Ukraine Market Report — Q1 2008
Inflation above thirty percent, an economy running well beyond capacity, and a policy response that was still expansionary. The quarter is the textbook description of an overheating economy.
Overview
Consumer inflation moved above thirty percent year on year during the quarter, the highest level since the 1990s.
This was not an external shock. It was a domestic demand expansion running into capacity limits, financed by credit and amplified by fiscal transfers.
The anatomy of an overheating
Four things were happening simultaneously and each fed the others.
Wages were rising faster than productivity, which raises unit costs and consumer purchasing power at the same time.
Credit was still expanding at a large multiple of output growth, adding demand that domestic supply could not meet.
Fiscal policy was expansionary, with social transfers increasing.
And the exchange rate was administered, which meant the currency could not appreciate to absorb the pressure through cheaper imports.
Any one of these is manageable. All four together produce exactly what was observed.
The policy question
The orthodox response would have been monetary tightening, fiscal restraint and exchange rate flexibility. None was available politically in the quarter.
Instead the currency was revalued modestly in May in an attempt to reduce imported inflation. It was the correct instrument applied too late and too small, and it compressed exporter margins at exactly the moment their external prices were about to fall.
Sectors
Metals — still enjoying peak global prices, with margins narrowing on domestic cost inflation.
Construction — the first signs of strain. Developers with foreign-currency debt and hryvnia revenue were finding refinancing more expensive.
Banking — external funding costs rising steadily; some smaller banks already having difficulty rolling over wholesale borrowing.
Retail — strong nominal growth, much of it price rather than volume.
What the quarter settled
That the economy had no remaining slack and no policy instrument in active use to slow it.
An economy in that position does not glide to a soft landing. It continues until an external condition changes, and then it corrects abruptly. The only open question in April 2008 was what the external condition would be and when it would move.
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