Ukraine: confront inflation now to avoid regrets later

Surging inflation in Ukraine has become a major concern. Twelve-month PI inflation in April exceeded 30 percent, among the highest rates in emerging markets. This makes fighting inflation a top political priority.

This is not a time for political point scoring. Successfully reducing inflation will require all major political forces to work together: the  Government, the President, the National Bank of Ukraine and the Verkhovna Rada.

The underlying cause of the rise in inflation is that domestic demand exceeds supply by a significant margin.

This overheating reflects years of:

a. real wages rising faster than productivity;

b. social transfers, including pensions, rising at an unsustainable pace;

c. an explosive growth in money supply and credit fueled by large

    capital inflows under the de facto exchange rate peg; and the

d. effects of improving terms of trade on national income and domestic

    demand.

Exogenous price shocks for food, energy and other commodities have played a notable additional role.

High inflation causes severe harm. Over longer periods, countries with inflation above single-digit levels have grown substantially slower on average than those with low inflation.

High inflation markedly lowers economic efficiency by confounding price signals. It gives rise to a price-wage spiral and undermines competitiveness.

It also weakens trust in the national currency, often stimulating capital flight and diverting domestic savings from investments in productive capacities.

Finally, inflation hurts the poor in particular, since they are much less able to protect themselves against the erosion of their savings and incomes. The public and politicians are right therefore to worry about inflation.

Now is the time to act in concert to curb inflation. If macroeconomic policies are appropriately tight, inflation could decline substantially in the second half of the year as growth slows to a more sustainable pace and the new harvest-most likely better than last year`s-helps lower food price pressures.

The IMF and the World Bank believe that inflation could return to the low teens in 2009 and to single digits by 2010. This would be in line with the experience of countries that adopted an appropriately flexible and tight macroeconomic policy mix, allowing them to contain inflation and weather shocks well.

But without ppropriate policies, inflation expectations are likely to drift further upwards, giving price increases momentum that would be increasingly hard to break.

Addressing high inflation is primarily a matter of controlling demand and costs. Structural reforms that raise the supply of goods and services are critical and should be implemented without delay, but their effect on supply and inflation will only materialize in the medium-term.

Thus, near-term actions to lower inflation should focus on macroeconomic policies managing domestic demand:

a. Fiscal policy should be tightened including by saving, rather than spending, budgetary revenue overperformance and any excess privatization receipts.

b. Social transfers should be contained through improved targeting, while retaining budgetary support to the most vulnerable parts of the population.

c. To break the incipient wage-price spiral, minimum and public wage increases should be kept at a level consistent with single-digit inflation.

d. At the same time, the scope for monetary policy tightening should be increased by gradually moving away from the exchange rate peg in the context of adopting inflation targeting as the monetary policy framework.

The authorities` initial policy response does not have consistent political support and has failed so far to stabilize inflation expectations.

The budget was kept in broad balance to date, and the NBU has taken several measures to tighten monetary conditions.

These steps, presented in the Government`s anti-inflation program of March 2008, go in the right direction. But they are already under attack.

To raise the effectiveness of anti-inflation measures, the authorities should stay the course and clearly explain that the hryvnia will be allowed to fluctuate within a wider band to allow for more active monetary policy, and that further increases in public spending and the minimum wage will be delayed until demand pressures ease.

By contrast, planned administrative interventions in supply and price formation would fail to sustainably raise supply or lower demand, and would exacerbate the inconsistency of the policy mix, thereby simply accumulating even greater problems for the future.

Ukraine is at a cross-roads and inaction could be very costly. Today, the issue is no longer whether some slowdown in growth is a price worth paying for lower inflation-some slowdown is inevitable and indeed desirable to bring demand back into balance with supply.

By acting now to consistently tighten macroeconomic policies Ukraine will be able to limit the costs of lowering inflation and inflation will come down markedly starting this summer.

Conversely, delaying such policy action could push Ukraine towards a prolonged period of high inflation, volatile and potentially negative economic growth, and raise the risk of a sudden breakdown in investor confidence. Such a scenario would primarily hurt the poor and the middle

class, at whom recent spending increases have been targeted.

Political backing is critical at this juncture. Sustained rapid growth is well within reach given Ukraine`s recent growth momentum and excellent potential stemming from top-notch human capital, considerable comparative advantage in several key sectors, favorable geographical location, and promise of convergence toward the EU`s level of productivity.

Political backing of near-term demand containment is key for ensuring the credibility of the necessary inflation-fighting package, and hence, its success.

Ukraine`s politicians have joined forces in the past around issues that mattered critically for the country`s future, such as WTO accession. Inflation-especially given its link to sustained growth-is clearly such a critical issue today.

Politicians should act now on the basis of shared long-term interests and back a coherent inflation-fighting policy package as well as a minimum critical mass of structural reforms.

By Balazs Horvath, Resident Representative in Ukraine,

International Monetary Fund (IMF) and by

Martin Raiser, Economic Advisor, Poverty Reduction and Economic

Management, Europe and Central Asia Region, The World Bank

Economic News (in Russian), Kyiv, Ukraine, Friday, May 16, 2008

Re-published in English by the U.S.-Ukraine Business Council (USUBC)

Kyiv, Ukraine, Friday, May 16, 2008 with permission of the authors.