Speech by NBU Governor Valeria Gontareva on Monetary Policy

Dear colleagues,

I’d like to greet all the participants at our traditional meeting following Board meetings on monetary issues.

I would like to inform you that the NBU Board moves ahead with monetary easing and has decided today to cut the key policy rate to 15.5%.

This decision was made possible due to the further alleviation of risks to price stability and is consistent with the achievement of inflation objectives for this year and the next.  

We currently observe a steady easing of inflation pressures, improvements in inflation expectations, and a stable foreign exchange market.

Headline inflation has remained in the single digit territory for the third month in a row, slowing to 6.9% y-o-y in June. In H1 2016, the Consumer Price Index rose by 4.9%. Actual inflation slowed at a faster-than-projected pace.   

What is behind the rapid slowdown of inflation?

Low aggregate demand, a gradual appreciation of the hryvnia exchange rate, and a high supply of food products have contributed to the sharp deceleration of inflation. Let us look at these factors separately.

First, as before, consumer demand put no downward pressure on prices. According to our estimates, in Q2 2016, Real GDP grew at a stronger pace compared to the previous quarter, but this growth was softer than expected.

In H1 2016, retail trade turnover rose by a modest 2.3%, pointing to weak private consumption.

The labor market showed signs of gradual improvement. However, it is still far from being sufficient to spur consumption. Real wages resumed growth in annual terms. However, as before, consumer demand put no additional pressure on inflation.

Second, a high supply of raw foods pushed food prices down in H1 2016. The seasonal expansion of domestic production, as well as an increase in imports, contributed to the decline in prices for select vegetables. Also, prices for fruits, sugar, milk, and dairy products registered a seasonal decline.

Third, external conditions remained favorable for Ukrainian exporters and, consequently, for the FX market. In particular, in Q2 2016, world steel prices showed a sharp increase, which more than offset a steep decline recorded in the previous quarter. 

However, steel prices have adjusted since mid-May, but still they are 30% higher than at the beginning of the year.

External conditions were favorable for other commodities exported by Ukraine. Thus, prices for iron ore rose by 35%, while prices for maize and barley went up by 10% and 22%, respectively.

The interbank FX market saw an increase in the FX supply. Banks’ net foreign exchange purchases from households have amounted to USD 1.6billion since the start of the year.

Overall, FX outside of banks decreased by USD 547 million in June, and by USD 2.5 billion in H1 2016.

As a result, the supply of foreign currency exceeded the demand for it in the domestic FX market. Under such circumstances, the NBU continued to purchase foreign currency to replenish its international reserves. Since the start of the year, the NBU has held 71 FX auctions and conducted a FX intervention at a fixed exchange rate. Overall, the NBU's net FX purchases in the interbank market reached USD 1.4 billion over this period.  

Simultaneously, the NBU remained firmly committed to a flexible exchange regime, while not hampering a gradual appreciation of the exchange rate triggered by fundamental factors, as we declared earlier. The UAH/USD exchange rate strengthened by 7.4% since mid-March 2016.

As anticipated, the consequences of June’s liberalization of administrative restrictions appeared to be manageable and did not destabilize the FX market. In particular, the NBU’s move to grant permission to repatriate dividends put no additional pressure on the FX market. The foreign currency purchased for the purpose of dividend repatriation amounted to approximately USD 100 million, which was well below the pre-announced amount, accounting for an insignificant portion of the demand for foreign currency. This can be attributed to the businesses' reluctance to divert funds away from operating activities and higher interest rates on hryvnia deposits, which are more attractive to businesses.

As we anticipated, the demand for foreign currency purchased for dividend payment purposes was fully met by increasing foreign exchange earnings from exports owing to favorable external conditions. Moreover, when permission for the repatriation of dividends came into effect, the NBU purchased as much as USD 476 million from the interbank market and the hryvnia continued to appreciate.

Overall, as we expected, these factors contributed to a faster-than expected slowdown in core inflation and more than offset contributions from increases in administered prices and tariffs, as well as fuel prices.

The slowdown of actual inflation, along with the exchange rate appreciation, contributed to improvements in inflation expectations of households, businesses, and the expert community. 

Under such circumstances, we have kept our headline inflation forecast unchanged at 12% for 2016 and at 8% for 2017. 

Although headline inflation is currently well below the target, we expect it to approach the target in H2 2016, mainly due to the reflection of upward adjustments in statistics for utility tariffs. The announced increases in communal services, effective in August, electricity, effective in September, and adjustments in utility tariffs for heating and hot water supplies, as well as the absence of preferential natural gas tariffs for households during the heating season, have been reflected in our current forecast.

At the same time, inflation in respect of other consumer basket components (core inflation and raw food prices) is expected to slow at a faster pace. The faster-than-expected deceleration can be attributed to the slowdown in imported inflation in the wake of low exchange rate volatility and improved inflation expectations. As a result, we expect that core inflation that reflects the underlying trend of price movements to slow to 5.5%.

In the medium-term, core inflation is projected to reach 5%.

The NBU has also maintained its annual Real GDP growth forecast unchanged at 1.1% by the end of 2016 and 3.0% by the end of 2017. The unaltered forecast reflects the offsetting effect of divergent factors.

In H2 2016, private consumption is expected to pick up slightly, supported by the rapid slowdown of inflation and easing depreciation expectations. However, private consumption growth is projected to remain moderate, being held back by significant increases in utility tariffs and prudent fiscal policy. Over the next few years, private consumption is expected to accelerate, fueled by deferred demand, household income growth, and a projected revival in lending.

Investment activity is expected to recover at a faster-than-projected pace. The need to reorient trade flows toward European markets will prompt Ukrainian exporters to increase investment while taking advantage of more favorable terms of trade. At the same time, the rally in global energy prices and the adjustment of heating and gas tariffs to economically justified levels will encourage the development and deployment of energy saving technologies.

Also, we have revised the current account deficit forecast downwards from USD 2.3 billion to USD 1.8 billion. According to our estimates, the pace of decline in exports will slow to 2% in the current year thanks to more favorable terms of trade and a projected increase in the yield of crops. A stronger recovery in exports will be held back by the imposition of a new round of restrictions by the Russian Federation on the transit of Ukrainian goods through its territory to Kazakhstan and Kyrgyzstan, effective from 1 July 2016.

However, given a reduction in trade volumes with Russia and other CIS countries, which has been observed in recent years, the impact of new restrictions will be much more limited than that of the previous restrictions.

The downward revision in the current account deficit forecast was also prompted by expectations of lower natural gas imports and larger private remittances from abroad.

Also, we do not expect the current account deficit to widen significantly in the coming years.

The current account deficit will be financed by future disbursements under the IMF’s EFF and external financing from other official creditors, as well as investment and debt capital inflows. External financing will enable us to continue the accumulation of international reserves and bring them to USD 17 billion by the end of 2016, and to USD 23.5 billion by the end of 2017.

The risks for further inflation developments this year have abated compared to the previous forecast. As a result, headline inflation might come in below the 2016 year-end inflation objective of 12%. The shortfall can be attributed to both domestic and external factors. These factors include the more significant effects of subdued consumer demand, the oversupply in the domestic market resulting from a high yield of crops, and favorable external conditions.

In the medium-term perspective, the resumption of cooperation with the IMF, absence of adverse shocks in external markets, and de-escalation of hostilities in the east of Ukraine, and, consequently, further improvements in inflation expectations remain the key factors supporting disinflation. 

Should the baseline forecast scenario materialize and risks to price stability abate further, the NBU will continue to move ahead with monetary easing. This move will promote the reduction of borrowing costs and boost economic growth. This move will also promote reduced borrowing costsand boost economic growth.

I would like to draw your attention to the fact that our updated projections will be available in the Inflation Report to be published on 4 August 2016.

At the same time, the NBU Board believes that the current economic situation and the balance of risks enable the regulator not only to ease monetary policy, but also to move ahead with its plans for gradual liberalization of FX controls.

We currently plan to extend the settlement deadlines for export and import transactions from 90 to 120 days.

We also changed the rules governing the execution of settlements under import contracts by clients. Up until now, banks were required to use a letter of credit payment method for settlements under import contracts exceeding USD 500,000. From now on, the letter of credit payment method will be required for import contracts exceeding USD 1 million.

These steps affirm our steadfast commitment to move ahead with plans for liberalization of FX controls and represent a breakthrough toward a free foreign exchange market and unrestricted capital movement.

Ukrainian businesses have long awaited this news. This move will enable Ukrainian producers to step up international operations while allowing the NBU to preserve stability in the FX market.

I would like to conclude our meeting with this good news.

The next meeting of the NBU Board on monetary policy issues will be held as scheduled on 15 September 2016.

Thank you for your attention!

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