Yesterday, SP Advisors held a conference call with Dmytro Sologub, NBU Deputy Governor, and Vitalii Vavryshchuk, Director of the NBU Financial Stability Department. Below we provide the key takeaways from the discussion.

To listen to the replay of yesterday's conference call please dial +380 89 323 99 67 (PIN: 800892#) or follow the link.

On the economy and monetary policy

• Ukraine is in the midst of a perfect storm, with a deep economic crisis aggravated by a military conflict and a crisis of confidence.

• GDP will decline by 7.5% yoy in 2015, according to NBU projections.

• Despite all the difficulties, the light at the end of the tunnel is already visible. Relative stability in the FX market is a key positive development over the past month. However, the NBU is well aware that the current stability of the FX market is fragile.

• A fundamental exchange rate adjustment has already taken place and the hryvnia is currently fluctuating in the acceptable range. Sizable external financial support and a good pace of reforms are doing the job and playing a stabilizing role.

• The NBU is committed to increasing its gross international reserves to the equivalent of 3 months of imports (SP Advisors: The NBU's projection for end-2015 reserves is USD 18.2 bln vs. USD 10.0 bln at end-March).

• Inflation has accelerated (SP Advisors: to 45.8% yoy in March) but this was primarily driven by the hryvnia depreciation and a temporary hike in prices for food staples. Inflation is the price that Ukraine has to pay for broad macroeconomic adjustments. The NBU plans to achieve a sustainably low inflation rate within the next two years, and has made that the monetary policy priority.

• The NBU has made significant progress in establishing a framework for full-fledged inflation-targeting. Recently, the NBU established a monetary policy committee, and published its first-ever inflation report (available here).

• The policy rate hike to 30% (SP Advisors: on March 4, 2015) was a badly needed, but temporary, measure aimed at stabilizing the FX market.

• Administrative restrictions in the FX market and for export and import operations were instrumental in stabilizing the FX market, but they are not a sustainable and effective solution to the current problems. The NBU will start lifting administrative restrictions gradually as the economic situation normalizes.

• Ukraine needs three pre-conditions for a continued improvement in the economic environment: external support, a decent pace of reforms, and the alleviation of security risks. Progress has been substantial on all three fronts over the past couple of months.

On the Ukraine-IMF program

• The Ukraine-IMF program is extremely ambitious, not only in terms of financial support, but also in terms of reform requirements. The program is affecting practically all important economic areas.

• Ukraine has always been an underperformer and all past IMF programs were halted prior to their planned completion. The NBU is confident this time will be different because there are many new faces at all government agencies committed to reforms.

• Ukraine has easily fulfilled all prior actions, and there won't be any problems meeting key quantitative targets for the first program review.

• The key risk to the program is a possible escalation of the military conflict.

On the banking sector

• The NBU has a detailed plan to reform the banking sector, comprised of 4 major elements:

•   Encourage bank shareholders to recapitalize their banks. The NBU will complete a diagnostic study (incl. stress tests) of Ukraine's top-10 largest banks by end-July and the next 20 banks by end-September. Based on the results, banks will have to develop credible recapitalization strategies with the goal of bringing their CAR back to 10% (the minimum NBU requirement) before the end of 2018. Shareholders of many foreign-owned banks have already committed sizable funding for their subsidiaries. In many cases EU (and Russian) parent institutions will prefer to convert the debt to their Ukrainian subsidiaries into equity.
•   Enforce commercial banks to reduce exposure to related parties. Banks will have to hire an external auditor, jointly develop a full list of related parties, and submit the list for NBU approval. The NBU will review the list and approve 3-year plans for the elimination of excessive related-party lending.
•   Gradually eliminate administrative restrictions, specifically with respect to maximum limits on daily withdrawals of retail deposits. The UAH 150,000 daily limit on hryvnia deposits is no longer needed and the UAH 15 000 daily limit on FX deposits can now be eased. Nevertheless, the introduction and elimination of all administrative restrictions should be coordinated and agreed with the IMF. The NBU is now in talks with the fund on these issues.
•   Create the necessary preconditions for macroeconomic stability in order to achieve a sustainable reduction in interest rates to make deposit-taking and lending less risky.

• Since the beginning of 2015, the NBU declared 47 banks insolvent. The central bank doesn't have a target for the ideal number of commercial banks in the economy – any viable bank with a sustainable business model should remain. The NBU will continue strengthening the supervisory framework and stabilizing the economy, and will ensure that only high-quality institutions remain functional. The cleanup of the banking sector is not yet complete, but the NBU is determined to remove all non-viable banks from the market in the next couple of months. This will provide a major boost of confidence to the banking sector.