The cost of defending a currency peg, and who eventually pays it

For most of the period between 2008 and 2014 the hryvnia was held at a rate against the dollar that the country's external position did not support. The central bank spent reserves to hold it, and the political system treated the number as a matter of national credibility.

That framing was the problem, and the episode is worth understanding in detail because the same mistake is made regularly elsewhere.

Why the rate was defended

Household savings and a large share of corporate borrowing were denominated in dollars. A devaluation would raise the local-currency cost of that debt immediately, produce a wave of defaults, and impose a visible loss on savers.

The political cost of that is concentrated and immediate. The cost of defending the rate — reserve depletion, suppressed exports, deferred adjustment — is diffuse and delayed. A government facing an election will almost always choose the diffuse cost, and Ukraine's did repeatedly.

What the defence actually cost

Reserves fell steadily, which reduced the country's capacity to absorb any subsequent shock. Export competitiveness eroded, because domestic costs rose while the nominal rate did not move, and the effect fell hardest on manufacturers competing internationally.

Import demand was subsidised in effect, widening the current account deficit and requiring more external borrowing to finance it.

And the accumulated pressure meant that when the adjustment finally came it was not a gradual slide but a collapse — a far larger move than any of the gradual corrections that had been available earlier.

The general principle

An exchange rate is a price. Holding a price away from the level the underlying flows support requires spending something to maintain the gap, and the spending continues until the reserves or the political will runs out.

Postponing the adjustment does not avoid it. It converts a manageable movement into an unmanageable one, and it transfers the cost from the people who could have hedged against a gradual move to the people who could not survive a sudden one.

What changed afterwards

Ukraine moved to a floating rate and inflation targeting, and has held that framework since. The currency now moves — sometimes substantially — and businesses have adapted to a world in which it does.

That is a better regime. A floating rate absorbs shocks continuously in small increments rather than storing them up for a single discontinuous event, and the credibility that used to be attached to a number is now attached to the inflation target instead.

The practical lesson for a company

Do not build a business case on a fixed rate that a central bank is defending. The defence tells you the rate is not the market rate, and the direction of the eventual move is almost always knowable in advance.

Match the currency of your revenue to the currency of your costs and your debt wherever it is possible to do so. Hedging instruments in an emerging market are expensive and often unavailable at the moment you most need them; a natural hedge in the structure of the business is worth more than a financial one on paper.

And treat any policy that is politically expensive to reverse as a policy that will be reversed late and abruptly. That is not cynicism about a particular country. It is a general feature of how governments weigh costs visible today against costs visible after the next election.

Related in this archive

• Privatisation: three waves, and what each one produced
• Ukraine and the IMF: the pattern across eight programmes
• An old balance-of-payments problem, and why it kept coming back
• Ukraine Annual Review 2012: stagnation with one door opened

Defending a fixed rate is like a company refusing to update its price list while the market moves: it looks like stability in the short run and consumes your stock and your cash in the long one. The cost was paid not by those defending the rate but by whoever had to import once the reserves ran out. Interest on a postponed correction always compounds.