Is the decline in government bond yields today the first step towards the monetary financing tomorrow?

After more than 500 days of the full-scale invasion, experts estimate that our country’s economy has just gradually started to recover. In 2023, the National Bank of Ukraine is expecting real GDP to grow by 2%. The rate of decline of inflation exceeds the expectations: in June, the consumer inflation rate was 12.8%. At the same time, Ukraine’s international reserves reached a record high of USD 38,999.5 million in early July.

Theoretically, such circumstances — stabilization of the macro situation, improved inflation expectations, and an increase in international reserves — could be seen as a signal to revise yields on bank deposits and government bonds.

The Ministry of Finance, which, despite the economic feasibility, was reluctant to raise rates on domestic debt securities from the outset, has already set a course to reduce the yields on domestic government bonds. In July, ICU analysts stated that the Ministry of Finance continued the trend of lowering interest rates on domestic government bonds, which began in June and has every chance of continuing.

Proponents of revising government bond rates often cite 2019 as an argument in favor of lowering them. This was when high yields amid investor optimism, currency liberalization, and a floating exchange rate made domestic government bonds primarily an interesting instrument for non-residents. At that time, speculative capital entered the country to buy government bonds with a yield of 18% and withdraw the proceeds abroad. Against the backdrop of the hryvnia’s revaluation, these were considered super profits.

The regulator, having embarked on the path of inflation targeting and floating exchange rates, could not fix the exchange rate, as these were mutually exclusive concepts. Then the Ministry of Finance’s slowness in reducing yields resulted in increased risks. The risks from a faster decline in yields would have been definitely lower.

Perhaps the delay in 2019 is why the Ministry of Finance is in such a hurry now. But the current situation is completely incomparable to 2019. And the reason is not only that a full-scale war has been going on for a year and a half.

Now, despite all the external similarities — high yields on government bonds and falling inflation — the “initial conditions” are different: we have a fixed exchange rate and strict currency restrictions. Non-residents are no longer lining up to buy our domestic government bonds. Instead, domestic demand for debt securities is growing, which is already an achievement.


Because the war is unpredictable.

Because the domestic investor keeps both the funds invested in government bonds and the coupon income on them in Ukraine, and they work for our economy.

Because in our conditions, increasing the state budget revenues and the volume of foreign aid is not easy and takes a lot of time.

Therefore, now more than ever, the Ministry of Finance needs to think a few steps ahead. It should not put the cart before the horse and not reduce the yield based on the rate of consumer inflation. First of all, it is necessary to ensure sustainable domestic demand for government bonds with an appropriate level of yield. After all, if domestic investors lose interest in government debt securities, it will take a long time to revive this demand if necessary. And time is a crucial factor now.

The only source of covering the budget expenditures, which are at a high risk of growing due to the war, will remain the emission, given that there is no sustainable domestic demand for government bonds. However, the emission not only fails to solve the issue, but it often even exacerbates budget problems, as expenditures end up rising. Macroeconomic stability is easy to lose, but it takes a long time to restore. Why go back to the cycle of “devaluation — high interest rates — tight currency restrictions” when this can be avoided by a prudent economic policy?

Source: Medium

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