Ukraine’s debt haircut showdown looms

Ukraine‘s hope of reaching a compromise with its international creditors hangs in the balance as the two sides prepare for complex negotiations to begin this month.

While Kiev has been open about its plan to impose a haircut on billions of dollars of public debt, investors are expected to resist losses.

A committee of foreign bondholders who account for more than half of the country’s external debt, including Franklin Templeton, has already been set up and is being led by Blackstone’s advisory arm.

This group could block proposals relating to bonds they hold, as could Russia which holds one bond in full.

However, academics say Ukraine is not necessarily out of options if this occurs. Governments in the past have found that looking within the machinery of their bonds can sometimes strengthen their hand.

The prime example is Greece, which used the fact that its debt was issued under local law to retroactively fit bonds with collective action clauses, binding investors to a deal they had resisted.

Ukraine’s debt is written under international law, however. Now that it has received a $17.5bn lifeline from the International Monetary Fund, Ukraine is hoping to cut its external financing needs by $15.3bn.

It is including quasi-sovereigns such as the City of Kyiv and state-owned Ukreximbank to the debt restructuring package and has already sought to buy time with Ukreximbank requesting a three-month maturity extension on debt maturing this month.

“The government wants to compromise,” says Paul McNamara, emerging markets investment director at GAM.

Academics say Ukraine is not necessarily out of options if this occurs. Governments in the past have found that looking within the machinery of their bonds can sometimes strengthen their hand.

However, analysts at Nomura say a deal will be difficult due to the small amount of eligible securities involved — 29 in all — and the fact that almost complete participation is required to meet the country’s restructuring target.

This seems unlikely. Finance minister Natalie Jaresko says no creditor will receive special treatment but one bond is owned by Russia’s National Reserve Fund, which holds $3bn provided to Ukraine’s former pro-Russian government. The bond, written under English law, also contains a covenant allowing the holder to call for early repayment if Ukraine’s debt exceeds 60 per cent of economic output, although Moscow has so far opted not to pull this trigger.

As there is no collective agreement clause in Ukraine’s debt, it cannot bind Russia to an agreement made by other bondholders.

“The biggest issue for Ukraine and bondholders is what the Russians do,” says Timothy Ash, chief emerging market economist at Standard Bank. “They are unlikely to co-operate. I expect they will wait until December when the bond matures, at which point Ukraine will not pay and the debt will go into arrears.”

The question then is whether this risks the country’s deal with the IMF, which has a rule about not lending to countries that miss payments to other governments. Fund officials suggest the IMF might tweak its own rules to get around the situation but academics say another option might be for Ukraine to make Russia’s debt unenforceable in English courts, arguing that Russia’s annexation of Crimea should be set off against the debt.

The biggest issue for Ukraine and bondholders is what the Russians do. They are unlikely to co-operate. I expect they will wait until December when the bond matures, at which point Ukraine will not pay and the debt will go into arrears - Timothy Ash, Standard Bank

This proposal is elegant, says Mark Weidemaier, associate professor of law at the University of North Carolina, although the UK may not be keen to support it. The alternative could be for Ukraine to argue “impracticability”, which applies when unexpected adverse events occur that make it commercially unreasonable for a borrower to pay. He argues: “Surely it is a basic assumption of a GDP-linked loan from Russia that Russia will not thereafter start a GDP-destroying war?”

Another suggestion put forward by Mitu Gulati at Duke University is that Ukraine makes use of the fact that its debt contains one provision — the payments provision — that states it is subject to appropriate laws but does not specify where. This means, he argues, that Kiev could say payments are subject to Ukrainian law and change the terms to suit its needs.

As speculation over debt negotiations continue, fears are growing that a fragile truce with Russian-backed separatists could collapse and that Ukraine will be pushed ever further into economic frailty. On Tuesday, Kiev announced that it was keeping interest rates at 30 per cent to address the threats of currency destabilisation and high inflation.

George Soros, chairman of Soros Fund Management, argued this week that Europe was so preoccupied by Greece it is had ignored Ukraine’s economic plight. “ . . . Europe has been drip-feeding Ukraine, just as it has Greece,” he wrote in an opinion column this week. “As a result, Ukraine barely survives, while Putin has the first-mover advantage.”

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