Ukraine Could Face Debt Carve-Up

Emerging Markets, May 14 2014

Ukraine could be forced to restructure or reissue its debt if further devolution of its provinces takes place, according to a new report.

Yesterday Bank of America Merrill Lynch analyst Vadim Khramov outlined a range of separation scenarios and their likely impact on the Ukrainian economy and, consequently, bonds. In his base case, Ukraine is pressured into deep constitutional reform which could lead to a more federal and decentralized Ukraine without formal separation. But he said full separation would mean a risk to IMF financing and, in the worst case, a default requiring “external and local debt restructuring with sizable haircuts to bond values.”

On Sunday the Donetsk and Luhansk regions of eastern Ukraine held referenda and voted overwhelmingly for independence. Although neither referendum is likely to be recognised internationally, the votes are nevertheless likely to be used by Russia to pressure Ukraine into constitutional change. Luhansk, Crimea and Donetsk between them comprise about 20% of Ukrainian GDP, population and employment, 26% of exports and 9% of imports, Khramov said. Crimea itself is only between 3-4% of GDP and, given its pension liabilities, may actually be net positive for Ukraine economically, leaving aside the loss of trade connections.

Khramov believes that, so long as decentralized regions continue to transfer fiscal revenues to the central government or arrange to cover external debt payments, there should be no threat to the IMF program that is in place to assist Ukraine in meeting its debt repayments. Even if Donetsk and Luhansk eventually gain full autonomy, the IMF is likely to continue the programme, he said.

But if the Kharkiv region was to be separated as well, bringing the total of Ukraine’s GDP that would be absent to 25%, as well as a large chunk of industrial production and exports, that would tip the balance. “Then debt to equity ratios would jump to about 80% of GDP and there is the possibility that the IMF would require debt restructuring, but the decision would still be political,” he said.

The worst case would be the further separation of eight southeastern regions, which would lead to substantial GDP and revenue loss, devaluation, and increased government debt to almost 120% of GDP. The southeastern regions comprise 63% of industrial production and 54% of total exports, BAML says, and their loss would be debilitating to the current account and the coverage of external financing needs. “In this scenario, debt dynamics would become unsustainable,” Khramov said, and debt restructuring would be inevitable.

Other economists are looking at Ukraine with mixed feelings. “The bullish case is that you’ve got the IFIs committing upwards of $30 billion, and that provides an enormous backstop in terms of the sovereign’s financing and reserves position,” said Stuart Culverhouse, chief economist at Exotix. “That should ensure the bonds that mature this year are paid. Ukraine is not heavily indebted, with public debt only 40% of GDP; the issue is more about liquidity where there is difficulty in rolling over debt.”

There are two caveats, though, he said. “Firstly, to the extent that we see further economic deterioration – and that’s possible given the political circumstances – the financing needs may increase.” Deeper recession brings problems at the corporate level or in the banking system, with exchange rate weakness that increases debt burdens. “If the debt burden increases, it may be the IFIs are happy to provide $30 billion, but what if it becomes $50 billion or $60 billion?”

Additionally, he said, a deterioration in debt dynamics could create an issue with solvency. “It doesn’t take much to get from a debt ratio of 40% to 70%, and at that point you’re in a grey area: does the IMF think that bond-holders then have to take some of the pain?”

Culverhouse said the loss of Crimea did not change Ukraine’s debt dynamics significantly but that “if you lose the East of Ukraine, that potentially does alter the macro dynamics of the country. But in the long run, maybe what you’re left with is a homogenous western Ukraine, allied to the EU, which is a more enticing position for bondholders, whereas Russia ends up with the costs of absorbing four million people.”