Banking Reforms in Ukraine and Russia: Similar Measures, Different Results
BY VADYM SYROTA
In March 2019, in an interview with IMF representatives, Elvira Nabiullina, governor of the Russian Central Bank, listed her major achievements as moving quickly to target inflation, allowing the exchange rate to float, restructuring the banking sector to eliminate weak banks, and reducing illicit banking operations. Essentially the same items were ticked off by Valeria Gontareva, former governor of the National Bank of Ukraine (NBU), in her annual reports and are in line with the policy recommendations derived from the Washington Consensus. The implementation of the same sorts of measures in Russia and Ukraine, however, has led to surprisingly different results. Several factors contribute to the discrepant outcomes achieved in these two countries applying the same tools.
Inflation targeting was the cornerstone of the reforms implemented in both countries. Inflation targeting entails a central bank implementing policies to meet publicly known, preset targets for the annual rate of inflation through the use of monetary tools (mostly by raising or lowering interest rates). Russia began targeting inflation in late 2014 and succeeded in curbing inflation in 2016 by actively hiking interest rates. Ukraine’s central bank, though it too considerably increased interest rates beginning in 2014, was not so adept at controlling inflation, reaching its medium-term target of 5 percent only in November 2019. This result is mainly attributed to the large amounts of sovereign debt issued and concern over Ukraine’s ability to repay such obligations in the near term. Another implication of inflation targeting implementation was the virtual suspension of lending to Ukraine’s productive sectors because of the enormously high interest rates on loans.
An integral part of an inflation-targeting policy is maintaining a flexible (floating) exchange rate—but doing so also risks exacerbating currency depreciation in the context of economic turmoil such as Ukraine and Russia experienced in 2014–2015. Theoretically, the free market should smooth currency rate fluctuations through adjustments to the balance of payments. In line with free market theory, the central bank in each country abandoned the exchange rate peg to the U.S. dollar. Despite considerable depreciation of the ruble, Russia managed to preserve its foreign exchange reserves from a drastic slump. Unfortunately, Ukraine entered the floating-rate regime under a vastly different set of political and economic conditions, and its results betray difficulties in achieving overall financial goals. Specifically, it retained a large degree of dollarization of banks’ assets and liabilities (according to the NBU’s Financial Stability Report, dated June 2019, 41–45 percent), and its sovereign debt remained mostly denominated in foreign currency (as of May 1, 2019, such obligations accounted for 68.2 percent of total sovereign debt).
For such reasons, Ukraine suffered from skyrocketing exchange rate depreciation (around four times), which prompted Kyiv to impose capital control measures (such as restrictions on how export earnings are used, limits on withdrawals of foreign currency deposits, and caps on dividend repatriation) to shore up the stability of the local financial market. Some believe that whatever macroeconomic stabilization has been achieved in Ukraine can be attributed to the successful use of capital controls rather than to inflation targeting. Russia’s Elvira Nabiullina, by contrast, in her 2018 Michel Camdessus Lecture emphasized the necessity of avoiding capital controls.
Cleaning Up the Banking Sector
With respect to banking sector clean-up, Ukraine’s and Russia’s banks had a lot of problems in common: hidden deficits on banks’ balance sheets that triggered the need to invest capital, nontransparent ownership structure, loans granted to associates that significantly exceeded permissible amounts. Tough regulatory actions (anti-money-laundering sanctions, higher capital requirements, revocation of banks’ licenses) greatly reduced the number of operating banks—in Ukraine by almost half, in comparison with the number operating in 2013. At the same time, the losses borne by the public were vast: the banking crisis cost Ukraine 38 percent of GDP, while money spent by the government on the public sector amounted to only 14 percent of GDP. Moreover, claims in both countries that some banks’ closures were politically motivated cannot be dismissed. So it is not surprising that international experts don’t consider either country to have made much progress in transforming its banking system.
Financial System Development: The World Economic Forum Rankings
According to the Global Competitiveness Report 2019 of the World Economic Forum, trend indicators of Ukraine's financial system development are in the cellar. For example, on macroeconomic stability (measured mostly in terms of inflation control), the usual key virtue looked for in assessing a central bank’s transformation, Ukraine ranked 133rd out of 141 countries evaluated. Assessment of its financial system as a whole placed it 136th out of 141 countries. Here, several extremely concerning areas stood out: the volume of nonperforming loans (139 out of 141), the soundness of banks (131), banks’ regulatory capital ratio (120), and the financing of small and medium-sized enterprises, necessary for a healthy economy (112). It is regrettable that President Zelenskyy didn’t initiate a public discussion with the central bank’s officials on these awkward statistics prior to his enthusiastic speech about Ukraine’s investment potential to a virtually empty auditorium at Davos.
Russia fared better in the Davos rankings. In macroeconomic stability it placed 43rd out of the same 141 countries evaluated, though its factor rankings for financial system development were often in the neighborhood of Ukraine’s. Areas of specific concern were the soundness of banks (rank of 115) and banks’ regulatory capital ratio (rank of 132). In the wake of the banking sector purge, Russian financial institutions haven’t enjoyed a sound financial standing and are not perceived as resilient to shocks.
Diverging Political Paths
Conspiracy theorists might be forgiven for believing that the controversial banking reforms in Ukraine and Russia were designed and implemented by the same mastermind. So the discrepant results achieved by applying the same tools have considerably impressed banking experts. In Russia, the state-owned financial institutions are able to concentrate financial sources on controlling the communications infrastructure and on delicate political tasks, both intended to maintain regime stability. In Ukraine, by contrast, a specific financial market has been created. At this point, Ukraine’s business sector, especially SMEs, suffers from lack of access to credit, while the state-owned banks, which dominate the banking sector, effectively serve as a warehouse for non-performing loans. Various political and business interests are realizing profits from the vast speculative opportunities still available as Ukraine’s banking sector fights its way to reform. Unfortunately, such harmful practices violate the principle of fair competition and lay the groundwork for future crises in Ukraine’s financial system.
Perhaps the overarching lesson to be drawn from this comparison of Russia’s and Ukraine’s financial sector is that the same or similar tools, when applied in a different political context, bode differently for each country’s economic development. We will continue to monitor the situation as further ramifications unfold.
The opinions expressed in this article are those solely of the author and do not reflect the views of the Kennan Institute.
About the Author
The Kennan Institute is the premier U.S. center for advanced research on Russia and Eurasia and the oldest and largest regional program at the Woodrow Wilson International Center for Scholars. The Kennan Institute is committed to improving American expertise and knowledge of Russia, Ukraine, and the region. Through its residential fellowship programs, public lectures, workshops, and publications, the Institute strives to attract, publicize, and integrate new research into the policy community. Read more