Graham Stack in Kyiv -

Ukraine's government is planning on solving its VAT refund arrears by issuing special bonds to companies. Analysts say these could offer 26-29% yields when sold on at a discount to investors.

Ukraine's new prime minister, Mykolai Azarov, stated on March 24 that the estimated UAH25bn (€2.3bn) in government VAT refund arrears accrued during cash-strapped 2009 could be securitized as a domestic bond issue, with the process to start before July 1.

Calling the VAT bonds a potential "bonanza" for investors, Sergei Fursa, an analyst with Kyiv-based brokerage Astrum, reckons it should be the best - "and, to be honest, the only" - trading idea on the domestic bond market in 2010. "Taking into account the experience of previous VAT bond issues, we expect that exporters will be offered a five-year bond with a coupon rate of 10-12% and the principal to be paid out in annual equal installments," Fursa tells bne. "We think that the issue's fair spread to the OVGZ [government bond] yield curve is 100-200 basis points. At the same time, we expect that companies will be ready to sell these bonds at sizeable discounts. Competition between sellers should push yields up, leading to higher discounts. In our view, the psychologically acceptable level of a future discount is 30%, implying 26-29% yields."

Aleksandr Pecherytsyn of ING agrees that the major upside potential for VAT bonds should come from the possibility to buy them from primary owners, ie. exporters that represent mostly the real sector, with a discount to par. "There is also a possibility for VAT bonds to trade with a premium of ordinary OVGZ in case they will be issued - as last time - with annual amortization of the principal."

Good value

Hit for six by the financial crisis in 2009, Ukraine's government basically froze the reimbursement of VAT to importers and exporters, including foreign companies, as a backdoor way of boosting revenues. Western powers, the International Monetary Fund (IMF) and Ukraine's export lobby are now demanding that Ukraine remedy the problem, with the issue also proving a major drag on the business climate in general.

Securitising VAT refund arrears was the method used successfully in 2004 by the government of current president, and then prime minister, Viktor Yanukovych, and was popular among non-residents who bought the bonds at a discount from the refund recipients.

Analysts say the government is unlikely to securitise the entire estimated UAH20bn-25bn of debt, but to revise downwards the amount it actually owes, and then issue a series of tranches of UAH5bn-7bn at three- to six-month intervals. "Obviously, VAT debt must be carefully reviewed and only a portion of it could be a) recognized b) securitized - hence talks about tranches. I would expect a five-year amortized note at coupon rate close to 9.5%," predicts Sergii Iagnych of Ukrsibbank.

Analysts see the VAT bonds not only as a cracking good investment, but also think yields on government domestic bonds will move back up to compete for investors, perhaps reaching 18-20% again after falling to nearly 11% in March. "Even UAH5bn-7bn will make sizable pressure on the domestic government bond market on the back of high government refinancing needs in April-June," says Fursa.

"If the government trims the volume of VAT claims and splits securitisation into several tranches," says Dmitri Fedotkin of VTB Capital, "the amount in question would still appear too big to be digested by the market."

Government officials are giving out mixed signals about the volume of VAT refunds they will acknowledge, though. PM Azarov, speaking on March 24, called a figure of UAH25bn "unrealistic," and said that the level of kickbacks demanded by officials for return of VAT had now reached 20-50% of the amount. The deputy head of the Tax Administration, Aleksei Lyubchenko, in the presence of new Vice-Premier Serhiy Tihipko, said similarly on April 2 that much of the debt was a result of fraudulent claims. They could have a point: Deputy Finance Minister Tetyana Yefymenko noted on April 7 that the volume of VAT claims had doubled in 2009 from 2007-2008 even though there had been a sharp drop in imports and exports.

The answer to the conundrum probably lies in the IMF's hands. According to the deputy head of the presidential administration, Irina Akimova, the IMF is insisting on resolution of the VAT refund problem as a condition for resuming financial support. If the government were to go through with the securitisation idea, along with other measures, and get the IMF and international lenders back on board, it would reduce the current dependency on domestic debt for financing the budget deficit, and keep yields at a sustainable level - but still very attractive for investors.