In the past several months a serious discussion has emerged on how to ensure sustained reconstruction of Ukraine. It is not only about after the war, but during the conflict. The discussion has coalesced around three points. First, there is not sufficient donor money to finance a near trillion-dollar reconstruction tab: Incentivizing the private sector is the only way to ensure a sustained recovery. Second, these incentives can be provided via a series of de-risking instruments such as political risk insurance, bank loan guarantees, and large-scale grants. Third, there are several enabling environment reforms the Government of Ukraine (GOU) can undertake to assure investors.
While each of these are important, there is one key de-risking change Ukraine can implement by year’s-end: A complete conversion to the Euro as its currency (known as “dollarization” or in this case Euroization).
Contrary to popular belief, permission from the European Central Bank (ECB) is not required. I along with the IMF, the EC, and USAID implemented such a reform in Kosovo in 1999 when for economic stability we adopted the D-Mark (which then became the Euro). Countries all over the world have dollarized (from Panama and El Salvador to Argentina, Montenegro, Cambodia, and more).
Some have only partially dollarized (e.g., Argentina) and those efforts are largely unsuccessful—since the disciplining feature of adopting a stable currency is squandered when governments can monetize its deficit (by printing domestic currency for the government to pay its bills). Fully adopting the Euro via a planned conversion of Ukraine’s currency (the Hryvnia) assets from private bank accounts, government accounts at the treasury, and all currency in circulation can be accomplished over a 6–12-month period.
While adopting the Euro does not require permission (they will need agreements with EU based banks to supply notes and replace damaged ones), joining the European System of Central Banks (ESCB), does require permission and has several advantages (more efficient cross-border payments, credit, note supply etc.). ESCB membership would be good but will take time. However, adopting the Euro has many advantages and makes eventual ESCB accession easier. The conditions are already in place for Euro adoption. Most posted prices are in hard currency (in Euros and US dollars—which have a stable exchange rate between them). This is to avoid requoting prices every day in Ukrainian currency. Additionally, most citizens already hold wealth in Euro denominated assets.
The advantages are numerous, the disadvantages are few.
Adopting the Euro would signal commitment to sound monetary/fiscal discipline, boost investor confidence, promote increased foreign direct investment, and lower borrowing costs. It would also provide Ukraine with a more stable currency. The Euro is managed by the European Central Bank (ECB). This stability will reduce inflationary pressures and provide predictability for businesses and consumers. At present, the National Bank of Ukraine (NBU) is increasing hryvnia base money at over 28% a year (to support the deficit), a rate that is unsustainable. If this monetary expansion is not slowed or stopped (which Euro adoption would do) the conclusion of the war--even with victory--will be met with hyperinflation and its resulting destabilizing political fallout. This is the last thing Ukraine would need after a peace agreement when its politics will almost undoubtedly be very fragile.
In adopting the Euro, Ukraine would no longer have to deal with exchange rate fluctuations, greatly benefiting international trade. It would also simplify financial transactions, making it easier for businesses to plan and budget. External shocks could no longer be absorbed by currency devaluations and thus may be absorbed more in the labor market, but these disruptions are from the war and there is little hryvnia depreciation can do to absorb those shocks.
Adopting the Euro would also be a step toward deeper integration with the EU. It starts the necessary alignment of Ukraine's economic and financial systems with EU standards, facilitating trade, and economic partnerships. Ukraine has already considered potential EU accession in many of its reforms as far back as 1993, and EU accession criteria and future conditionalities permeate all reform agendas. Adopting the Euro is the boldest act it can take to pave the way towards EU integration.
There would be downsides to Ukraine adopting the Euro: Joining the Eurozone means giving up control over monetary policy to the ECB, and Ukraine would no longer set its own interest rates or be able to independently respond to economic shocks. This can be a disadvantage if the ECB's monetary policy is not aligned with Ukraine's specific economic conditions, but that will need to align soon anyway. It’s better to get on with it.
In a Ukraine with the Euro, its National Bank would not be able to accommodate bank runs or other needs by printing money. It will need to have adequate Euro reserves on hand to bail out banks or provide last resort loans—being the lender of last resort. This could be addressed by converting the NBU into a banking and payments authority with the full-time job of supervision and regulation, with reserve management under its authority as well. The level and flow of Euro reserves could be a part of donor packages offered to Ukraine over the next several years.
Ukraine’s adopting the Euro may result in a loss of competitiveness for certain sectors in Ukraine. The stronger Euro could lead to higher production costs and reduced competitiveness in export-oriented industries, which could negatively impact employment and economic growth in those sectors. However, the de-risking of business decisions and increased investment as well as stability in prices far outweigh the competitive advantages for older and often sclerotic Ukraine enterprises.
Euro adoption would entail transition costs, including the cost of updating financial systems, re-pricing goods/services, educating citizens, and introducing tax payments in Euros. But Ukraine has already started financial reforms to harmonize with EU/Basel III standards, and they have privatization programs underway for State-Owned Enterprises (although some were put on hold for the war to facilitate war-time procurement), so they have already incurred some necessary costs.
One interesting benefit to the ECB of Euro adoption in Ukraine would be the seigniorage revenue it will obtain. Assuming Ukraine’s currency needs to grow at about 5% of GDP a year (US currency growth rate is 7%) that would amount to 12 billion Euro a year (or roughly the cost of 400 F-16 fighter jets, although the EU countries would be more likely to use that money to further subsidize health care or agriculture.) But the EU would not need to keep that seigniorage: For instance, South Africa returns seigniorage revenue to Botswana and Lesotho, which use the South African Rand. Similar arrangements can be made between the ECB and Ukraine.
The loss of Ukraine’s ability to conduct its own monetary policy would have some short-term drawbacks, but such a step would ultimately stabilize its financial system and business environment, helping it to draw foreign investment when the war ceases. It should take this step immediately.
