Lifting of exchange rate restrictions and liberalisation of capital movements: How and when? (Press release)

Lifting of exchange rate restrictions and liberalisation of capital movements: How and when?

Ukraine’s most recent political and economic crisis forced the National Bank of Ukraine (NBU) to introduce strict currency regulations in order to stabilise the foreign exchange market and reduce pressure on the national balance of payments. Administrative measures helped to stabilise the situation, but the current tough set of restrictions on capital movements harms Ukraine’s path to economic recovery, holds back inflows of foreign investment and damages the business climate. State policy should be guided by a strategy of liberalisation of capital movements in order to set the foundations of long-term currency and financial sector stability.

In the research “Lifting of exchange rate restrictions and liberalisation of capital movements: How and when?” experts from the Centre for Economic Strategy analyse if easing Ukraine’s current regime of capital regulations is desirable and what preconditions exist for partial liberalisation of capital movements, based on international experience. Possible alternative policy options for capital movements and currency regulations are also examined in this research.

Liberalisation of capital movements boosts economic growth as it encourages inflows of foreign capital, financial sector development and facilitates access to financial resources for the state, companies and citizens. After almost three years of stagnant investment in the Ukrainian economy, attracting capital is an important precondition for economic recovery.

At the same time, Ukraine’s openness to international flows of capital can cause economic risks. Cyclical global flows of capital lead to strong volatility– powerful inflows of currency into the country can rapidly change to outflows and create preconditions for a new economic crisis.
According to International Monetary Fund recommendations, lifting of restrictions on flows of capital which were implemented to fight crises should be gradual and prudent. Based on the current situation in Ukraine (and international experiences) alternative policy options for flows of capital and currency regulations for the short and long term should be separately considered.

In the short-term perspective (3-6 months) partial lifting of restrictions on flows of capital is a better alternative to the existing regime of regulations but this step requires certain preconditions of financial stability and an increase of investor and public confidence in Ukraine’s financial system. Even partial lifting of restrictions will be a positive sign for investors and will improve economic expectations.

In the long-term perspective (3-7 years) full financial liberalisation is the best alternative for Ukraine considering its current level of integration into the global economic system and the requirement to attract large amounts of investment for structural modernization. However, the domestic economy needs long and complex preparation for this step in order to fully take advantage of free flows of capital and minimize the risks of volatility.

“International practice shows that Ukraine should follow an integrated approach to the liberalisation of flows of capital. This involves creating conditions for improving the institutional capacity of the country to manage the volatility of capital flows and transform inflows into productive investments”, said Maria Repko, deputy director of the Centre for Economic Strategy. “The necessary preconditions for full lifting of restrictions on flows of capital are continued macroeconomic and financial stability, a favourable business climate, well-developed domestic securities markets and the presence of solid supervision in the financial sector”.

An integrated approach to liberalisation of capital flows should include gradual lifting of restrictions on different types of flows of capital. This depends on success of reform measures and necessary preconditions. At the first stage of liberalisation, restrictions are lifted and a favourable environment for foreign direct investment and implementation of foreign trade operations are created; at the second stage – free flows of portfolio investments into the stock of capital and liberalisation of outflows of FDI are allowed; at the third stage – liberalisation of short-term flows of capital is conducted, at the final stage – lifting of restrictions on foreign investment for residents.

Realisation of all stages of liberalisation requires implementation of a number of reforms to create a favourable institutional environment (including measures for consolidation of the role of the financial market, improvement of prudential regulation and supervision for the introduction of the appropriate level of risk management among market participants, etc.). If flows of capital are liberalised without the right institutional environment, the domestic economy will not be able to absorb additional liquidity and it will lead to formation of “bubbles” in the real estate and consumer credit markets which can lay the groundwork for future crises.

For more detailed information about CES research on “Lifting of exchange rate restrictions and liberalisation of capital movements: How and when?” contact Maria Repko, CES deputy director (tel.: +380 44 492-7970, office@ces.org.ua).