The Impact of the Budget Deficit on Inflation in Ukraine

Research Report

Commissioned by INTAS

May 2001

R. Piontkivsky, A. Bakun, M. Kryshko, and T. Sytnyk

International Centre for Policy Studies

Ukraine, Kyiv 04070, Str. Voloska, 8/5

Tel.: 044/463-4937

Fax: 044/463-5970

1. Introduction 4

2. Theoretical Links 5

2.1 Aggregate Supply and Aggregate Demand Analysis 5

2.2 Sources of Financing and Money Decomposition 6

2.2.1 Borrowing From the Central Bank 7

2.2.2 Borrowing From the Public 9

2.2.3 Running Down Foreign Exchange Reserves 9

2.2.4 Accumulation of Arrears 10

2.3 Specific Theoretical Hypotheses 10

2.3.1 Olivera-Tanzi Effect 10

2.3.2 Deferred Inflation Effect 11

2.3.3 New Fiscal Theory of Price Level 11

2.4 Closing Remarks 11

3. Developments 13

3.1 Definitions 13

3.2 Dynamics 14

3.3 Financing 15

3.3.1 Direct NBU financing 16

3.3.2 External Financing 16

3.3.3 T-bills (OVDP) Financing 17

3.4 Inflation Performance 18

4. Empirical Analysis 21

4.1 Methodology 21

4.2 Regression Results 22

4.3 Policy Implications 23

5. Conclusions 24

6. References 25

7. Appendices 26

Appendix 1. Data Used in the Estimation 26

Stationary Series Graphs 26

Original Series Graphs 27

Summary Statistics 27

Appendix 2. Augmented Dickey-Fuller Unit Root Tests Results 28

Appendix 3. Granger Causality Tests 29

Appendix 4. VAR Results 31

Appendix 5. Stability of VAR scheme 32

Appendix 6 Cross Correlations 33

Cross Correlation of Inflation and Government Balance 33

Correlations for Contemporaneous Values of Variables Examined 33

Appendix 7. Effects of VAR components on Inflation 34

Impulse Response Functions 34

Impulse Response Functions (cumulative effect) 35

Variance Decomposition 36

1. Introduction

Since becoming an independent state Ukraine has experienced high levels of both inflation and budget deficit, making itself an interesting case study of the relationship between the two fundamental indicators.

In early 90-s consumer price inflation reached a 10000% a year, the highest level among transition economies not at war. Budget deficits exceeded 10% of GDP. As economic policy become more constructive, the budget deficit level diminished. The rate of inflation declined even more sharply to moderate levels. This can be clearly seen as a proof of the deficit-induced hyperinflation. The major source of deficit financing had been National bank credits.

However, as government became able to use other sources of financing of a much smaller deficit, the link and causality between budget deficit and inflation turned to be less evident.

Though it is widely acknowledged that fiscal imbalances were by far a major determinant of inflation, there exists no comprehensive study of the impact of the budget deficit on inflation in Ukraine. De Menil (1997) and Banaian et al. (1998) analyzed the issue for the first half of the 1990s. The main finding was that fiscal deficit did matter, but only to the extent it contributed to the money growth. As most of the budget imbalance was being monetized during that period, it is of no surprise that independent influence of the deficit not found.

Later on, as more possibilities emerged to finance the deficit — through newly created T-bills market or from external sources — the link between deficit, money and inflation seems to become much more complicated.

The goal of this research is to analyze the dynamics of the Ukrainian budget deficit and inflation, try to reveal their mutual impacts, and summarize the lessons from the second half of the 1990s’ experience. The main hypothesis for empirical testing is whether fiscal imbalance itself helps to explain the inflation dynamics after the hyperinflation period. Based on the monthly data from 1995 to mid-2000 our major finding in VAR specification is the implicit conclusion, that fiscal imbalance, apart from other, purely monetary factors, does play a role in the inflation determination. A monthly 1%GDP decrease in budget deficit, all of which was previously monetized, subtracts from annual inflation 0.8%. If a non-monetized part of the deficit is cut, then annual inflation is lowered by 0.4%. Among the monetary factors, the most inflationary seems to be the monetization of the deficit. The dynamics of the National Bank’s claims to government (monetization) appear to be more tightly linked to the inflation than the monetary base and the exchange rate.

The research team of this project consists of Alex Bakun, Maxym Kryshko, Ruslan Piontkivsky (team leader), and Tetiana Sytnyk.

The remainder of the report is organized as follows. Section 2 presents a theoretical framework for the analysis. Section 3 describes the historical developments of the budget balance, sources and costs of its financing, and inflation dynamics. In section 4 we explore the relationship empirically and discuss some policy implications. Finally, section 5 is a conclusion.