Ukraine: Costs of conflict

As Russian troops surrounded military bases on Ukraine’s Crimean peninsula last year, Michael Hasenstab made a tough decision.

Known for his risky — and profitable — bets on government bonds, Mr Hasenstab watched as the events in Crimea sent prices of Ukraine’s debt lower. As a fund manager at Franklin Templeton, he had already bought more of the country’s bonds than anyone else. Now, sensing that the market panic was an overreaction, he bought more. The crisis in Ukraine would not escalate, he decided.

This time he was wrong.

More than a year of violence between Ukrainian forces and Russian-backed separatists has cost the lives of close to 7,000 people, vast swaths of Ukraine’s industrial heartland have been eviscerated, and the country is in the grip of recession.

As Ukraine teetered on the verge of default this year, Mr Hasenstab and the rest of the country’s creditors were asked to write off part of its national debt. Last week, after months of fractious negotiations, they agreed. By swallowing an immediate write-off of 20 per cent on $18bn of bonds, creditors like Mr Hasenstab agreed to take a loss they had insisted was unnecessary — a move they will have to explain to investors.

Officials in Kiev initially cheered the deal, even though it fell short of the debt relief they had first sought and that many, including billionaire financier George Soros, supported.

But that jubilation soon gave way to scrutiny from critics who asked whether the deal backed by the International Monetary Fund will leave Ukraine struggling to boost its economy before it has to start meeting debt obligations once again. Because Ukraine has only planned to restructure a small portion of its $72bn debt, there is mounting suspicion that it will be forced to renegotiate the terms of the deal at a later date. And some suspect that the bondholders got a better deal than first thought, especially with the inclusion of a “sweetener” for investors.

“The deal is positive for bondholders,” says Vadim Khramov, Ukraine economic analyst at Bank of America Merrill Lynch. “The deal is generous enough to prompt a short-term rally while simultaneously raising long-term sustainability issues.”

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Ukraine: The costs of conflict

Although the deal agreed with the IMF and creditors fell short of the debt relief Ukrainians wanted, it averted default and gave the war-torn country hope for a fresh start, report Elaine Moore, Roman Olearchyk and Neil Buckley. But its worries are far from over.

In public, both the pro-western government in Kiev and the IMF hailed the deal as a breakthrough. For the Ukrainians, it presented an opportunity to put the debt question in the past and concentrate on rebuilding the economy. And for the IMF, the Ukraine deal was held up as a model restructuring — and offered an opportunity to shift discussion away from the fraught Greek debt renegotiation.

The agreement will “help restore debt sustainability”, says Christine Lagarde, managing director of the IMF. Securing an accord with private sector creditors was a crucial component of Ukraine’s rescue funding from the IMF, along with tough domestic reforms.

Natalie Jaresko, the minister of finance and one of the new government’s foreign-born technocrats, says the IMF’s plan is “crucial” for Ukraine.

“In a post-revolutionary society legitimacy is very important, domestically and internationally,” she says. “That’s what the IMF has given us.”

The need for political legitimacy has been thrown into relief this week as violent protests over plans for separatist regions to gain greater powers have left three national guard troops dead. Western governments hope that financial support will stabilise the ex-Soviet state.

Huge commitment

For Ukraine, meeting the IMF’s demands has been tough. Although the fund agreed to provide a $17bn package in April last year, it quickly became clear Ukraine would need much more than originally envisaged. Early this year, the IMF calculated that the funding gap stood at $40bn.

Mindful of its bruising experience in Greece, when private bondholders were able to cash in their investments before the country underwent the biggest sovereign debt restructuring in history, the IMF had no intention of providing the money alone. Instead, it has offered to loan Ukraine $17.5bn, with other lenders including the US, the EU and World Bank providing a further $7.5bn. The remaining $15.3bn, the IMF insists, will have to come from Ukraine’s private creditors, including Mr Hasenstab.

The impact on Ukrainian bonds has been disastrous. Prices for bonds due to mature in 2017 dropped from 100 cents in the euro to just 39 cents in March, when negotiations began, although they recovered to 66 cents following last week’s deal.

For Mr Hasenstab, Ukraine accounts for just a small sliver of his portfolio and as a contrarian investor he has successfully sought out difficult investment environments in the past, including Ireland in the depths of the eurozone crisis.

“We typically picked points when Ukraine — even before this crisis — has gone through periods of stress where the market has sold off,” he told the FT.

But Ukraine’s debt crisis culminated at a time when emerging market funds are showing signs of strain and Mr Hasenstab’s funds at Franklin Templeton are underperforming. He joined a committee of investors in March who between them hold close to $9bn of Ukrainian debt — enough to block a restructuring deal — and began to raise a series of objections.

Why, the group wanted to know, did the IMF demand that Ukraine meet the oddly specific target of a debt-to-GDP ratio of 71 per cent by 2020 from close to 100 per cent this year? And why restructure debt now when the situation in the east could deteriorate further?

There were also questions about why Kiev had picked bonds and loans worth under $23bn for its restructuring plans from a total of $72bn of government debt, putting so much of the burden on one set of creditors. Igor Hordiyevych of BTG Pactual, a member of the bondholder committee, says investors were sympathetic to Kiev. “We would have preferred a situation without a 20 per cent haircut but bondholders recognise that Ukraine has serious problems. A haircut is not the desired outcome, but the inclusion of the upside instrument could be a good deal for investors.”

But within Ukraine, there has been wariness about the size of the country’s creditors and their intentions. Advisers to the government point out that its largest creditor, Franklin Templeton, has more than $800bn of assets under management — close to 10 times the size of Ukraine’s GDP.

“There is suspiciousness that fund managers . . . who participate in the talks with the Ukraine government, once again gamble,” says Alexander Valchyshen, head of research at Kiev-based investment bank ICU. He says their first bet was investing in the country under its former pro-Russian regime, and the second was that they would be repaid no matter what happens to Ukraine.

Harsh realities

As negotiations between Ukraine and its creditors dragged on, Kiev took a harder line, declaring that it was prepared to default on its payments without a deal.

But a default would be disastrous, not only for Ukraine but for the rest of the world, argues Andy Hunder, president of the American Chamber of Commerce in Ukraine. “It is important to understand the realities and the complexities of the country,” he says. “An economically robust Ukraine is essential to western security in the region.”

Despite its financial problems, on the streets of the capital city life has carried on, albeit marred by this week’s violent protests. Since the bulk of the slump in output has been in the war-torn east the effect has been less immediately visible elsewhere, although the devaluation of the hryvnia has limited purchases of goods such as cars and imported foods.

Cobblestones that during the anti-government protests 18 months ago were ripped up to hurl at riot police have been restored to the main boulevard, Khreshchatyk. Giant hoardings hide the rebuilding work on a burnt-out building around the Maidan, or main square.

Many citizens have reserves of resilience and resourcefulness developed during the shortages of the late Soviet period and the post-communist downturn of the 1990s. But all have been affected by the plunging hryvnia, with spiralling utility prices hitting the poor and elderly particularly hard.

The question is whether these problems will be eased by the deal with bondholders or reappear if the country is forced back to the negotiating table.

Effective debt reduction

The markets, says Gabriel Sterne at Oxford Economics, appear unwilling to factor in the downside risks that remain in Ukraine. These include a possible escalation of fighting in the east, further banking sector losses and weaker than projected fiscal adjustment.

“I think the lesson is clear that if you are determined to avoid a disorderly restructuring, you struggle to get enough debt reduction,” he says.

Research by Harald Finger, senior economist at the IMF, says the price of avoiding default can mean a smaller deal, which can then necessitate further debt restructuring. Governments that restructured debt without default secured an average 8 per cent reduction in creditors’ bondholdings. Those that defaulted first, including Russia in 1998 and Argentina in 2001, secured deals that involved an average reduction of 48 per cent.

S&P, the rating agency, has maintained its negative outlook on Ukraine despite last week’s deal, citing the tense relationship between Kiev and Moscow and the bond that Ukraine sold to Russia in 2013, which is due to mature in December, as risks.

If Ukraine honours that $3bn redemption this year, S&P calculates that it will be difficult for the government to find the $5bn in debt relief that underpin the IMF’s assumptions.

Further problems may arise from the “sweetener” offered to investors as part of the restructuring. Creditors were offered an unusual bonus that pays off if Ukraine recovers, but nothing if it falters. These investments, also proposed by Yanis Varoufakis, the former Greek finance minister, sound good. But by promising to pay out a percentage of growth for two decades they could become a “chain around a future government’s neck”, warns Timothy Ash at Nomura.

Kiev hopes to use the agreement to focus on a more positive message of nascent recovery and to garner support from a weary population, but its debt worries are likely to continue.

“Ukraine’s debt restructuring illustrates the dilemma inherent in all government debt crises,” says Jakob Christensen, economist at frontier market specialist Exotix.

“If you can secure a deal quickly you save your economy a lot of pain, but on the flipside it may not be comprehensive. I’d say it’s unlikely that this is the end of Ukraine’s debt problems.”