Despite an initial surge of optimism about Ukraine's financial health after it clinched a crucial restructuring deal with private creditors, the country is increasingly expected to default on a $3bn Russian-held Eurobond due for redemption in December 2015.
The likelihood of the scenario grew after the agreement was reached with a committee of Eurobond holders on August 27, giving the green light for a 20% haircut on the principal, postponement of redemption by four years, with interest of 7.5%.
"The government of Ukraine officially declares that Russia will not under any circumstances gain better conditions than the other creditors,” Ukraine's prime minister Arseny Yatsenyuk stated defiantly after the deal was reached after six months of mutual snubs and wrangling.
Russian officials sounded equally unyielding in refusing to accept any restructuring of the Kremlin-held debt. "We will emphatically demand full repayment in December this year of $3bn taking into account interest payments," Russian Finance Minister Anton Siluanov said on August 27.
But Russia has a far weaker position now that Ukraine has reached a deal with the private creditors, Ukrainian officials are hoping.
Regrouping for next round
According to a Ukrainian government source quoted by the website Apostrof, a Ukrainian default on the Russian-held bond will no longer trigger a cross default on other Eurobond debts following the August 27 deal.
This only leaves Russia the option of going to court against Ukraine in London, if Ukraine restructures the Russian-held bond. Russia may have a hard time in court, however, since Moscow is in fact being offered better terms from the restructuring than the private creditors, according to Oleh Ustenko of the International Bleyzer Fund.
The Russian-held Eurobond has a coupon rate of 5%, well below the market rate at the time of issue, which was politically motivated. The restructured bonds will be paid at an interest rate of 7.5% which will at least partly compensate Russia for the haircut, and constitutes more favourable conditions than offered to the private bondholders.
Even if Russia were to win a case likely to last several years, that would leave the Kremlin with the limited option of seizing Ukraine's overseas assets. But as Ukrainian Finance Minister Natalie Jaresko argues, Ukraine has few overseas assets to take anyway.
The other leverage the Kremlin believes it has, is that the International Monetary Fund (IMF) has a policy of not lending to countries that are in arrears on official debt, meaning that Ukraine's default on the Russian held-bond would effectively freeze the IMF bailout.
But given clear signs of Western and IMF willingness to support Ukraine as far as possible, the Fund has at least two ways of getting round this, say experts. One would be for it to accept Ukraine's arguments that the Russian-held Eurobonds are not official debt, as Russia claims they are. "They are listed for trading on the Irish Stock Exchange - how can this be official debt?" Yatsenyuk said on August 27.
To date, IMF officials have notably to commit on whether the Fund would count the Russian-held Eurobonds as private debt or not.
Even if Russia's counter-arguments - that the bonds were bought at a coupon rate significantly lower than the market rate - hold, the IMF might simply change or reinterpret its rule on not disbursing loans to countries who are in default on official debt to other countries.
IMF policy shift?
Indeed, in 2013, the IMF prudently considered changing this policy, fearing that it "subjects the Fund to the risk that it could not assist a member in need due to one or more holdout official bilateral creditors who seek favorable treatment of their claims", according to a policy review study.
IMF experts argued that in this case "[c]onsideration could be given to extend the [lending into arrears] policy to official bilateral arrears".
"The basic question will be the verdict of the board of directors of the IMF on the status of the debt," says Olena Bilan of Dragon Capital in Kyiv. The IMF board of directors reached decisions based on a majority of votes.
Ukraine sounds determined to go the distance against Russia on the issue. "The prime minister's comments point to a potential application of debt-payment moratorium," says analyst Oleksiy Andriychenko of the brokerage Art Capital.
Cocking a thumb at Russia would also go down well politically, important for a government seeing popular support erode due to the economic collapse.
The West would also support the move politically, with internationally well-connected economic adviser to Ukraine's government, Anders Aslund, coming out strongly in favour of non-payment of the bond. "Why should Ukraine pay anything to its aggressor?" Aslund blogged on August 27. "The United States and the European Union need to reinforce their manifold sanctions against Russia by providing full legal and political support to Ukraine and insist that the country should not pay Russia."
But some voices in Ukraine still counsel caution, with the aim of getting Russia off Ukraine's back as quickly as possible. "If we are serious about reducing our dependency on Russia, my recommendation is to pay the money in December 2015," advises Ustenko of the International Bleyzer Fund, adding that Ukraine can make the payment from IMF funds received this year.
In July, Russian President Vladimir Putin made the same suggestion regarding the IMF funds and stressing, like a raft of ministers and officials beneath him, that Moscow wants its money back in full.
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