National Bank of Ukraine buying war bonds to finance the budget. Is this the right tactic?
On March 8, 2022, the NBU management board determined that the central bank would buy out war bonds if necessary and thus finance critical government expenditures. The government uses the funds received from the sale of domestic government war bonds, including to the National Bank of Ukraine, to finance military and social spending.
Most economists understood the NBU's decision to finance critical government spending and supported this step. At the same time, the understanding of the nature of this funding differs. Some economists believe that funds raised by the government from the sale of war bonds to the National Bank of Ukraine do not work for the economy, but instead end up in the banking system.
Why is that not so, and to what extent is it useful or not for the economy to finance the budget deficit via the central bank?
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The funds for which the National Bank of Ukraine buys out domestic government war bonds go to government accounts. Then it spends these funds, transferring them through banks to enterprises and individuals. Technically, some of them continue to be accounted for in bank accounts, since both enterprises and individuals mostly use non-cash payments. At the same time, it is wrong to say that money does not work for the economy. As I mentioned, the funds go to the accounts of enterprises and individuals, respectively, and they spend them. What is it, if not the economy?
At the same time, the maintenance of the banks' liquidity at high levels is primarily due to the good functioning of the banking and payment systems, and, despite the war, maintaining confidence in banks and as a result preventing outflows from the banking system.
Today, the financing of the National Bank of Ukraine is helping the economy. The fact is that current inflation is really more related to supply factors, while demand has decreased significantly, because people are objectively spending less due to lower incomes and the need to save “for a rainy day.” Therefore, incentives from budget policy are now the right step, and the NBU, by buying out domestic government war bonds, is supporting this.
At the same time, the division of inflation into “monetary” and “non-monetary” is convenient for post-factum analysis, but it is a slippery path for predicting its future dynamics and making decisions. This separation also creates the misconception that the NBU can only influence “monetary inflation.” In fact, central banks affect all components of inflation, but their impact on monetary components is greater.
Thus, even so-called “non-monetary inflation” (logistical obstacles, disruption of production chains, fluctuations in world prices, etc.) can easily become monetary in the face of deteriorating inflation expectations among economic counterparties. No economic model can predict the time of transition from non-monetary to monetary inflation. That is why trust in the regulator is so important, and why, for example, it is precisely this trust in the Federal Reserve System's ability to curb inflation that leads to the fact that rates on long-terms obligations of the U.S. government do not reflect the significant increase in current inflation.
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That is why the National Bank of Ukraine finances only critical budget expenditures, and will give up financing the budget as soon as possible. In order to speed up this moment, the Ministry of Finance of Ukraine should stimulate market demand for domestic government war bonds and gradually replace it with funding for the NBU budget.
How can this be done? First of all, you need to raise rates. The rate on war bonds today is much lower than current inflation - 11% against 16.4%. We know what inflation forecasts for this year - from 20%, and also what the level of risks is in the economy. Under such circumstances, trying to keep profitability makes domestic government bonds a non-market instrument. The desire to receive market financing and the unwillingness to “meet” market requirements are mutually exclusive.
Instead, an increase in rates on domestic government war bonds will attract a lot more investors. In particular, the banking system has great potential, the UAH liquidity of which as of May 9 exceeded UAH 227 billion, and the currency liquidity of which was UAH 7.3 billion.
The banks keep most of their UAH liquidity in NBU deposit certificates. The Ministry of Finance of Ukraine proposed to reduce interest rates so that banks would be more actively involved in the purchase of domestic government bonds. At the same time, in my opinion, such a proposal is not constructive.
The National Bank of Ukraine has repeatedly noted that as the monetary transmission mechanism intensifies, it will return to inflation targeting with floating exchange rate formation and will apply a discount rate to bring inflation back to the target of 5%. Instead, the reduction of interest rates on NBU certificates of deposit and the actual change in the operational design of monetary policy effectively means the destruction of the monetary transmission mechanism itself.
The National Bank of Ukraine has come a long way in developing an inflation targeting regime and gaining confidence in its policies, so in my opinion, such steps are counterproductive and will only harm the economy. The loss of confidence in the NBU will at least lead to worsening inflation expectations and, as a result, to even higher inflation and the need to raise rates even more.
Instead, the intensification of market attraction through the placement of domestic government bonds by the Ministry of Finance of Ukraine, in particular by raising interest rates on these securities, will minimize risks to the fiscal sector and at the same time maintain macro-financial stability and confidence in the NBU.
