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IMF's Plan B Falling Apart in Ukraine

Private western creditors resist a voluntary haircut as the numbers simply don't add up

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This post first appeared on Russia Insider

The first quarter of 2015 is the quarter when Ukraine’s economic crisis has fully hit home. 

Output continues to collapse.  Inflation has risen - some estimates place it at  just below hyperinflation levels. The foreign exchange rate of the hryvnia has plunged. 

The hryvnia’s total collapse has only been averted by a combination of capital controls, sporadic interventions by the Central Bank and 30% interest rates.

Meanwhile the drain on Ukraine’s foreign exchange reserves has accelerated. They have now fallen to just $5.6 billion, impossibly low given the pressure Ukraine is under.  

The collapse of Ukraine’s foreign exchange reserves is the reason why Ukraine is now only paying for imports of Russian gas days at a time.  It simply doesn’t have the money to do anything else.

Domestically, it appears that with tax revenue insufficient and borrowing impossible, the government is being forced increasingly to print money to meet its payment obligations - something which all but guarantees inflation will accelerate and that the hryvnia will come under further pressure in the coming weeks.   

Ukraine has published a budget.   It is full of enactments intended to satisfy the IMF.  However, in a situation of gathering collapse, one has to wonder how much reality there is to any of the figures in the budget, even if one assumes the government’s good faith, which it would be unwise to do.   Beyond a certain point the sort of accounting needed for a budget becomes impossible.  Ukraine is rapidly approaching that point if it has not reached it already.

Those who have been reading Russia Insider will find nothing surprising in any of this.  We have been predicting this collapse ever since we went online in October.  We have also been saying that the only thing that could avert such a collapse was financial help from a West on a totally different scale to anything we have seen until now.

What then is the West doing?

A few weeks ago the IMF chief Christine Lagarde announced a combined IMF and Western financial package for Ukraine, which she said was worth $40 billion.

It is strange how people took this figure at face value. 

The actual IMF package that has just been approved is $17.5 billion.  Western countries and institutions (principally the EU and the World Bank) have pledged a further $7 billion.  That gives a total of just $24.5 billion.  So where does the other $15.5 billion needed to reach Lagarde’s $40 billion come from?

The answer to that question may be found in a piece we published on 22nd January 2015 (before Lagarde’s announcement) (Ukraine- IMF Admits Failure, Scraps Plan A, Goes for Plan B). 

Most of the $15.5 billion is not actually money at all.  It is largely made up of the amount Ukraine's private Western creditors are supposed to forego in repayments as part of a “voluntary” haircut.

In our previous piece we pointed to the obvious difficulty of this plan.  This is that the Russians, who are Ukraine’s biggest creditor, have said they are not prepared to be part of a haircut or a restructuring.  The Russians again reiterated that on 16th March 2015.

For the plan to work Ukraine’s private Western creditors must therefore be persuaded to agree to a haircut that the Russians are refusing to be part of.   What we said about that was:

“It will be interesting to see whether Ukraine’s private creditors agree to the sort of voluntary haircut they are being asked to make. Many of them may not be happy to agree to a haircut so that Ukraine and its Western supporters don’t have to talk to the Russians.

They may very well balk at a plan whose effect would be to privilege loans Ukraine owes Russia over loans Ukraine owes them. No doubt there will be a lot of arms twisting to get them to agree but it is likely the negotiations will be tough.”

Every part of this comment has now come true.  As the Financial Times article we reproduce below shows, Ukraine’s private Western creditors are indeed “balking at a plan whose effect would be to privilege loans Ukraine owes Russia over loans Ukraine owes them”.  They are now busy forming a group and getting legal advice and it looks as if the negotiations will indeed be tough.  The word the Financial Times uses is “combative” whilst it quotes an IMF report which says:

“Creditors may balk (note the choice of word - AM) at the terms being offered in the debt operation and holdouts may try to free ride ( the last is a not so thinly veiled reference to Russia - AM).  The negotiations may be protracted, particularly as some creditors have large positions in specific bond issues.”

As we said in our previous piece, intense arms twisting will now take place behind the scenes but it is a far from a foregone conclusion that it will achieve any result.  The Financial Times suggests Ukraine’s private Western creditors are prepared to put up a stiff fight in which case it is unlikely the haircut (if it happens) will remotely approach the figures Lagarde is talking about.

This exposes the unreality of the whole package.  Back in January the IMF was saying that Ukraine needed an extra $15 billion over and above what was already committed simply to get through the next few months. 

That was reported before the full extent of Ukraine’s economic crash became clear.  The true amount needed is probably much bigger.

It is unclear how much more money Ukraine is getting under the new package.  However what is clear is that but it is far less than the $15 billion the IMF was talking about in January.  The IMF itself has only increased its aid package by about $5 billion.

The numbers don’t add up.  If Ukraine’s Western creditors refuse a haircut of the sort Lagarde is demanding, then the numbers will become totally impossible.  In that case default followed by a bank crash and hyperinflation are just weeks away.

One point about the latest IMF package has attracted some attention and needs to be explained. 

The Russian contribution to the IMF loan is $13 million.  This is a token amount the Russians are paying in order to scotch any remaining idea that Ukraine can default on its debts to Russia without this having any greater consequences.

As I have explained previously, though this idea has been repeatedly floated, for example by George Soros, the legal advice is it won’t work.  If Ukraine defaults on its Russian loans then legally speaking it is in sovereign default and there is nothing more to it.

There have been some suggestions this doesn’t matter and that Ukraine can simply default on its Russian debts and the Russians would then be bogged down in unending litigation in the courts whilst Ukraine could proceed to restructure the remainder of its debts with the West.

This underestimates both how legally clearcut this case is, which makes it unlikely that it would in fact be especially protracted, and also what the effect of a law case between Ukraine and Russia in the High Court in London would be. 

Far from hurting Russia (which surely no longer expects to be repaid its money), such a case would be far more likely to scare Ukraine's private Western creditors, who would be worried about the effect on their loans if the Russians win the case and Ukraine is declared in default.  They would most likely to refuse to participate in a restructuring until they know what the result of the case - and Russia's position - is going to be.  A legal case between Ukraine and Russia in London makes a successful restructuring of debts less (not more) likely

The idea of a selective default by Ukraine covering only its Russian debt has now become even harder because of Russian involvement in the IMF loan.  

If the IMF opposes a default of Ukraine's debts to Russia, then it is obliged to withdraw its support.  This is because the IMF’s job is to act as a sort of trustee for Ukraine’s creditors (including Russia) whilst Ukraine is subject to an IMF package. 

It has now become harder for the IMF to breach that trust by permitting a default of Ukraine’s debts to Russia given that Russia is itself a participant in the IMF’s loan package.  Politically speaking anything is possible.  However such a step would be bound to provoke strong opposition within the IMF bureaucracy, both because of its illegality but also because of the harm it would do to the IMF’s credibility at a time when the IMF is being challenged by a series of new institutions sponsored by China.

Personally I think this is unlikely to happen, especially now that Russia is contributing to the IMF loan package.  George Soros apparently thinks so too, which is why his advice to Ukraine is to cut out the IMF entirely and deal instead directly with the EU - something which the EU however has ruled out.  The Financial Times article, which refers to proposals to win the support of Russia, anyway suggests this idea is dead.


From the Financial Times

Ukraine’s biggest creditor has formed a bloc and hired advisers to prepare for tough negotiations with Kiev, after the stricken country last week set out proposals for a drastic restructuring of its $17bn international debt.

According to a person familiar with the matter, Blackstone’s advisory arm has been hired to advise the group, which controls about 50 per cent of the country’s international bonds and therefore has the power to make or break the restructuring.

The bondholder bloc is led by Franklin Templeton, which is by some distance Ukraine’s single biggest creditor having snapped up about $7bn of Kiev’s debts, according to another person familiar with the matter, most of it ahead of the country’s revolution and subsequent crisis.

Blackstone represented Greece’s creditors in 2012, and will once again square up to Lazard, the investment bank that advised Athens and is now acting for Ukraine’s government.

The restructuring is part of a new $40bn International Monetary Fund-led rescue of Kiev. The previous $17bn bailout programme unravelled after Russia annexed the Crimea and fomented a separatist civil war in eastern Ukraine, ravaging the economy.

Finance minister Natalie Jaresko last week held a conference call with creditors setting out the government’s position. She said Kiev was looking for about $15bn of debt relief and warned that this could include principal reductions on the face value of its bonds, in addition to lower interest payments and extended repayment schedules.

Negotiations are likely to be combative. A person close to the talks said the bondholder group was unwilling to accept outright haircuts, and believed the targeted debt relief was too high.

Russia will be another big hurdle. The country is owed $3bn by Ukraine through a bond issued as part of a bailout for the pro-Moscow government that was ousted last year. Russia has indicated that it is unwilling to restructure the debt.

In last week’s conference call Ms Jaresko stressed there would be no special treatment for any creditors, including Russia. “We invite the holders of the Russian bonds as well as all of our other eurobonds to participate in this process on the basis of transparency, good faith and inter-creditor equity,” she said.

Russia could choose to hold out and refuse to restructure its bond. That would force Ukraine either to seek a deeper haircut on the other creditors to repay Moscow in full or risk protracted litigation at the same time as it attempts to restore and reform its recession and war-battered economy.

The bondholder bloc has already started to explore options in case the Russian government proves unwilling to restructure its debts. The IMF highlighted this as a big risk to the success of its new programme.

“Creditors may balk at the terms being offered in the debt operation and holdouts may try to free ride,” the IMF report said. “The negotiations may be protracted, particularly as some creditors have large positions in specific bond issues.”

The restructuring mandate is a fillip to Blackstone Advisory Partners, which is being spun out of the US investment firm alongside several other advisory arms and merged into PJT Partners. It will be listed in New York soon. Weil Gotshal is the bondholders’ law firm, while White & Case represents Ukraine.



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