Nicholas Watson in Prague -

On September 3, Ukraine was valiantly insisting that its plans to issue a sovereign Eurobond before the end of the year would go ahead. But with the country's existing bonds dropping to a four-year low that day as the country's political crisis deepened and little in the way of good news predicted ahead, many believe Ukraine will have a tough time selling any new debt, either at home or abroad.

As Prime Minister Yulia Tymoshenko renewed hostilities with her on-again, off-again political ally President Viktor Yushchenko, Finance Minister Viktor Pynzenyk was telling reporters that the country would, as planned, issue debt on both the domestic and external markets "when the suitable moment arrives."

Finding that suitable moment is proving hard. Ukraine had been expected to issue a five-year, $500m Eurobond in September after delaying the issue in July due to the deteriorating conditions on the global credit markets. But since July, things have only gotten worse as conflict erupted between Georgia and Russia, prompting worries Moscow might put the squeeze on Ukraine next, and a flare-up in the tensions between the parties of the governing coalition caused yields to rise to a four-year high on September 3. The yield on the 6.875% note due 2011 climbed 15 basis points to 8.17%, the highest level since May 2004. The risk of owning Ukraine's bonds rose in tandem: credit-default swaps (CDS), contracts that protect bondholders against the risk of default, rose to 453-463 basis points, compared with 390 basis points in early July. That means it cost between $453,000 and $463,000 to protect $10m of the country's debt from default for five years.

There has been some good news since, which the Finance Ministry, needing to plug a projected 2008 budget deficit of UAH14bn-16bn (€2.1bn-2.3bn), will have taken heart from.

Emerging market bonds, including Ukraine's, got a good bounce on September 8 when the US government removed any lingering uncertainty over its support for the giant mortgage institutions Freddie Mac and Fannie Mae when it took them over, causing bond spreads to tighten and CDS rates to fall for the first time since August 28. And some strategists are claiming that CDS are simply pricing in too much risk now. "There has been no let-up in the negative sentiment surrounding Ukrainian debt amid the liquidity and political crisis, but we believe it is excessive," BNP Paribas argues. "Risks of a Georgian-like conflict with Russia are overstated and Ukraine's economic growth remains robust."

Contrary to the common perception that Ukraine's fundamentals are extremely bad, bonds are illiquid and under pressure from untamed inflation, and capital markets remain inaccessible, BNP argues inflation is moderating from its peak of 31.1% in June - it fell to 26.8% in July - and financial institutions have continued to raise funds thanks to their foreign ownership whereas corporations have, so far, managed to tap Eurobond markets fairly successfully. The accumulation of foreign exchange reserves also offers a buffer to the current account deficit; according to data released September 3 by the National Bank of Ukraine, forex reserves reached $38.06bn by the end of August versus $37.91bn at the end of July.

Clouds in a silver lining

Such a sanguine view isn't shared by all. Nikolay Podguzov and Anastasiya Golovach of Renaissance Capital are predicting further widening of spreads this year, with five-year CDS hitting 530-580 basis points by the end of 2008.

Despite the Ukrainian government's projected additional budget revenues of UAH30.4bn, they predict Ukraine's budget deficit will be UAH14.5bn-15.5bn in 2008. At the same time, government spending is set to increase further alongside more political uncertainty with the approach of presidential elections in early 2010.

To meet that budget gap, Ukraine either needs to borrow the money or get it from privatisation. The latter, though, is hostage to the dreadful political situation. Year to date, the budget proceeds from privatisation have amounted to a miserable UAH300m, just 3.3% of the UAH8.92bn projected for the full year. Any governmental plans to privatise key assets ahead of the elections and use the proceeds for popular spending programmes will very likely be frustrated by the president's veto.

Thus, debt will have to fill the void, even though the government's access to the capital markets remains highly questionable. Raising debt on the domestic market has proved difficult; so far this year, the Finance Ministry has only borrowed UAH628m in the domestic bond market compared with the planned UAH7.77bn, a mere 8% of the full-year borrowing programme. "The reform of the domestic state bond market has been delayed and we believe the government will find it difficult to borrow more than UAH2bn-3bn, even offering OVGZ [government debt] at 11-12% yields," says Renaissance's Podguzov. "The odds are that the Ministry of Finance will continue to test the market's interest for its instruments and will offer yet more attractive yields at future auctions, but we doubt that the government can fully hit the target of domestic borrowings this year due to the Ukrainian state debt market's limited capacity."

That leaves the delayed Eurobond. Assuming the Finance Ministry manages to at least partially fulfil its domestic-borrowings programme, to the tune of UAH2bn-3bn, and adding in the UAH1.7bn credit facility from the IMF extended in the first quarter, analysts put government borrowing needs at UAH12.0bn, or approximately $2.5bn.

Not an easy sell, especially in this market. The spread between Ukraine's Eurobonds and US Treasuries, as measured by the JPMorgan EMBI+ Global Index, reached 564 basis points in early September, which is the highest spread since January 2003. The spread increased by 17.7% in August 2008 and by 2.4% in a single day from September 2 to September 3 as it became clear the period of relative calm in relations between Yushchenko and Tymoshenko was over, as the PM joined forces with the opposition leader Viktor Yanuovych to strip the president of many of his powers. On September 16, the coalition

However, later this year could offer a window of opportunity for the state to sneak into the market. While domestic politics, international jitters over Ukraine's position vis-à-vis Russia, and the continuing instability in global financial markets will keep emerging-market Eurobond yields high throughout September, a raft of expected good data, such as healthy GDP figures showing the economy is still barrelling along, should restore foreign investors' confidence somewhat in Ukrainian sovereign Eurobonds, thereby lowering the country risk premium and stabilising the EMBI+Ukraine spread at 450-470 basis points. Indeed, on September 15 data showed that annual GDP growth in August was 10.9% versus 7.3% in July, meaning that GDP grew by 7.1% in the January-August period year-on-year, against 6.5% growth posted in the January-July period.

"The government will continue to focus on primary auctions in September and October, mainly attracting funds from short-term bonds and keeping the planned Eurobond issue as an alternative option to until the end of the year," reckons Volodymyr Gabriyelyan of Foyil Securities.

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