Ben Aris in Moscow -
Ukraine has lined up all the ducks it needs to successfully default on its privately held bonds. Ukrainian Finance Minister Natalie Jaresko indicated she wanted to meet with both the International Monetary Fund (IMF) and the ad hoc committee of private creditors in Washington before or on June 30. But alas, a statement issued by her ministry admits that no talks with the committee had ever actually been started. Jaresko herself then appeared to put the icing on the default-cake scenario, signalling that no decisive meeting was likely, tweeting: “I have repeatedly stated my desire to meet with the Creditors Committee & enter into direct negotiations.”
And so it come down to the wire of a self-imposed June 30 deadline that Kyiv set itself to cut a deal to reduce the size of the outstanding principle, and absolutely nothing has happened. A default now looks inevitable after the creditors said they see no need for the 40% ‘haircut’ on the bonds Kyiv has been pushing, with the IMF behind it.
Most of the "negotiations" between the two sides so far have been conducted through reports in the press and a flurry of letters, periodic recriminations, and no indication that either camp will back down.
Hedging big bets
Five international hedge funds on the committee hold about $10bn of Ukraine’s debt from a total of $17.3bn in sovereign Eurobonds and $31.4bn in domestic debt. US fund Franklin Templeton owns the largest single chunk of about $6.5bn and chairs the committee.
A key part of the IMF demand for a haircut is for Ukraine to reduce its debt/GDP ratio to 71% in 2020 – considered to be a sustainable level that would allow the economy to recover. In absolute terms, that means paring the country's debt to $56.1bn from about $74.9bn as of the end of March, of which some $5bn needs to be cut off the debt coming due this year. "Since it's impossible to extract $18.8bn from the servicing of these two types of debt (the average coupon income is 7.1%), principle reductions are a must," Concorde Capital said in a note earlier this month.
The bondholders are obviously unhappy with this. Franklin Templeton has countered that a maturity extension and a deferral of interest payments would be a better option. It has also suggested that Ukraine use part of its IMF loans to pay off part of the debt. The committee maintains that the proposed haircut demanded by Kyiv would result in the country losing access to international capital markets for years and rule out a quick return to financial health, which could well be true.
The time has almost run out and the sides seem as far apart as at the start of the process. "In addition, and despite previous statements to the contrary, the proposals by the ad hoc Creditors Committee do not meet the three criteria agreed with the IMF,” the Finance Ministry statement said. “That proposal includes utilizing $8bn from the international reserves of the National Bank of Ukraine for no consideration. This measure has been strongly rejected by the IMF in their statement of 12 June 2015."
Can't pay, won't pay
Without the haircut (or a default) there is no way that Jaresko can finance budget spending or reduce the debt/GDP ratio to 71%. "Ukraine is unable to service debts generated over past three years. The total amount required to service the external debt, in fact, is equal to our military spending which makes up 5% of the country’s GDP," Ukrainian Prime Minister Arseny Yatsenyuk said on June 25.
Ukraine went into the Euromaidan protests at the start of 2014 with a very healthy debt/GDP ratio on the order of a bit more than 30%. However, the level of debt has soared in the subsequent 18 months. Ukraine state debt inched up again by 0.5% in May to hit 87.9% of GDP and is on course to reach over 90% by the end of this year.
The Maastricht criteria for joining the euro limits debt/GDP levels to 60%, which is considered a comfortable level. In the meantime, many Eurozone countries have seen their debt balloon to at least 90%, which is considered to be already in the flashing red light zone on the edge of sustainable, and several are well beyond even this level.
Already up to its neck in hock, Ukraine plans to borrow even more, as with only two months of import cover of hard currency in reserves it simply doesn’t have enough money to function and start the process of recovery. "We anticipate [Ukraine will borrow another] $5bn from the IMF, €1.2bn from the EU and UAH1.8bn from the World Bank by the end of 2015," Alexander Paraschiy, head of research at Concorde Capital, said in a note on June 28. "At the same time, we will have to pay back $0.8bn to the IMF and nearly $4.3bn on Eurobonds (which are subject to maturity extension). All in all, assuming no debt restructuring in 2015, we expect the state debt to approach the UAH1.7 trillion level, which is 91.7% of GDP, by the year end."
If it looks like a duck…
The clock has been running down for months and given that Jaresko has had no talks with the creditors at all, it must have been increasingly clear that default was coming. Both Kyiv and IMF have been actively preparing for it – just in case.
In June, the Ukrainian parliament, the Verkhovna Rada, passed a set of laws that would allow the Finance Ministry to halt interest payments on bonds, unilaterally giving itself the ability to impose a "technical default" – ie. Kyiv would take the same route as Russia did on its Eurobonds and ruble-denominated GKO bonds in 1998, where the government doesn’t refuse to pay back the money, just suspends payments for several years.
Another piece in the puzzle was the IMF's admission that the $3bn bond owed to Russia's sovereign wealth fund was an "official" debt rather than a "private" debt on June 23. The distinction is important, as under the IMF's own rules it can lend to countries that default on private debt but can’t to a country that defaults on official debt, or money lent to them by international financial institutions (IFIs) or other governments.
There has been a lot of discussion over the status of the Russian debt, as clearly Kyiv didn’t want to pay it off. It has even been suggested that this bond, issued by the former Ukrainian president Viktor Yanukovych's government in December 2014, is "odious debt" – ie. a debt imposed specifically to cause harm to a borrower or exert control over the debtor, which under international law doesn’t have to be repaid, something that still could happen. However, Kyiv dodged the bullet for the meantime by paying off a $75mn coupon on the Russian bond earlier in June as scheduled. It seems that the IMF was afraid of a nasty legal battle with the Kremlin if it repudiated the official status of the Russian-held bond – a fight it was unlikely to win.
Finally, the IMF bought some extra insurance by saying earlier this month that even if Ukraine does default and even if legal battles are started, the Fund can continue to lend to Ukraine under its "lending into arrears" policy that was first adopted in 1989.
Lending into arrears was introduced precisely so debt holders couldn't use the IMF's ability to provide assistance as leverage against debtor countries. So Ukrainian bondholders, especially the funds managed by Franklin Templeton's Michael Hasenstab, should be more malleable if the IMF keeps pumping money into that country, even if it makes good on its threat to declare a moratorium on private debt payments. There would be no deadline for a debt deal and Ukraine has an official sanction to default at will.
Everything now seems to depend on the meetings or absence of meetings in Washington around June 30, Ukraine’s emerging ‘D-Day’, which may yet decipher either as deliverance or default day for the country’s finances. Jaresko is reportedly being represented at some consultations with both creditors and IMF by the Ukrainian government’s Commissioner for Public Debt Management Vitaliy Lisovenko.
A last-minute deal is not out of the question after so much prolonged brinkmanship. The June 30 date was Kyiv's own, after all, and some are saying that if the creditors suddenly want to thrash out a solution in person, Jaresko can still hop on a plane to Washington. But given the "we tried" statements and tweets fanning out across the spectrum, the bets are increasingly on Kyiv putting the ‘D’ in default.
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