On December 18, 2015, the government of Ukraine announced it had no intention of honoring a $3 billion Eurobond loan owed to Russia that would mature on December 20. Given the cross-default clause written into that bond, under British law, this was a momentous decision. It gave the Kremlin the right to have Ukraine declared in sovereign default, which would have precluded further financing from the International Monetary Fund (IMF). This, in turn, would have led to state failure.
At least that is what would have happened, if long-accepted rules had still applied. But that is no longer the case. Just as the Kremlin has demonstrated it can ignore treaties regarding national sovereignty and respect for international borders, the IMF is demonstrating equal deftness in bending global finance rules to suit geopolitical priorities.
Hammered by Russian trade sanctions and war in the Donbas, Ukraine was technically bankrupt as early as spring of 2014. Responsibility for preventing such an outcome was delegated to the IMF. This may have been politically expedient in the short term. Hungarian financier-philanthropist George Soros has estimated the cost of a true rescue package at $50 billion in aid – not loans. But short-term expedience is being bought at a steep long-term cost.
Casting the IMF in the role of Ukraine’s ultimate protector not only lends credence to Russian conspiracy theories of the IMF as an extended arm of United States foreign policy. It also undermines the integrity of the IMF in its relations with other countries in financial distress, and it adds impetus to Russo-Chinese ambitions to create financial institutions of their own, such as the $100-billion Asian Infrastructure Investment Bank, where the U.S. will have no influence.
The IMF would have been well advised to steer clear of political involvement in the tug-of-war between Russia and the West over Ukraine. But much as the fund was forced into taking a lead role in rescuing Russia in the 1990s, an operation that ended in massive default in 1998, it has been thrust to the fore in shoring up Ukraine.
Fact or fiction
On April 30, 2014, when sovereign default was imminent, the fund organized a rescue package worth $17 billion, of which $3.2 billion would be made available up front. Its approval would also release commitments from other sources, bringing the total aid package to $27 billion over two years.
In a comment, Timothy Ash, then head of emerging market research at Standard Bank, quipped that it was a “thing of sheer beauty. Well worth reading. Beautifully crafted and written, but unfortunately in my view more a work of fiction than of fact.” He added, “Reading the IMF document, with very optimistic assumptions built in, a future revisiting of [a restructuring] at a relatively early opportunity is not a low tail risk.”
It would not take long for Mr. Ash to be proven right. By early spring 2015, Ukraine had $5.6 billion in (dwindling) foreign reserves and $5.4 billion in Eurobond principal and interest payments coming due over the year. A sovereign default again seemed inevitable.
On March 11, the IMF again came to the rescue, this time with a four-year Extended Fund Facility worth a total of $17.5 billion, with $5 billion for immediate disbursement. Assuming that other lenders would follow, and that foreign creditors would agree to a “haircut” providing debt relief of $15 billion, at that point the total package came to $40 billion.
By August, following months of tough negotiations, private bondholders agreed to freeze bond repayments for a period of four years and to cut the total principal by 20 percent. It seemed like a triumph. But a major problem remained, namely, the $3 billion Eurobond owed to Russia.
In addition to the cross-default clause, it also carried a stipulation that Russia would have the right to call default when Ukraine’s sovereign debt exceeded 60 percent of GDP. It came to be known as the “booby trap bond,” representing a Russian gun held to the head of the Central Bank of Ukraine. Or so it was thought.
The Ukrainian government framed it as private debt, meaning that Russia must be treated as other private creditors, that is, it must be part of the restructuring operation. The Kremlin refused, insisting that the debt was sovereign. And the IMF agreed, announcing it recognized the debt as official and sovereign.
As Ukraine made it clear it would not pay, the IMF board was in a pickle. According to its charter, the fund is not allowed to lend to countries that “are not making a good-faith effort to eliminate their arrears with creditors.” That rule had been repeatedly enforced in the past.
It looked like serious trouble. If the Kremlin were to claim its right to call a default, the impact would be devastating. The IMF bailout program would collapse and so would Ukraine.
Yet, the solution was alluringly simple.
On December 8, 2015, IMF Spokesman Gerry Rice announced that the IMF’s Executive Board “met today and agreed to change the current policy on non-toleration of arrears to official creditors.” Anders Aslund of the Atlantic Council wrote a commentary on that under a telling headline: “The IMF Outfoxes Russia.”
The tables have indeed been turned. Russia is likely to win a lawsuit but will find a decision hard to enforce. Since the private debt has been restructured, it will not be affected by the cross default option. And the IMF may continue lending, thus keeping Ukraine afloat. It is understandable that many have taken delight at seeing the Kremlin outsmarted. Yet, there are serious grounds to question if this is what the IMF should be involved in.
Russian Foreign Minister Sergei Lavrov slammed the partisan nature of the decision: “Since Ukraine is politically important – and it is only important because it is opposed to Russia – the IMF is ready to do for Ukraine everything it has not done for anyone else.” And he showed legitimate concern over the impact on the credibility of the IMF. Since the change of rules on lending to countries in arrears was “designed to suit Ukraine only, it could plant a time bomb under all other IMF programs.”
Having shrewdly freed itself of the prohibition against lending to countries in arrears, the IMF is faced with two other key obstacles. One is a prohibition against lending to countries that have no visible means to pay back. That rule was imposed after its disastrous 2001 loan to Argentina. The other precludes lending to a country that cannot credibly commit to implementing imposed conditionality.
While the current state of the Ukrainian economy casts serious doubt on the former, the current state of Ukrainian politics casts even greater doubt on the latter. It is revealing that the budget for 2016 could be adopted only in the early hours of Christmas Day, under massive pressure.
A little off the top
The key question is whether these kinds of shenanigans are really helpful to Ukraine. On January 21, on the sidelines of the World Economic Forum in Davos, Ukrainian Finance Minister Natalie Jaresko told reporters she was confident that things were looking up. Inflation was falling, GDP was improving, international reserves were being replenished and reforms were being implemented. But this is largely a facade.
It is true that quarterly GDP growth did improve in 2015, from -0.5 percent in Q2 to +0.5 percent in Q3. But this must be viewed against a backdrop where GDP measured year-on-year dropped by 17.2 percent in Q1, by 14.6 percent in Q2 and by 7.2 percent in Q3. The compounded damage is staggering, especially but not exclusively in the Donbas region.
The ability to generate income to repay loans is not only being compromised by the fact that rampant corruption is tolerated. It is also worth noting that following the restructuring deal, which was hailed as a major step forward, bondholders had good reason to be satisfied. Bond prices rallied not only because the haircut had been limited to 20 rather than 40 percent. The deal also stipulated that coupons would continue being paid and it offered higher average interest payments.
Investors will receive warrants tied to economic growth, allowing them to recoup some of the losses from the write-down. As Grant Webster, a money manager at Investec Asset Management Ltd. in London told Bloomberg, “That means in dollar terms the Ukrainians aren’t paying creditors much less than they were. In fact, they’re probably paying them more once the potential warrant payout is included, which is staggering.”
The bottom line is that following two IMF-organized bailouts, and some clever rule bending, little has been achieved beyond postponing the day of reckoning. There is still plenty of damage that the Kremlin can do to make sure that the IMF will not succeed.
On December 16, 2015, Russia’s President Vladimir Putin signed a decree suspending the Commonwealth of Independent States (CIS) free trade agreement with Ukraine. Done in response to Ukraine joining a free trade agreement with the EU as of January 1, 2016, it will undermine the country’s prospects for economic recovery even further. And while the war in the Donbas may have simmered down, it could reignite at any moment, if the Kremlin sees such a need.
The IMF may have won a tactical battle against Russia, but unless foreign and domestic investors can be convinced that Ukraine is on the mend, it will remain on life support. The only way to bring investors back is to hammer out a deal between Russia and the West. Since it will have to entail giving up Crimea and allowing Russia to pull out of the Donbas with some honor, it will be hugely controversial. But the alternative is worse.
Absent a deal, and recognizing that the IMF cannot cover for Western governments’ inaction indefinitely, it will be up to the EU in particular to make a tough choice. It must either put up tens of billions of euros in real aid, or allow Ukraine to fail, perhaps even to revert to Russia.
Such perspective adds credence to rumors that a deal may indeed be in the works, clearing the way for Ukraine to embark on a long and hard road towards reconstruction.
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