Why investors who bet big on Ukraine should shoulder their own losses
Ukraine is flat broke. Kiev is running out of hard currency reserves to pay its foreign debts. Inflation is at 60 percent due to huge increases in gas prices. The country’s economy collapsed at an annualized rate of 17 percent last quarter. A full-scale economic depression is unfolding.
There may be only one way out of this mess for Ukraine: to default on its international debts and tell its foreign creditors to take a hike. While some argue that government debt restructurings are akin to theft from “powerless” creditors, Ukraine’s foreign bondholders are sophisticated investors — including one of America’s biggest investment firms — who knew the risks of investing there. No money from the International Monetary Fund (IMF), which is injecting cash into the Ukrainian economy, should go toward repaying Ukraine’s debts to foreign creditors.
To assist Ukraine, the IMF and other Western donors recently agreed to lend Kiev $40 billion to stabilize its economy. This number, while huge, is deceiving. A good chunk of the $40 billion was already promised to Ukraine in an earlier IMF loan. More importantly, the IMF requires $15 billion of this assistance to come from the restructuring of Ukraine’s international bonds — in essence, demanding that Ukraine’s foreign creditors accept a loss on their investments.
Kiev and its creditors, however, disagree on how to achieve this savings. Ukraine is demanding that its creditors accept a “haircut” — or loss in the face value of the bonds. Creditors such as Franklin Templeton — the country’s largest creditor, which reportedly owns almost half of the government’s foreign debt — assert a “haircut” is not necessary, and that reducing interest payments and extending the maturities of the bonds yields the necessary savings that the IMF demands.
If Ukraine cannot negotiate a debt reduction plan with its investors by June 15, when the next IMF review of Ukraine’s bailout program occurs, its IMF loan could collapse — sending Ukraine’s economy into an even deeper tailspin. In response, Ukraine’s parliament just passed a law authorizing the government to impose a moratorium on bond payments to its foreign investors if negotiations fail.
Some of Ukraine’s foreign creditors buy assets in struggling countries at low prices, hoping to sell at a big profit when prices recover later. They seem to be savvy at finding one-way bets. For example, as the value of Templeton’s Ukrainian bonds dropped from 80 cents on the dollar to 50 cents when the war in Ukraine’s east began, the head of the firm’s Global Bond Fund spoke publicly about Ukraine’s merits as an investment destination, explaining to nervous investors that billions in IMF cash backstopped his Ukrainian bond holdings.
Counting on the IMF has worked so far. Ukraine received almost $10 billion from the IMF in the last 12 months, some of which went right back out to pay foreign bondholders. While it’s natural that foreign creditors want to limit their losses, Ukraine’s collapsing economy and massive defense expenditures makes it likely that Kiev’s $40 billion aid program will not be sufficient.
Kiev should therefore stick to its guns and insist that foreign creditors share in the pain of its citizens and take a loss on the principal of their investments. If foreign creditors continue to refuse this “haircut,” then the government should stop paying interest on these bonds until its creditors agree to accept one. The aim is not to forgo repaying its creditors indefinitely, but to push its investors to accept better terms than they are offering. Citigroup argues that prices of Ukrainian bonds indicate markets already expect a 20 percent haircut — and Kiev has an obligation to its citizens to secure the best deal it can.
Indeed, Ukraine’s citizens are already suffering. The average monthly salary in Ukraine is only $186, and skyrocketing inflation is decimating the purchasing power of ordinary citizens. Kiev is also implementing a painful IMF-mandated economic austerity program involving massive cuts in social spending programs of nearly $30 billion. While Ukraine’s current unemployment rate is just shy of 10 percent, if the results of the Greek economic crisis are any guide, both the unemployment and poverty rates could easily double. The Ukrainian government’s first responsibility is to its people, and if Kiev implements the painful social spending cuts mandated by the IMF, then at a minimum Ukraine’s IMF money should not be used to protect sophisticated foreign bondholders from the consequences of their poor investment decisions at the expense of ordinary Ukrainians.
While Ukraine’s central bank governor worries that Ukraine risks becoming a “pariah country” if it does not meet its obligations, she needn’t be concerned. There have been 187 sovereign debt restructurings between 1970 and 2013, and recent IMF research found that emerging market governments almost always come to terms with their creditors eventually and return to international markets with a clean bill of health. Moreover, once a country’s debt load becomes manageable, inflation drops substantially while economic growth rates at least double — exactly what Ukraine desperately needs after years of economic crisis.
Ukraine does not control its own destiny on the battlefront. On the financial front, however, Kiev holds a strong hand — and should not hesitate to play it.