Caution, government bonds: how government bonds affect the Ukrainian economy
It is no secret that domestic government bonds are a traditional tool for the government to cover its debt. Investors always buy domestic government bonds since these bonds are secured by the state’s financial and other resources. Therefore, they are essentially risk-free. Banks are the most avid buyers. It is the safest profitable way to invest money. As a result, money flows from banks into the government debt and stops circulating in the economy, which helps to repel the inflation. Everything seems to be rather normal. Everybody wins. Or do they?
It is all about interests
With the beginning of 2018, the National Bank of Ukraine has been rising interest rates diligently. In January, they accounted for 15% as compared to 13.5% in December 2017, 16% in February 2017 and 17% in March 2017. There is a high probability that the emerging upward trend will be continuing. That said, the increase in rates will raise the bonds profitability for investors, and that is the reason stocks are so hyped these days. Investors are keen buyers of domestic government bonds, which allows the government to obtain more money to repay the state debt.
Ukrainian players are not the only ones to partake at the exchange market. Ukrainian non-residents also engage in the game en masse. According to the National Bank of Ukraine, their bonds portfolio increased from ₴5.2 to ₴14.5 billion, that is almost tripled. Such flurry of investors’ activity has a positive effect on the hryvnia exchange rate. Secondly, by encouraging non-residents to buy government bonds, the Ministry of Finance increases the number of loans in hryvnia. This loan carries more benefits for the government since it allows avoiding foreign currency risks.
Banks lose their interest to provide lending for businesses and the economy. Nowadays, these loans have around 16% interest rates. The domestic government bond has a higher interest and, thus, this investment can generate more income and be almost risk-free. In the corporate segment, however, there is a huge number of liabilities, and many liabilities remain outstanding for a very long time. As things stand now, investing in domestic government bonds is the most logical thing to do. A surge in interests only encourages their reluctance to provide business lending. Meanwhile, the lack of loans means an economic slowdown for Ukraine and an increasing gap between Ukraine and developed countries.
Therefore, we have a situation where we fix one thing and break another. Even though the issuance of domestic government bonds is a solid tool to solve the state debt problem, it works against the Ukrainian economy, which should not be the case.
Non-residents will not be able to acquire domestic government bonds forever. For all intents and purposes, there will be a moment one day, when they decide to cash-in the bonds at hand and translate their hryvnia yield in hard currency. What happens to the national currency and its stock market? There are two ways to look on this matter: pessimistic and optimistic.
Pessimists are positive that investor’s withdrawal will weaken hryvnia and prices will rise. Optimists say the National Bank will not let this happen. Over the past years, the regulator has managed to accumulate enough foreign exchange reserves (US$18 billion as at this day). These reserves should be enough to support the national currency when times get rough.
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