Autumn 2008: how the peg broke, and who paid for it

The sequence took about eight weeks. World steel prices, which had roughly doubled between 2006 and mid-2008, fell by more than half in the third quarter. Ukrainian mills cut output sharply. Export receipts collapsed at the same moment that foreign parent banks stopped rolling over funding lines to their Ukrainian subsidiaries.

The National Bank defended the exchange rate until reserves made that untenable, then allowed a disorderly move from 5.05 toward eight. An IMF stand-by arrangement of around sixteen billion dollars was agreed in early November.

Why the damage was larger than the shock

An export price collapse and a sudden stop in capital flows would have caused a recession in any economy. What made this one severe was the composition of debt.

Between 2005 and 2008, Ukrainian banks lent heavily in dollars, euros and Swiss francs to households and companies whose income was entirely in hryvnia. The interest rate differential made it look sensible: a foreign-currency mortgage carried a rate several points below a hryvnia one. Under a fixed exchange rate, borrowers were being paid to take currency risk they did not understand they were taking.

When the rate moved by sixty per cent, so did the local-currency value of those liabilities. Households that could service a loan in September could not in December. The losses propagated into the banking system as non-performing loans, and from there into the fiscal position through deposit guarantee payouts and recapitalisation.

This is not a Ukrainian pathology. The same structure produced the same result in Hungary, Latvia, Iceland and, in different form, in Thailand a decade earlier. It fails everywhere it is assembled, and it is assembled wherever a credible-looking peg coexists with an open capital account.

What the policy response got right and wrong

Right: the IMF programme, quickly. Ukraine had no other source of financing and no capacity to run a counter-cyclical fiscal policy. The programme covered external obligations and stabilised the payment system.

Wrong, or at least costly: defending the peg for as long as it was defended. Reserves spent holding an unsustainable rate are reserves unavailable for managing the adjustment. A managed depreciation beginning in September would have cost less than a disorderly one in November, and would have damaged confidence less.

Also wrong: the moratorium on foreign-currency mortgage foreclosures. It was politically unavoidable and socially defensible, but it left banks holding claims they could not enforce, valued at something close to par, which delayed recognition of losses by years.

What survives from this

Three durable changes come out of the crisis. New foreign-currency lending to unhedged retail borrowers is prohibited — a rule that should have existed in 2005 and that holds thereafter. The exchange rate regime becomes de facto managed rather than fixed, and eventually, after 2015, genuinely flexible. And the banking sector's foreign ownership share, which peaked in 2008, begins a long decline as parent banks reassess the region.

What to do now

For businesses: match currencies. If your revenue is hryvnia, your debt should be hryvnia, and the interest differential is the price of not taking a risk you cannot quantify. This applies to your counterparties as well — check which of your Ukrainian customers and suppliers have foreign-currency debt, because their solvency is your receivable.

Shorten payment terms. Take security where you can get it. And assume that the credit conditions of 2006 and 2007 do not return within five years, because they will not.

Related in this archive

• How large capital is organised in Ukraine, and what it means for an entrant
• The wealth ranking a year on: what moved, and what the movement actually tells you
• Emerging-market story or special case? The framing determines the analysis
• Ukraine Annual Review 2008: two economies in one year

What I learned in the weeks the peg broke is that currency risk sits in the contract rather than on the balance sheet: everyone earning in hryvnia and owing in dollars went under at the same moment. I have never left the currency to chance in a contract since. The lasting lesson of 2008 is not the exchange rate but that a fixed peg is a liability rather than a guarantee.