Zurich, 26 February

• The recent decision of the National Bank of Ukraine to announce a more flexible exchange rate policy can be seen as first gesture in front of IMF and EU demands
• Ukraine is in need of large-scale and quick financial assistance, expected to be more than USD 35 bn.
• IMF/EU and Ukrainian authorities need make the choice between increasing currency flexibility, fiscal austerity and serious structural reforms.

Key Economic Indicators

Source: IMF WEO as of October 2013, Thomson Reuters

The today move of the National Bank of Ukraine to officially announce a more flexible exchange rate policy can be seen as anticipation of IMF/EU demands. Today the UAH (national currency) slumped even further reaching the level of USD/UAH 10, bringing total depreciation to 20% from the beginning of the year. With markets expecting the IMF to demand more FX flexibility but doubting the sufficiency of reserves, the near term outlook of the currency before external support is in place is highly uncertain, with a substantial risk of overshooting.

Ukraine will need large-scale and quick financial assistance ultimately, possibly more than USD 35 bn. Given both, an unsustainable external and fiscal position, it is no doubt that Ukraine will need large-scale financial assistance going forward. Recent rumored sums in the range of USD 25-35 bn might be sufficient to cover the immediate financing gap over the next 1-2 years.

Market voices presume that even a somewhat larger sum might be needed in order to have sufficient buffers. Any large-scale IMF/EU support package should bring in sufficient buffers for potential downsides (e.g. retaliation measures of Russia, potential recapitalisation needs in the banking sector). In order to reach an overall financing volume of USD 35 bn (or more) EU and European countries (via bilateral loans) have to make sizable important commitments.

IMF/EU and Ukrainian authorities will have to meet the right decision. The challenge will play an important part between increasing currency flexibility, fiscal austerity and structural reforms. There is no doubt that a large-scale joint IMF/EU support package cannot be just about the provision of funding to Ukrainian authorities (i.e. the Ukrainian National Bank and directly or indirectly also the Treasury). Large-scale IMF/EU financial assistance is likely to come with tangible demand for reforms and conditionality attached. The targeted areas for reforms will most likely be similar to previous support packages (as the main vulnerabilities and weakness of the Ukrainian economy are more or less the same compared to previous bail-outs). Therefore, the question of the exchange rate regime will surely be an issue of dicussion.  IMF argued already for years in favour of a higher degree of exchange rate flexibility in case of Ukraine (which was also included in previous IMF deals, but was not implemented).

The question of changes to the Ukrainian exchange rate (regime) has to be seen in context of recent exchange rate developments geographical region. The Russian rouble (RUB) and Kazakh tenge already experienced significant devaluations (in case of the RUB spread throughout 2013 and 2014; in case of Kazakhstan as a large one-off devaluation recently). These developments are logically increasing (market) pressure on UAH. Therefore, from this perspective additional UAH devaluation. /RLU