Thanks to a better than projected harvest, slower increase in regulated prices, and easing inflationary pressures from abroad and domestic demand, consumer prices kept slowing in Ukraine. In August 2011, prices for foods and beverages declined by 1.2% on a monthly basis (mom), driving the whole consumer price index down by 0.4% mom. As in the previous month, the monthly price drop was led by fruits and vegetables, particularly potatoes, a staple food in Ukraine.
In an anticipation of a record high potato harvest in Ukraine this year, prices on potatoes slumped by more than 60% from June to August 2011. Prices on other vegetables (carrot, onion, cabbage, etc.) retreated 25%-35% from the previous month. Higher supplies of fresh fruits (e.g., apples) explain the sharp reduction in their costs in August (-11.5% mom).
Rich grain harvest amid grain export restrictions and good harvest in neighboring countries (Russia, Kazakhstan) pressured domestic prices on cereals down. A delay in natural gas price increases and waning pressures from international energy and food prices contributed to domestic price growth slowdown. Indeed, domestic fuel prices remained unchanged in August 2011, while the cost of utility services went up by a moderate 0.5% mom.
On the upside, supply shortages due to continuing stagnation in cattle breeding and inefficient government support programs caused prices for milk, dairy and meat products to rise by 1.4% mom, 2% mom and 3.3% mom respectively. Despite these increases, in annual terms consumer price growth slowed to 8.9% in August 2011. Inflation, however, may speed up again in the coming months due to reinstatement of higher excises on gasoline products and a low statistical base effect. At the same time, tighter monetary policy and slower domestic demand will help contain consumer price growth to about 10-11% yoy at year-end.
Since the end of July 2011, the National Bank of Ukraine has been keeping Hryvnia liquidity tight. Policy tightening was aimed at both reducing inflation pressures and maintaining Hryvnia exchange rate stability. During August, cash balances on correspondent accounts of commercial banks declined to just UAH 12 billion (about $1.5 billion) compared to an average of about UAH 18.6 billion over January-July 2011. Moreover, during the first ten days of September, they were at a six-year low of UAH 9.4 billion.
The low liquidity stance of the banking system may be attributed to higher reserve requirements, Hryvnia sterilization operations (though in August they were much less sizable than in the previous few months – UAH 5.3 billion versus a monthly average of UAH 22 billion over February-July) and population withdrawals of Hryvnia deposits, which was not observed since October 2009.
The stock of population deposits in national currency, which account for almost 60% of total Hryvnia deposits, declined by 0.5% mom in August. Deposit outflow may be explained by declining deposits rates and intensified Hryvnia depreciation concerns. Indeed, flooded with ample liquidity during January-July, commercial banks were gradually reducing deposit rates. Since the beginning of 2011, a weighted average rate on short-term population deposits in national currency fell by about 200 basis points to less than 12% pa in July-August.
In addition, during the last few years, the resumption of economic activity after vacation seasons correlated with stronger demand on foreign currency and, hence, higher depreciation pressures on the Hryvnia. Coupled with rising concerns over existing vulnerabilities of the Ukrainian economy amid continuing global financial turmoil and worsened global economic growth prospects, these expectations might explain strong population demand for foreign currency and Hryvnia deposit outflow in August.
Maintaining Hryvnia stability was another reason for liquidity tightening. September was also a month of large domestic debt redemption (UAH 5.5 billion, a 2.3% increase in monetary base and more than 30% increase in banking system liquidity , ceteris paribus). Ample Hryvnia liquidity in the banking system could induce the materialization of depreciation pressures, stemming from worse export prospects, high external debt financing needs, strong population demand for foreign currency and fragile banking sector (due to a large number of European bank subsidiaries in Ukraine).
In addition, we believe that short-term monetary tightening will have a limited impact on credit activity. Excluding bank loans to state-owned enterprises, credit to private companies rose by less than 10% yoy in August. The high share of non-performing loans in commercial banks’ balance sheets and high credit risk requires commercial banks to increase qualification requirements for potential borrowers (e.g., higher collateral).
In turn, these requirements and still high credit rate restrict demand on credit resources. Furthermore, scarce liquidity may cause consumer loans to grow at a slow pace (in August, the stock of Hryvnia-denominated consumer loans advanced by 26.2% yoy) , which will help contain inflation pressures and import growth. In the longer-term, however, to maintain price and exchange rate stability monetary tightening measures should be complemented by the government policies to ease supply-side rigidities (i.e., measures to support and stimulate private sector development).