Debt deadline looms for Ukraine
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Emerging Markets

Debt deadline looms for Ukraine

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Political leaders in Ukraine have used all their skills to buy time with a debt restructuring. But next month they must choose whether to repay Russia $3bn or default and jeopardise their IMF bailout

Ukraine is at a crossroads. Since the overthrow of former president Viktor Yanukovych and the installation of a pro-Western government, the economy has flat lined, shrinking 6.8% in 2014, according to data from the World Bank.

Inflation has soared along with national debt. The ratio of outstanding government bonds and loans to gross domestic product passed 100% for the first time in the first three months of 2015 and continues to rise.

On the ground, things are worse. Much of the country’s prime industrial capacity has been destroyed in the clashes that continue intermittently to rage in the east, where Ukraine’s fragile forces compete for territory with Russian-backed militia.

Stretched to financial breaking point, Ukraine’s leaders were forced this year to reach out to a scattered and often capricious group of private international creditors to alleviate a growing sense of internal crisis.

As first spring and then summer wore on and the country’s debt burden grew, its cries for help became louder. A slew of sovereign debt repayments loomed, not least a $500m note due in September, and a $3bn bond owed to Russia by mid-December.

Pleading poverty, the government begged for a haircut on its foreign debt. It had good reason to do so. Like Greece, its sovereign obligations, which topped $70bn in the first half of the year, were becoming unmanageable. Moreover, trimming its debt, as well as stretching repayments over a far longer period, were essential prerequisites to securing a $40bn financial lifeline from the International Monetary Fund.

So when, after months of often-acrimonious discussions, the Ukraine government and a core group of its largest commercial creditors announced an $18bn debt restructuring agreement in the last week of August, it surprised even seasoned analysts.

One Ukraine-based economist told Emerging Markets just a week before the deal was announced that the “brinkmanship between Kiev and its creditors would go on through September and possibly into the new year as well”. Western creditors would “blink first”, she added, but only after the IMF weighed in.

In the end, it was possible that both sides blinked, given the immense and unyielding pressure of the situation. At first glance the deal, which cuts the country’s total obligations to commercial creditors by $15.3bn over four years, looked to be good for everyone.

The country’s largest private sector creditors, led by US asset manager Franklin Templeton and including the likes of BTG Pactual, TCW and T Rowe Price, secured a better deal on the country’s troubled debt than many had expected.


WIN-WIN SITUATION?

The country itself secured an agreement to freeze all debt repayments for the next four years — essential to getting its economy back on track. Resorting to the usual cliché, Ukraine finance minister Natalie Jaresko described the deal as a “win-win situation”.

Yet was it? By cutting a deal with its global private creditors, Ukraine maintained its tenuous link to the global capital markets. Russia’s general bellicosity and its annexation of the Crimean peninsula last year ensures that it cannot make the same claim.

The restructuring deal was approved in mid-September by Ukrainian parliamentarians despite fears that a Greek-style populist backlash might jeopardise or derail the vote. Ukraine has also used the deal to push for added financial assistance from its leading international partners.

In September, it secured a €500m ($559m) payment from the European Commission to provide financial relief to the country’s struggling farmers. Later in the month, Russia agreed to resume gas shipments to the country, alleviating fears that Ukraine citizens would shiver long into the winter.

Ukraine’s leading political lights, many of whom came from the private sector, have also shown a willingness to think differently. US-educated Jaresko co-founded a specialist frontier market fund, Horizon Capital, while in his former life energy minister Volodymyr Demchyshyn was a banker at ING.

When a group of minority international creditors threatened to rebel against the original debt restructuring, Ukraine offered to swap both the $500m print due in September and a euro denominated note due in October into a new bond that creditors can redeem in 2019.

Analysts were quick to applaud that nimble-footed deal, though one asked witheringly whether the country “would even have sufficient funds in place to settle that payment” in four years’ time.

But beyond this, a slew of questions remain. Not least, whether the August deal is far from the resounding triumph Ukraine would have the world believe.

There is little doubt that the 20% haircut is the best available deal for Ukraine, given that Jaresko was holding out for a figure of 40%. Note too that the average haircut on sovereign debt restructuring deals since 1970 is 37%.

Liza Ermolenko, emerging Europe economist at London-based Capital Economics, says the deal was “a good but far from perfect deal” for Ukraine. Creditors, said a fund manager involved in the talks, “were happy to get a better deal than they had expected and so were content not to gloat afterward or question their good fortune”.

And while the deal does indeed reduce Ukraine’s foreign debt, the long-term effect will be minimal. The ratio of foreign debt to total economic output will fall, but only to 90% from 95%, while obligations to all international creditors will be trimmed to $67bn from $71bn.

For all the mutual backslapping, Ukraine’s finances will remain for the foreseeable future in a parlous state. In a way the haircut helps to ease the country’s financial pain only fleetingly, much as painkillers might briefly alleviate a chronic condition. To truly heal itself, Ukraine needs to find a way to reduce its debt load to a manageable level and locate new and sustainable sources of economic growth.


TIED TO RUSSIA

This will not be easy. In September, the World Bank said Ukraine’s economy would shrink by 12% in 2015, revising an earlier contraction of 7.5%, before returning to positive growth in 2016 and 2017. Trade with Russia meanwhile slipped to $22.4bn in 2014, according to data from Ukraine’s State Statistics Service, down from $38.2bn in 2013.

“It will take years for the Ukrainian economy to return to its pre-war and pre-crisis levels of growth,” says Anastasia Nesvetailova, director of City University’s Political Economy Research Centre in London. “The loss of Russia, its biggest market, has been devastating for the economy, while no alternative destination for its exports, already significantly diminished, has emerged.”

Katya Kocourek, a senior associate in London at due diligence firm Stroz Friedberg, adds: “Ukraine is inextricably linked with Russia. Until we see significant developments with the Minsk II peace accords, I can’t imagine a turnaround in its economic fortunes. The conflict within its eastern borders is very much connected with its internal financial crisis.”

This in turn raises serious questions over an IMF bailout. The Fund has lent $11bn to Ukraine since the onset of hostilities in the east of the country and regularly proclaims its determination to come good on a $40bn “financial assistance” programme.

Yet even if that compact is finalised over the coming months, many fret about a negative feedback loop wherein Ukraine, desperate to grow in order to reduce its debt burden, is forced to hack at spending in the quest for a balanced budget, further reducing its chances of returning to health.

Nor are there any firm guarantees that the terms and conditions the IMF will undoubtedly levy on a bailout would or could be met. Will Ukraine’s leaders be able to rein in corruption and privatise vast swathes of the economy — both likely prerequisites to any deal?

Could they realistically promise to force the oligarchs who run the country to pay more tax, even while systematically stripping them of much of their power?

Moreover, is it possible even to contemplate real economic reform when a country remains in a state of conflict with its chief trading partner? Many expect the IMF bailout to go ahead — but for Ukraine to struggle to meet its onerous terms and conditions, forcing it to explain its shortcomings time and again to an increasingly weary set of international creditors.


REPAYMENT TIME

To many, a Greek-style scenario playing itself out on the Dnieper river is all but inevitable. Ukraine officials recognise this looming threat, yet what chance do they have?

“Kiev does not have many options,” notes City University’s Nesvetailova: “It will continue to seek a financial facility from the IMF, given that alternative sources of credit, for instance from the EU, have been insignificant and very slow in materialising.”

The next big event for Ukraine comes in December. Will the country swallow its pride and make good on the $3bn worth of securities it bought from Russia just months before Russian president Vladimir Putin annexed Crimea?

Ukraine faces the ultimate dilemma here. If it pays up, it punches a new hole in its already cratered finances. If it does not, the IMF may consider it to be in technical default on its foreign debts. That would make it hard, if not impossible, for the Fund to offer financial assistance.

Yet even here, given its straitened circumstances, Ukraine may struggle to pay up in two months’ time. “It is likely that Kiev will not pay, at least not in full, and not in time for the repayment deadline in December,” says City University’s Nesvetailova. “Ukraine does not have the funds to dedicate to external repayments at a time of severe economic crisis.”

And she adds that Moscow’s tin-eared tactics may ultimately backfire. “Russia has accepted a costly option for itself: either to lose the money Ukraine owes it or to embark on a lengthy, costly and risky process of international court proceedings to try and claim the assets.”

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