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Ukraine and the Impossible Trinity

Written by A Forex View From Afar on Wednesday, April 01, 2009

Ukraine announced it will impose strict rules on the capital movement, while also forcing banks to quote the national currency, the hryvnia no lower than a limit set by policy makers.

These moves are meant to stop or at least to reduce the strong capital outflow that threatens the Ukrainian economy, as is the case with most other emerging economies. However, this also drives the country near to a default scenario.

Over the last few months, the hryvnia has lost almost 40% of its value against the dollar, as investors turned the inflows looking for a higher yield, into outflows looking for nothing more than safety. The National Bank of Ukraine lost one third of its reserves during this period, as it tried to curb the currency’s decline.

What the Ukraine is currently trying to impose, strict capital flows, is certainly not what investor’s want to see or hear. Additionally, the country is running through a “small” political crisis, being lead by a President that is pro-Europe, while the government is pro-Russia, something that has the potential to disrupt the country’s fragile stability (if it has not done so already). Along with the current political struggle, the Ukraine now faces another problem, called the impossible trinity.

During the early 1980s, when the foundation of an open economy was being laid, economists developed the so-called impossible trinity model, which states that a country cannot control its monetary policy, its currency and its capital movements simultaneously. In order to function properly, a country has to give up to one of the three.

However, this is exactly what the Ukraine is trying to achieve these days. Until now, the Ukraine controlled its monetary policy and had a free, tradable, currency, as most open economies do. However, now it will also control its currency and its capital flows, trying to achieve something that no other country has achieved for the long term.

In a normal open economy, as investors pull money out of the country, the local currency depreciates, until a certain point when it is not profitable (or justifiable) to depreciate the local currency. Because the Ukraine will keep the hryvnia at artificial high rates, it will create an incentive to draw more money from the country, until the point when the government runs out of funds. Secondly, by keeping the currency rate at an artificial level, it makes the exporter’s life harder, while encouraging imports, expanding the trade deficit.

In this case, I have the impression that the Ukraine is heading towards a very hard social and economic crisis, which will ultimately end up as a political crisis. This comes, after the rather fragile economy passed through a similar situation in 2004. The impossible trinity is among the few economic concepts that have never failed, until now, and the history of economic crises reminds us of that.

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  1. 1 comments: Responses to “ Ukraine and the Impossible Trinity ”

  2. By Tessa on April 11, 2009 at 2:18 AM

    I recently came accross your blog and have been reading along. I thought I would leave my first comment. I don't know what to say except that I have enjoyed reading. Nice blog. I will keep visiting this blog very often.


    Ruth

    http://muffinsnow.com

TheLFB Team & The View From Afar Blog

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