Ukraine’s depressing economic bind – and sovereign default risk

By:
Sid Verma
Published on:

The scale of Ukraine’s challenge to correct economic balances is staggering, even if a political consensus is reached that would see an IMF support package. What’s more, markets might be understating sovereign default risk given strict debt covenants in the 2015 Russian-backed dollar bond that is sure to be used in a regional chess game, say analysts.

Ukraine is marching towards economic collapse, a financing crunch, precipitous currency devaluation, sovereign default and insolvency of the banking system – without urgent financial assistance.

And the $2 billion tranche of the $15 billion Russian bailout, originally due late-January and of which $12 billion remains to be delivered, remains on hold as Moscow rejects the legitimacy of the incoming administration.

The macro numbers are grim, according to the Institute of International Finance (IIF):

* FX reserves are as low as $16 billion, equivalent to two months of imports, as of end-January;

* Ukraine’s sovereign debt is trading at distressed levels with CDS above 1,000 basis points and cash bonds at around 800bp to 900bp;

* Pension fund lacks cash to pay obligations – and tax receipts have crashed;

* Around 40% of loans in the country are now classified as NPLs, thanks to recent hryvnia depreciation and unhedged FX positions;

* The broader fiscal deficit came in at 9% of GDP in 2013 while real interest rates are in the region of 14% to 15% and the current account could hit 7% of GDP this year.

Standard & Poor’s estimates state-backed borrowers have $13 billion in foreign currency debt servicing in 2014, in a February 21 statement that saw the agency lowering Ukraine’s long-term rating from CCC+ to CCC on default fears.

According to the IIF, the recent currency devaluation is too small to correct imbalances while “rising financing costs and weak foreign demand are likely to more than offset whatever modest gains exporters might get from the weaker currency, making a major improvement in the current account unlikely”.

Against this backdrop, the institute estimates the country’s financing needs are at least $25 billion this year, with $9 billion in sovereign external debt obligations this year, including $2.7 billion to the IMF, and $3.3 billion to Gazprom for natural-gas payment arrears. 

Ukraine’s policy bind via IIF
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The source of financing remains hotly contested. The EU foreign affairs committee official said this week the EU is considering a €20 billion aid package, while German chancellor Angela Merkel has indicated any package would be provided in conjunction with multilateral partners.

It’s unclear whether the EU’s energy and geopolitical objectives to support Kiev is worth braving the controversy that would be triggered if it provided a large financing package on a bilateral, ex-IMF, basis to a non-EU state, while peripheral EU members has struggled to obtain bailout funds, speculates Dmitri Petrov, EEMEA analyst at Nomura.

The IMF would, therefore, be the principal cheque-writer in the medium-term at least, he says. The question is what chain of political events is needed for the IMF to demonstrate its willingness to deal with a Ukrainian government of highly contentious constitutional status, with uncertain public support, and amid a torrent of Russian dissent.

To understate the point, the status quo is not an option, given macroeconomic imbalances and the fallout from a sovereign default.

Write Ondrej Schneider and Lubomir Mitov, IIF economists: “Under the current circumstances, a multi-year IMF programme supported by additional disbursements from the EU and other bilateral creditors appears the only viable solution.”

The economists add an IMF-supported programme would need to be swift, impose aggressive conditions and has little margin for error, given the deteriorating macro picture since the last bailout approved in 2008, with the real GDP – compared with 2009 – dropping 16%, and a 50% rise in aggregate external debt in five years at 80% of GDP.

The IIF economists say the IMF bailout would need to include a “major fiscal adjustment (perhaps by 4% to 5% of GDP, measured on broad public-sector deficit-basis), significant further exchange rate adjustment (for a total of 30% depreciation or so), followed by a free-floating exchange rate and a shift to inflation targeting, as well as a major (80% to 100%) hike in administered natural gas prices and smaller adjustments in other utility tariffs along these lines could cut the current-account deficit in half to $7 billion to $8 billion and reduce foreign borrowing needs to less than $20 billion”.

They continue: “In addition, the programme would need to set aside an extra buffer, perhaps of up to $5 billion, to recapitalize banks that are likely to be hard hit by the hryvnia depreciation. This is a still very substantial amount, but if successfully implemented, should sharply reduce borrowing requirements going forward and lay the groundwork for sustainable growth over the medium term.”

Even if a domestic and international political consensus is reached that would see an IMF bailout along these lines, further complicating this endeavour is the current exchange-rate misalignment. Citi estimates that the hryvnia is about 25% to 30% overvalued relative to its end-February 21 value of 7.99, estimating 10 against the US dollar.

In this context, Kiev’s external debt position would test the debt covenants in the 2015 bail bonds issued by Ukraine, in which Russia was the sole buyer, as part of its $15 billion support programme.

This states: “Debt ratios: So long as the notes remain outstanding, the issuer shall ensure that the volume of the total state debt and state guaranteed debt should not at any time exceed an amount equal to 60% of the annual nominal gross domestic product of Ukraine.”

Timothy Ash, head of emerging market ex-Africa research at Standard Bank, says: “Public debt was $73.1 billion as of the end of December, and around half of this was FX. With nominal GDP of around Hrn1.44 trillion, and an end-year exchange rate of 8.3, this gives a debt ratio of 42% of GDP.

“However, at an exchange rate of 10, as seems likely any time now, this ratio increases to 46% of GDP. So basically each one big-figure move in the exchange rate costs this ratio around 2% of GDP on the public debt ratio – or thereabouts.”

He adds: “Now around $3 billion or so is thought to be owed by Naftogaz to Gazprom for debt (around 2% of GDP) and there may well be other claims on the sovereign out there now, including promissory notes, VAT refunds, et al, so the danger is that the above ratio may already be above 50%.”

He says EU support would have to be “carefully weighed against this 60% GDP threshold which might be used by unfriendly third parties to force a sovereign debt event”.

He continues: “€10 billion distributed as part of an IMF programme in 2014 could easily come perilously close to the 60% debt/GDP ratio threshold. There was clearly a reason why Russia lent Ukraine cash via a Eurobond, and also included this 60% public-sector debt/GDP ratio as a covenant.”

Before the uprising, a number of sell-side shops, including JPMorgan, were overweight Ukraine external credit, citing attractive compensation for default risk against the backdrop of stated Russian support.

However, the uprising, the subsequent Russian ire and the covenants in the 2015 bond complicate the bailout story.

Concludes Standard Bank’s Ash: “Any bailout will need to take this [2015] documentation into account – it may cap the scale of any bailout programme, or force official creditors to deal with the issue of private-sector bondholders as part of any deal.”

Nevertheless, most sell-side analysts and investors are banking on bridge financing from international sponsors in the short-term coupled with an IMF programme, given Kiev’s geopolitical significance.

According to Deutsche Bank, the market-implied Ukraine default risk, as of February 14, was just 12%, lower than that of Argentina and Venezuela.

Source: Deutsche Bank