Unbridled Inflation, or Who Benefits from the NBU's High Key Policy Rate

On October 31, the Board of the National Bank of Ukraine decided to keep the key policy rate at 13% per annum, which in real terms (minus inflation) amounts to 4.4% per annum.

Given the rising inflationary risks, the NBU would have had to raise the key policy rate if its current level was consistent with the economic conditions at hand.

However, by raising the key policy rate excessively in the past, the central bank has limited its monetary room. The stabilization resource of the key policy rate has long been exhausted. Rather than adding stability to the economy, raising it now will only widen banks' interest margins and increase their profits at the expense of the state.

The cycle of a truly positive key policy rate has been going on in Ukraine for more than two years. The purpose of maintaining a high key policy rate is to attract hryvnia assets to reduce inflationary pressures and currency risks. However, the de facto high key policy rate has not had a significant impact on inflationary dynamics.

In terms of regulating economic activity, it is advisable to look at an alternative modern experience. Over the past two months, the US Federal Reserve and the Central Bank of Russia have changed their key interest rates. The Fed cut its key policy rate by 50 basis points, to a target range of 4.75–5%, in an effort to stimulate aggregate demand. In contrast, the Central Bank of Russia raised its key policy rate by 300 basis points, to 21% per annum, in an effort to curb demand. Both central banks are able to use the key policy rate to influence real economic processes and inflation, as both countries have developed domestic bank loan markets and stock markets. In the United States, bank loans to the real sector reach almost 200% of GDP, in Russia — more than 70% of GDP, while in Ukraine they are less than 15% of GDP.

Numerous factors have led to the dysfunction of the key policy rate in Ukraine as a tool for stabilizing the economy:

• More than 90% of businesses in the country operate without attracting resources from the loan or stock market.
  The factors of inflationary processes are dominated by structural factors (primarily cost growth, military expenditures of the government, etc.) that do not depend on the value of money in the economy.
• The population in general has a low propensity to bank savings: 60% of deposits are owned by 1% of depositors, and bank deposits of the population account for less than 20% of private consumer spending per year.
• Military uncertainty offsets market incentives and encourages people to have savings in more reliable assets than the hryvnia.
• During the war, banks have expanded their interest margins to gigantic proportions (12.5% in September 2024), which eats up most of the initial momentum of the key policy rate.

The Ukrainian novelty of attracting free hryvnia funds into the banking system without developing lending instruments has failed.

During the war, banks were able to attract only UAH 104 billion of household term hryvnia deposits (an increase in the net balance). In turn, since the beginning of the war, households have spent more than UAH 530 billion to purchase foreign currency (including UAH 326 billion in the first three quarters of this year). Last year, the proportion in the distribution of household priorities between foreign currency and hryvnia investments was 3 to 1, while in January–September 2024 it was 15 to 1.

The artificial attraction of hryvnia assets without an increase in economic productivity is not working, as the country still has a foreign trade deficit that can only be covered by boosting domestic production. The hasty abandonment of the fixed exchange rate was another factor that added fuel to the fire, resulting in a rapid increase in foreign currency demand.

Since the beginning of this year alone, the NBU has spent $27 billion to support the hryvnia, of which 35% is due to foreign currency demand from the population. Since the beginning of the war, the NBU has already spent over $75 billion. The main source of the NBU's foreign exchange interventions is the government's external assistance, without which foreign exchange reserves would have been depleted in November 2022.

Thus, the NBU's high key policy rate did not significantly affect the attractiveness of hryvnia deposits or the stabilization of the FX market. Moreover, mistakes in the implementation of interest rate and foreign exchange policies led to the irrational use of foreign exchange reserves to support the hryvnia exchange rate. Meanwhile, external assistance compensated for both the shortage of foreign currency in the foreign exchange market and the shortage of goods in consumer markets. In other words, both the decline in inflation and the stability of the hryvnia exchange rate are mainly caused by external assistance, not the NBU's policy.

In turn, the high key policy rate has helped to significantly strengthen the financial stability of banks and increase their profits. Thanks to an increase in interest income from the state (interest on domestic government bonds, certificates of deposit and preferential loan programs), the banking system has been demonstrating record high levels of profitability, liquidity and capital adequacy for the second year in a row. In the first eight months of 2024, banks earned UAH 137 billion in pre-tax profits. Banks receive more than 50% of their interest income from the state. In 2024, it is estimated that banks will receive about UAH 200 billion of interest income from the state. This astronomical figure is a direct result of the NBU's interest rate policy in recent years.

During the war, banks also received additional income from the banal expansion of bank interest margins. While in 2022 the interest margin averaged 9 percentage points, in 2023, it was 10 percentage points, and in 2024, it exceeded 12.5 percentage points.

What about the Ukrainian lending market? The level of lending has once again declined and as of September amounted to 14.9% of GDP.

The main aspect of credit demand is the price of borrowed funds. The real interest rate on loans in Ukraine exceeds 10% per annum. Tight interest rate policy parameters with rates significantly higher than the inflation rate curb business appetite for bank loans, as their high cost undermines the profitability of real production.

Another aspect of lending development is the existence of a targeted policy of the government and the central bank to support lending. These include programs to reduce the cost of lending to businesses and banks, and government guarantees.

The third aspect is the revision of financial regulation requirements for banks' lending activities and credit risk assessment.

The credit channel is a key channel of monetary transmission; therefore, its development should be the focus of the central bank's policy to maintain its ability to effectively implement its monetary policy in the future.

Unfortunately, the NBU has once again gotten carried away with assessing the sustainability of banks, introducing stricter requirements for the capital structure of banks and developing niche credit products, such as ESG lending.

The resources of the banking system and its intermediary activity should play a progressive role in supporting the wartime economy. The persistence of tight monetary conditions hinders the attraction of banks' borrowed funds for investment projects and job creation, restricts the return of refugees and the prospects for recovery. The high cost of loans counteracts the improvement in the foreign trade balance, as it limits the availability of borrowed funds for producers who could compete with imports or export their products. The NBU's policy continues to cause destructive shocks to the real economy, and only sufficient external financial support keeps the economy from slipping into a state of economic crisis and currency destabilization.