As the dollar reaches new historical lows against pretty much all other global currencies, Ukrainian monetary policymakers must be wondering how much longer they should defend a narrow exchange rate corridor against the greenback.
Ukraine's currency, the hryvnia (UAH), has been de facto pegged to the dollar since the 1998 financial crisis. Since a currency revaluation in April 2005, the hryvnia has been trading at UAH5.05:$1, which places it comfortably within a declared band for movement of UAH 4.95-5.25:$1. As such, it has been very successful in stabilising the economy by giving people faith in the local currency. This in turn has helped bring down inflation and facilitate economic growth.
Ukraine is not unique in this respect. A number of countries in emerging markets use hard dollar pegs to fix their exchange rate frameworks. The difference is that in their case, such as in the Gulf, the US is their biggest trading partner.
Thus, the weakening dollar is not having a substantial impact on those countries' principle export commodities. In Ukraine's case, its main trading partners are EU member states, with a substantial part of those transactions nominated in euros.
As a result, the dropping value of the dollar is having a direct impact on Ukraine's external competitiveness vis-à-vis Europe. There is both a positive and a negative effect. On the one hand euro strength against the dollar means that Ukrainian principle export commodities, such as steel, chemical products and machinery are more competitive in terms of price.
However, to become more competitive and increase productivity, Ukraine needs to import capital goods - factory equipment, technology, materials - a lot of which comes from Europe and is nominated in euros.
Consumer goods like cars, washing machines and mobile phones are also getting more expensive because of a stronger euro. This in turn results in inflationary pressure - a monetary evil policy makers are at pains to eradicate.
Another possible negative effect that could be generated by weakening dollar is that majority of people traditionally held their savings in dollars. It made sense, because the prices for housing, cars and even salaries were all referenced in dollars.
However, there is a risk that a weaker US currency could result in a switch from dollar prices to euro prices, which would be equivalent to a 40% price increase. This took place in other East European countries such as Bulgaria and Romania as well as the Baltic states that used to have dollar-based economies, but now use the euro as their reference currency.
In the case of these countries, the transition was relatively slow and smooth and the gap between the dollar and the euro was much smaller. A sudden switch at this point would be very expensive for consumers and would effectively erode a substantial part of people's savings.
"A stable hryvnia-dollar exchange rate remains an important psychological anchor among Ukrainians and therefore the key monetary tool in stabilising the currency," said Adomas Navickas, a partner at KBC Securities Baltic Investment.
A more gradual transition through relaxation of the exchange rate mechanism and widening of the dollar-hryvnia corridor may be the best solution. It would allow the market to determine the value of the Ukrainan currency with the central bank intervening to offset sudden external shocks.
Volodymyr Stelmakh, governor of the National Bank of Ukraine, suggested back in May that a shift in monetary policy may be imminent. However, nothing has yet taken place, in the absence of a functioning parliament and clear political vision.
Indeed, given the political situation it is probably best no major monetary policy changes are implemented until there is a stable government. The peg was introduced precisely because there was no faith in policy making. The fear is that short-term political tampering with the exchange rate would only undermine faith in the local currency, as politicians are often accused of fixing the exchange rate to suit their own business goals.
Seen from that perspective, the recent election has hopefully served as an important milestone in creating a political consensus on future monetary policy. It is clear that Ukraine cannot retain a hard dollar peg indefinitely and policy makers need to project a clear vision of where to go next. As in its geo-political choice, the answer is probably either closer to the euro or the ruble.