Money for Victory. Are There Alternatives?

Here is the most urgent question for the development of the country: where do we get financial resources for the further development of our state? The question is a daunting one, given the current situation, when almost half of public expenditure is financed by our allies. But we must exert efforts to find additional resources.

 

Banking sector

In the first 11 months of 2023, the activity of the banking sector was characterized by a decrease in the level of financial intermediary services and a high level of profitability. More than UAH 2.2 trillion in deposits of legal entities and individuals are concentrated in the banking system. Free liquid funds of banks amount to almost UAH 1 trillion. However, the redistribution of these funds for the purpose of supporting economic development or financing the fiscal deficit remains extremely weak.

As of December 1, 2023, loans issued by banks amounted to only UAH 1 trillion, which is nominally 1.2% below the level at the beginning of the year (for business loans: UAH 751 billion and minus 2.8%, respectively). In recent months, there has been some revival of lending levels: + UAH 40 billion in the loan portfolio for July-November. However, the increase in deposits during the same period was almost three times larger — UAH 107 billion.

Bank liquidity will continue to grow progressively, as will the profitability of banking activities. Since the beginning of December and as of December 28, 2023, the total liquidity of banks (required reserves + certificates of deposit) has increased by UAH 115 billion (+14%), and since the beginning of the year – by UAH 424 billion (+80%). The main reason for the increase in bank liquidity is the fiscal deficit. The majority of banks' liquidity is in certificates of deposit of the National Bank of Ukraine — 65%, or almost UAH 620 billion. In 2023, banks’ investments in certificates of deposit brought banks an annual return of 15 to 25% (at an average inflation rate of 14%). Certificates of deposit form more than 30% of all interest income of banks, which exceeds other types of interest income (on business loans, on consumer loans, on domestic government bonds, etc.). The net profit of the banking system for 11 months of 2023 reached UAH 131 billion (a sevenfold increase compared to the previous year).

Banks' investments in government bonds remain moderate. Since the beginning of the year, banks' net investments in hryvnia-denominated government bonds have increased by UAH 171 billion (up to UAH 575 billion). Benchmark domestic government loan bonds on the balance sheets of banks increased by approximately the same amount after they were given permission to form their mandatory reserves at the expense of special issuance of the bonds. That is, in fact, the expansion of banks' investments beyond the influence of the factor of changes in the normative regulation of liquidity is not observed. Banks mainly carry out a rollover of redeemed domestic government loan bonds into new issues of the loan bonds without expansion (excluding benchmark domestic government loan bonds).

In general, the money supply multiplier (the ratio of the M3 money supply to the total value of the monetary base and certificates of deposit) is below 2.0, evidencing a critically low level of financial intermediation in the economy. For comparison, in 2022, the money multiplier in the US was 4.0, in Poland — 3.2, in Georgia — 3.3.

Therefore, it can be stated that the activity of banks as financial intermediaries of the economy does not contribute to the effective redistribution of domestic savings for the purpose of investment development of the country.

 

The lending issue

The low level of bank lending is a significant obstacle to the economic recovery of Ukraine, as is clearly stated by the IMF in the updated Memorandum. It is noted that during the war, the level of bank lending to the Ukrainian economy significantly decreased (from 18.8% of GDP in 2021 to 14.2% of GDP in 2023). What is more, this is despite the fact that about 13% of the bank's loan portfolio belongs to preferential lending support programs. One of the reasons for the low level of lending is the channeling of banks' funds into attractive deposit certificates of the National Bank of Ukraine.

The mobilization of credit resources should become an important driver of private sector growth and a source of satisfying the significant investment needs of the economy during the post-war recovery period. Therefore, according to the requirements of the IMF, the NBU must develop a comprehensive strategy for expanding credit to the country's economy. The deadline for this task is the end of May 2024.

It is also interesting to note the rational position of the IMF regarding the possibility of attracting the money creation resource of the NBU to finance the state budget deficit. IMF documents indicate that the use of monetary financing of the budget is risky for maintaining stability. However, in case of adverse shocks, such as external finance deficit, the option of monetary financing of the deficit can be used. For this, the NBU and the Ministry of Finance should develop framework forms that will regulate the conditions and terms of using such financing in accordance with the design of the IMF program and the recommendations of the recently completed Assessment of the NBU's protective mechanisms.

The NBU should take into account that a one-point change in the key interest rate by 1–2 percentage points will not change anything significantly. A slow movement in the direction of lowering interest rates on loans and deposits will continue. Will this have any effect on financial stability and exchange rate stability? Definitely not!

Financial stability in the national economy is supported almost exclusively by a sufficient amount of foreign aid. The volume of this aid not only covered the structural gap in the balance of payments (about 20% of GDP), but also made it possible to increase foreign exchange reserves to more than five months of imports.

An interesting point is that the IMF requires a package of tax measures amounting to 0.5% of GDP. Interest on deposit certificates in 2023 will amount to 1.5% of GDP. A halving of the key rate will already give 0.75% of GDP. The IMF is looking in the wrong place.

 

Resources

In 2022-2023, tax and interest withdrawals from the economy doubled. More specifically, tax revenues to the consolidated budget increased by 2.1 times over two years (mainly thanks to the personal income tax of the military), and interest income of banks increased by 1.9 times (data for ten months of 2023 were used).

At the same time, the nominal GDP grew by only 22% during the same period.

In other words, we have a catastrophic situation with the multiplication of funds withdrawn from the real economy. Going forward, we will not be able to increase withdrawals consistently unless we experience productivity growth in the economy.

Consolidated budget expenditures on the real economy also increased very moderately: non-military and non-interest expenditures for 2022–2023 increased by only 44%. The money flows through the state finances once, and then simply lies in the accounts of the banking system or is withdrawn into foreign currency outside the banks.

It is necessary to expand the fiscal and monetary tools for supporting the real sector of the economy, namely business credit support programs, favorable monetary policy, other grant and credit assistance programs.

 

On plans B, C and further down the alphabet

Financing the Armed Forces costs us 20–30% of GDP. This is a gigantic amount. According to the updated annual plan, state budget expenditures for the national defense sector in 2023 should amount to UAH 2.1 trillion (32% of GDP). For the year 2024, the state budget currently has a significantly smaller amount - UAH 1.2 trillion. But equally in terms of GDP, it is also a lot — 16% of GDP. Such volumes cannot simply be additionally withdrawn from the economy through taxes or other mandatory payments. All tax revenues of the consolidated budget of 2024 will amount to 26% of GDP. Before the war, tax deductions amounted to 27% of GDP. That is, the resource here is minor. It should also be borne in mind that an additional increase in the tax burden will suppress economic activity.

Historical experience shows that the main financial resource of warring countries was not taxes, but loans, grants and monetary aid. Taxes accounted for only 30% of the financial resources of the US government during World War II, and 20% during World War I. In Ukraine, tax payments formed 45% of all government resources in 2022–2023.

Instead, the resource of the domestic debt market remains largely unused. The banking system has more than UAH 700 billion of free bank liquidity (which is mainly stored in NBU certificates of deposit), and more than USD 118 billion is in non-bank circulation. cash foreign currency.

There are 700 billion hryvnia term deposits of households and businesses in the banking system's accounts, and about 700 billion hryvnias in current hryvnia and foreign currency deposits of the population. Potentially, these funds can be used to finance the fiscal deficit.

It is necessary to initiate the simplification of the access of individuals to foreign currency bonds by reducing the accompanying costs for operations with these securities (opening accounts, transferring funds and crediting payments, etc., which de facto determine a high threshold for entering an investment position).

It is also worth considering the possibility of a reasonable relaxation of financial monitoring requirements for funds invested in government securities.

If the resources of the domestic debt market will not be sufficient, the resource of issue financing of the budget deficit by the NBU should be used. Direct financing of the budget deficit by the National Bank during 2022-2023 amounted to only UAH 400 billion, or only 4% of the total resources used by the government during this period. This is an insignificant amount, and it does not pose a threat to financial or currency stability.

Read this article in Ukrainian and russian.