Episode 3: Ukraine

The result has been the birth of a new type of sovereign debt restructuring. After decades in which no sovereign Eurobond ever defaulted, international bondholders are being dragged into national debt crises.

Ecuador was the first to default, missing coupon payments on its Brady bonds and Eurobonds. Ukraine is now the second. On January 20 the Ukrainian government failed to make an interest and partial principal payment on a $74 million loan arranged by Chase. Because the missed payment is worth more than $15 million, holders of Ukraine's other debts can now press for early repayment of their bonds.

"We are not talking about a country being unable to make small interest payments," says Alex Garrard, an analyst at Warburg Dillon Read.

Bonds with a face value of nearly $2 billion are due to mature in the next two years. Ukraine's foreign currency reserves stand at only $1 billion or so. The biggest headache is a e500 million Eurobond which matures in March.

Ukraine's other debts include $258 million, at face value, of zero-coupon bonds outstanding, the fruits of an earlier, voluntary bond restructuring, a Dm1.5 billion bond and $1.4 billion of restructured Gazprom debt.

With no chance of paying, Ukraine's only option is to offer investors new bonds with longer maturities. It has appointed ING Barings to put together a voluntary exchange offer for its bondholders, which should be announced early in February.

That has raised hopes that Ukraine will emulate Pakistan's approach to restructuring bonds, which seems to have kept all parties happy.

At the end of last year it offered investors new paper in exchange for three types of outstanding bond. More than 90% of investors took up the offer and default was avoided.

The new bonds did not offer investors a great deal. Bonds which matured in 1999 and 2000 were exchanged for paper with a six-year maturity and which would pay nothing for the first three years. The coupon, when the bond begins to pay interest, is a relatively low 10%.

The reason investors took up Pakistan's offer was simple. The new bond, offered as part of a credible restructuring of the country's other debts, gave investors more than the old debt, which was trading at a steep discount to its face value. The price of the old bonds rose. Pakistan managed to relieve its short-term repayment problems and the multilaterals were satisfied that bondholders were being forced to take some pain.

Some investors assume that Ukraine has a similar deal in mind. But it will find it harder to restructure its bonds than Pakistan for three reasons. First, its debt burden is larger than Pakistan's. Second, there is a complication over the legal status of its bonds: they were issued indirectly through a fiduciary. It is unclear what the role of such an agent should be in the event of a default or restructuring.

But the greatest difficulty is the nature of the investor base. Much of Pakistan's debt was held by local institutions, many of them state owned. It was relatively easy for the Pakistan government to contact them and persuade them of the merits of its exchange offer.

Ukraine's bonds, by contrast, are widely dispersed. Many are held by European retail investors. "This creates difficulties locating investors," says Garrard. "It also has repercussions in price performance. There is a huge asymmetry of information. But I think the bond price can recover - assuming there is a restructuring. And we will see a gradual replacement of the retail investor base by distressed debt specialists."

By mid January, the price of Ukraine's e500 million Eurobond had fallen to about 60 cents in the dollar, having traded at 80% in early 1999.

Because the bonds likely to form part of Ukraine's exchange offer are so widely held, Garrard assumes that no more than 40% of investors will take up the deal. Most investors will either fail to hear about the exchange deal, or will turn it down in the hope of a better offer in future. Unable to meet its repayments, Ukraine will almost certainly default on the bonds which are not swapped for the new paper.

Because it can count on fewer acceptances, Ukraine provides a better test than Pakistan of the feasibility of voluntary exchanges as a way for troubled governments to restructure their debts. The danger of this strategy is that some bondholders could turn down the offer and make a legal claim to other assets.

Other problems could also undermine Ukraine's restructuring efforts. Any package would depend on a resumption of IMF lending to the country.

IMF loans were frozen last year after the government failed to meet the fund's targets on economic reform. Recent allegations that earlier IMF loans to Ukraine had been diverted might make the multilateral less willing to offer new credits.

For investors, the worst thing Ukraine's government could do is vacillate. This has been the fate of Ecuador's bondholders. The Ecuadoran authorities have yet to put any kind of offer on the table and a meeting with bondholders scheduled for last month was cancelled at the last minute.

Ecuador is in a state of political turmoil, largely brought about by the bond default: no recent finance minister has lasted much more than a month in office, and a coup on January 21 toppled the president. While all this is happening, bondholders are not being paid.

Ecuador has shown how not to restructure sovereign debt. It gambled that it could reduce its burden of repayments by picking off only one class of investors - those who held Brady bonds collateralized by US treasury bonds. That gamble failed when investors chose not to release the collateral but, instead, voted to accelerate the bond. That triggered cross-default clauses. And Ecuador now has no chance of accessing the markets for the foreseeable future.

Many investors remain outraged by Ecuador's default, believing the country's slide into the abyss was the avoidable result of misjudgement by the US treasury and G7 governments.

"This is a country which has been driven to political chaos in large part by those who would use it as a test case for private-sector burden sharing," says Jerome Booth, head of research at investment group Ashmore. "Their actions have been completely myopic. And it is very important that investors like ourselves do not allow the cancer to spread."

But Booth believes that Ukraine poses less of a risk of contagion than Ecuador. "Ukraine's problems, unlike those of Ecuador, are largely of its own making. And its problems were very visible. People who bought its bonds understood the risk they were taking. Investors are very concerned about Ukraine and they are not going to take it lying down. But Ukraine doesn't have the institutions that Latin America has and which should have known better. Ukraine has more excuses than Ecuador."