A Tale of Two Crises: How Central Banks Define the Conflict in Ukraine

A typical source of stability increases the complexity and highlights the consequences of the Ukraine conflict.

“The central bank, in accordance with the law, conducts an independent policy. But of course we look carefully at what is happening,” Russian president Vladimir Putin told the head of the International Monetary Fund in late 2014. In times of stress, central banks become crucial to the functioning and recovery of national economies. The aftermath of the global financial crisis of 2008 may have taken a very different path had the major central banks of the world not intervened. Institutions like the Federal Reserve and the European Central Bank are credited by many with mitigating the damage to, and even saving, the world’s financial system and economy. But what happens when the source of stress is not purely driven by markets? What is the extent to which a central bank can change a military conflict?


Economies on the Plunge

Figure 1. Ukraine’s industrial production has fallen precipitously, while production in Russia has suffered a more moderate impact. Source: International Monetary Fund

The national banks of Russia and Ukraine may be finding that out. One country has been invaded, its capital ravaged by war in 2014; another has been the target of sanctions imposed by the West. In terms of the real economy, Ukraine has had enough to manage with the destruction of capital—most of the country’s mines, for example, are in Donetsk—and as a result industrial production is down a staggering 20 percent. A globalized economy and coverage of the event are a double-edged sword; even though the actions of Russia and pro-Russian separatists are scrutinized and condemned by the international community, the global market can punish uncertainty and the expectation of economic turmoil.

With Ukraine expected to go into recession, investors pulled their money out of the country, which resulted in its currency, the hryvnia, crashing in value; in early 2014, a dollar traded for less than 10 hryvnia, while a year later it went for around 23. In addition, the loss of investment to Ukraine was crippling, meaning the capital it lost was not going to be replenished anytime soon. Bleak is the picture for a country ravaged by invasion or civil war, whatever the appropriate term is. There are bright spots, such as the uptick in defense spending, which should give a boost to the economy, and intervention from the International Monetary Fund. But where does the central bank come in?

Figure 2. The hryvnia has crashed in value as investors have fled the Ukrainian market; Russia has faced a similar problem as sanctions take their toll.


Two Scenarios

Figure 3. How each central bank has responded to the crisis over time. Source: Internatioinal Monetary Fund, National Bank of Ukraine

It depends on that bank’s objectives. Unlike the Federal Reserve, which also pursues “maximum employment”; like many central banks around the world, the National Bank of Ukraine sets price stability as its overriding goal, even at the cost of temporary high levels of unemployment. (It is interesting to note that the word “employment” is not mentioned once in a statement of the monetary policy framework.) With that as its goal, on March 3, 2015, the NBU hiked its policy rate from 19.5 percent to 30 percent, reducing the chance of hyperinflation and further runs on the currency. However, the Ukrainian economy is facing a massive contraction in 2015, and at some point the central bank may need to ease credit by lowering interest rates, which unfortunately means some inflation may occur. Ukraine faces no easy choices as it manages the civil war; the one thing the central bank should do is communicate and act predictably to assure both the people and foreign investors that they have not lost all control of the situation. It also has an incentive to show it is in control to ensure loan support from the IMF. Unfortunately, higher levels of unemployment may lead to more dissatisfaction among the Ukrainian population with a government already viewed as corrupt.

Russia also faces recession, but for different reasons. First, nations in the West did not take kindly to alleged Russian involvement in Ukraine and responded with targeted sanctions in March 2014. To make matters more difficult, the price of oil plunged. The market responded the same way it did in Ukraine, and the value of the ruble was on its way down as well. The central bank’s response was crucial in the ultimate results. According to its monetary policy reports, the Bank of Russia also focuses on price stability, with a goal of 4% inflation for 2015. The Bank moved quickly and aggressively in 2014, using its foreign exchange reserves (selling foreign currencies, effectively increasing the relative demand for rubles) to support the value of the national currency. The tactic, in tandem with other developments, seems to have worked. But the ruble might be due to rebounding oil prices, and more optimistic expectations for the impact of conflict on the economy as dialogue continues between the U.S. and Russian governments. Now the central bank is trying to restore its foreign exchange reserves, buying foreign currencies at the cost of a slightly devalued ruble. Russia appears to be out of the woods for now (though apparently it is not out of Ukraine).


Mad Money Policy

The national banks of each country have responded aggressively to changes in the economic environment—the question is whether it is enough, and perhaps it’s even appropriate. In Ukraine, the National Bank can only do so much, such as convey some sense of stability to investors. At the end of the day, it is a supply-side problem—Ukraine needs to stop losing capital, and that is a matter of military success. The Bank of Russia has stabilized its currency, as it set out to do, but it is unclear for how much it can take credit. The fact is that the uncertainty surrounding Russia’s political situation caused investors to worry, and falling oil prices made the situation worse. Russia appears to be willing to put up with the economic consequences for now.

Figure 4. The classic trilemma, in which a country cannot maintain free flow of capital, a fixed or stable exchange rate, and optimal monetary policy simultaneously.

But the central banks face difficult choices, and the countries will have to suffer the consequences. Each faces the classic trilemma of international economics: among exchange rate stability, free capital flows, and independent monetary policy—the ability to pursue optimal economic results, like price stability and maximum employment—a central bank can realistically manage only two.  In sacrificing the third option, each central bank is incurring pain on the nation’s people. With the current policies, that will mean more “short-term” unemployment—and it is unclear how much people will be able to put up with before they lose faith entirely in their government.



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