Following in Russia's footsteps?

If the local currency T-bill market is a good indicator of a country's financial health, Ukraine is seriously unwell. Known locally as OVDPs (in Russian OVGZs) they are hryvna-denominated zero-coupon notes that are held by the National Bank of Ukraine (NBU) in a dematerialized form. Maturities on all notes are 12 months or less. Total capitalization in the T-bill market was about $5 billion at the start of this year and even after the Asian crisis last year, Ukrainian T-bills were seen by foreign investors as an attractive play. They still own around $580 million worth.

The major buyers included off-shore hedge funds and such investment banks as Merrill Lynch, Warburg Dillon Read, ING Barings and Credit Suisse First Boston. Last year, before the Asian crisis, yields fell to as low as 18%. New T-bill issues were easily oversubscribed and an increasing number of foreign fund managers visited Kiev to find out what OVGZs had to offer. One attraction was that none of the foreign ownership restrictions that have complicated the GKO market apply to OVGZs. Another was that there are few other ways to gain exposure to Ukrainian credit risk. The Republic has just five Eurobonds outstanding with a face value of just over $2 billion.

Ukrainian debt was so easy to sell then, that even without a rating from the international credit agencies and having defaulted on $9 billion of debt owed to Russia, Ukraine was able to tap the Eurobond markets. The party is now over.

Party's over

The ministry of finance has recently announced a voluntary redemption program, Foreign investors can roll T-bills into new, two-year securities with minimum dollar yields of 22% and hyrvna yields of between 40% and 45%. Local investors face restructuring at 40% yields. Since Ukraine's outstanding dollar Eurobonds of that maturity yield up to 100%, the swap will be painful, though it falls short of being confiscatory.

This voluntary redemption looks suspiciously like default in disguise. Ukrainian commercial banks were not forced to accept its terms, but they were bribed to. The NBU, while insisting that the programme was voluntary, indicated that all banks participating in the package would be given emergency short-term financing to guarantee liquidity if necessary. The banks that refused to take part would not be eligible to receive any emergency financing.

Says Johann Jonach, president of Alfa Capital Ukraine, which is the largest T-bill dealer in the secondary market: "It may have seemed that there was some indirect, unofficial arm twisting involved, but at the end of the day, all the banks holding T-bills willingly agreed to the redemption package. They did so because the National Bank of Ukraine ­ which acts as the lender of last resort ­ asked them to. Thus, there was no mention of the word default. Otherwise, they would have been left on their own without any possibility for refinancing should a liquidity crisis occur."

A Russian-style moratorium has been categorically ruled out by the Ukrainian government. Even for T-bills maturing in August, investors were paid in full and sufficient dollars were in the currency market to permit them to convert and repatriate their proceeds. NBU governor Olexander Kachenko clearly stated on national television that: "The steps taken by Russia in their T-bill market will, under absolutely no conditions, be repeated in Ukraine." To guarantee that all the capital markets do not collapse as they have in Russia, the NBU has at times frozen all currency trading in the country out of fear that the hyrvna may go into free fall.

However the voluntary redemption is defined, the government's hand was forced. From 1996, at the launch of the hyrvna, until early this year, currency stability had been at least partially achieved. The hyrvna remained within the central bank's trading band of 1.75 to 1.8 to the dollar. However, the Asian crisis caused an exodus of foreign investors from T-bills and the central bank ­ the National Bank of Ukraine ­ was forced to spend the bulk of its hard currency reserves in the open market. At the start of 1998, the central bank reported reserves of approximately $2.1 billion. At this point, the foreign share of the T-bill market had dropped to 25%. By July, central bank reserves had fallen to $800 million ­ only enough to pay for one month's imports and in the words of Moody's so "dangerously low" that the country has been downgraded from B2 (where it had fallen in July) to B3.

The local-currency bond sell off by foreigner investors increased the pressure on the currency. As foreign holdings in the market slowly dropped, more and more hryvnas were sold to buy dollars, steadily depleting central bank reserves. At the same time, as hard currency slowly left the debt market, it also left what was left of the equity market. Currency flows into the country from direct investment, never very high, dried up, as did privatization revenue. At the end of last year, optimistic forecasts put expected privatization revenues at around $1 billion for 1998. At the end of the summer, scarcely $50 million had in fact been raised.

"What has effectively happened over the last several months ­ and especially the last few weeks of August ­ was that the government ran out of foreign currency," explains Michael Sito, a debt salesman at Wood & Company in Kiev. Capital was leaving the country so quickly, and domestic bank demand for dollars was so great, that in just one week in September the central bank spent $300 million to support the hyrvna.