Ukraine needs sizeable private debt forgiveness

Wars are expensive, and Russia’s invasion has cost Ukraine billions of dollars. Kyiv was already in a complex debt situation going into the war, having restructured its private debt in 2015 after Russia annexed Crimea the previous year. But the country must now balance borrowing to fund the war with managing old debt obligations.

Doing so is a tricky juggling act. Kyiv has to meet the fiscal expectations of sovereign and multilateral creditors, whose funding is supporting the war effort and keeping the economy alive. Simultaneously, it needs to remain alluring to private investors, whose cash flows will be crucial to the day after the war — when reconstruction must begin in earnest. But those goals are clashing as Ukraine grapples with $20bn of outstanding private bonds.

Private creditors, mostly US institutional investors such as Pimco, were generous to pause debt payments after Russia’s invasion. But the war has gone on longer than expected, and payments are set to resume in August. Last week, a committee of bondholders rejected Ukraine’s G7-approved proposal to reduce the overall value of the debt by 60 per cent and to shrink the annual coupon payments. Their counterproposal of a 22 per cent haircut and 7.75 per cent coupon threatens to pull capital away from Ukraine when it is desperately needed, and could cause it to miss debt reduction targets required for a $15.6bn IMF funding facility.

Creditors have every right to heed their bottom line, but the counter proposal is well below market analysts’ expectations of a 30 to 45 per cent cut. Lowballing a sovereign debtor is common in restructuring negotiations. But this is no typical restructuring. Ukraine’s debt situation is due not to fiscal mismanagement but to Russia’s invasion. Indeed, being the investor that drives Ukraine into default could be reputationally damaging, given the threat Russia poses to European security.

Ukraine now has three options. It could switch tack by lobbying to pause payments until 2027, when sovereign creditors will restructure their debt. It could choose to default, recognising that it cannot easily tap the international markets during the war, regardless of a restructuring deal. Or it could stand its ground.

Though the first two options have some rationale, they pose risks. Delaying payments will result in a larger eventual cost to Ukraine as interest accrues, and delaying negotiations on the size of the payments will not assuage multilateral and bilateral creditors’ concerns. Defaulting, meanwhile, could anger all classes of creditors and jeopardise future funding. Having to deal with bankruptcy proceedings would divert Ukraine’s vital focus from fighting on the eastern front.

Ukraine’s best path is to stare down bondholders, and seek around a 40 per cent debt reduction, commensurate with market expectations. The country cannot be distracted by a lengthy bankruptcy deal and must stem financial outflows as the cost of the war mounts. Annual payments will be necessary to maintain its appeal to future creditors, but should be small and symbolic.

Kyiv should, though, be wary of pushing bondholders too far. Disgruntled bondholders might then sell their claims to hedge funds or other private entities. As Zambia and Ghana have shown, sovereign defaults become messier as the number of creditors rises.

At the recent G7 summit, leaders agreed to use the interest on Russia’s frozen assets to help fund Ukraine’s war effort. Though promising for Ukraine’s finances, the deal will take time to implement. In the meantime, bondholders should not treat this as any other sovereign restructuring. The entire war effort is on the line.