] on Aug 9 NBU released a decree saying that from Sep 1 reserve rates on demand and time deposits of corporates and individuals in local and foreign currency would be raised by 1pp from 7% to 8%. This should the increase the cost of credit resources. According to Aval Bank's president Alexander Derkach in the nearest future there would no longer be loans extended at 15% in UAH and 11% in USD.

Still, Derkach predicts the rise of banks' interest rates will not happen before end-year. We think banks can still raise rates earlier than year, albeit significant administrative pressure may be applied. We are quite negative about rather rough methods used by NBU.

NBU plans to liberalize currency market, but possibly not until Mar 2006 general elections

Nevertheless NBU made the first moves to restrain inflation. Still, they are not enough to solve the problems. Representatives of Ukrainian banks started to appeal to NBU to liberalize the FX market. FIRST, they want NBU to cancel the 1.5% duty to state pension fund levied on FX transactions. SECOND and
most importantly, banks want NBU to allow arbitrage transactions making it possible for banks to both sell and buy foreign currency during one day.

NBU very quickly responded to these appeals. First NBU deputy chairman Anatoly Shapovalov confirmed on Aug 11 the bank generally supports the idea of FX liberalization. Shapovalov said in an interview to Kommersant-Ukraine daily newspaper that NBU would reduce its presence on the interbank market.
Shapovalov argued that it is necessary, because FX trade rules were set up in 1999 to prevent a possible financial crisis related to the 1998 Russian banking collapse. We must remark that these rules are quite outdated now.
Unfortunately, Shapovalov did not unveil when NBU would make first steps to liberalize the market. He said a free market can cause financial disparities due to wider FX rate fluctuations. In any case, we do not expect NBU to make serious moves toward liberalization until the Mar 2006 parliamentary vote.

Moreover, NBU reps, including Shapovalov, head of the group of NBU's advisers Valery Litvitsky, and others declare the bank will not change the UAH/USD rate in the nearest future. Commercial banks share the view that NBU will keep the FX rate unchanged till year-end. For example, Pravex-Bank's VP Denis Bass speaking to Interfax said the official UAH/USD rate will stay at about 5.05. We should note that it would depend to a great extent on global FX trends.

In our view, the recent UA appreciation can indeed slow down inflation. However, exporters can suffer from a stronger domestic currency. That would further trim GDP growth. Authorities might then decide to increase money supply administratively, having taken on significant social obligations after last year's turbulent presidential election. The boost to money supply and income growth can spur inflation, undermining NBU's efforts.

ANALYSIS: by Roman Bryl, Ukraine Analyst
IntelliNews - Ukraine This Week

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