Russia has to pay for Ukrainian reconstruction
Big take out - those Yes Minister types in the UK and US Treasuries need to get their heads out of the sand and understand that the failure to allow the transfer of frozen Russian assets to Ukraine is creating a national security issue, and is actually prioritising the protection of Russian property rights against the property rights of Western tax payers and creditors (Western pensioners). It is not fine to take money from Western tax payers and Western creditors to fund Ukraine’s reconstruction just because the bigger priority seems to be to make sure that Russian asset holders are paid in full. This is putting the property rights of a murderous, Fascist and genocidal regime above those of law abiding Western tax payers and creditors.
I was invited to speak this week at a Ukrainian Centre for Economic Strategy (CES) event around the topic of what to do with Ukraine’s mounting war driven debt burden. This ended up being pretty thought provoking, especially on the issue of frozen Russian assets.
Against that backdrop I thought it useful to put my own speech, and perspectives, down in a published format.
I guess the starting point when we think about how to deal with Ukraine’s rising debt burden from fighting the war against Russia, and how the West deals with it, is to spell out at the outset what the West’s objectives should be with regard to Ukraine. And I think that is fairly strait forward. The West absolutely has an interest in Ukraine being economically able to conduct and win the war, but then win the peace. In this latter respect, the aim will be to help Ukraine’s recovery and reconstruction to the point that it is economically self sustaining, and can fund the bulk of its own defence. Actually Ukraine’s ability to defend itself also helps our own defence - it should now be self evident to Europe, and the West, that Ukraine is the front line for us, and the defence of the West against actual Russian aggression and expansionism. Helping Ukraine rebuild and recover should be in our self interest - every Russian tank taken out by Ukrainian defenders is one less for NATO to face down the line. And given Putin’s track record, we will have to face those tanks if we don’t act now.
Ukraine started the war with a modest debt burden of less than 50% of GDP, the result of prudent debt management policies. Obviously, the war resulted in a huge loss in GDP (dollar GDP declining from $180bn to perhaps $125bn), while budget deficits exploded and Ukraine was forced to borrow to cover a large part of its financing needs. The West has covered a large part of Ukraine’s 30-40% of GDP budget deficits, but around half of that has been provided in the form of debt, rather than grants (the US mostly provides grants, the EU credit on long term low interest terms), hence, upwards pressure on the country’s debt ratios. Producing a credible macro framework to calculate debt ratios is difficult in war time conditions, but the IMF tried this as part of itse recent $15.6bn EFF loan agreement for Ukraine. They predict - finger in the air stuff - that the public sector debt to GDP ratio will rise to just short of 100% at the end of 2023, peaking around 105% the year after on the assumption that the war peters out by this date. So this far the war has more than doubled Ukraine’s debt burden.
Ukraine valiantly paid its debts in the early part of 2022, but finally relented and agreed a debt standstill in effect in August 2022, where private creditors agreed to suspend debt service for 24 months, with Paris Club creditors extending this to three years. The Fund indicated that they expected further debt treatment to limit debt service paid during the duration of the EFF. This suggests some kind of agreement will need to be reached again with private creditors as the current 24 month standstill ends in August 2024.
The Fund includes a DSA in its EFF, but until the war ends this is really make believe stuff. No substantive debt restructuring negotiations can occur until the war ends, and a credible macro framework can be constructed. Private creditors are unlikely to agree to any restructuring, beyond a further extension of the current debt standstill perhaps for another year, at least until the war ends, and again a credible macro framework can be constructed. Creditors will simply argue what’s the point agreeing anything when the numbers are so uncertain, but let’s all just come back when the security situation is clear and we can input serious numbers, which make sense, into a DSA. If the war is continuing the default settings will be to just extend the current 24 month debt service suspension.
So what happens when the war ends?
And note here that I am still in the optimistic camp of assuming an early end to hostilities this year, assuming that either a) Ukraine’s much touted counteroffensive works, punches thru Russian lines, which then collapse, and then Ukraine imposes the peace; b) the counteroffensive is more limited in effectiveness but encourages both sides to come to the negotiating table, perhaps brokered by China, et al, but again this year.
Assuming the war ends a macro framework will be constructed - I will then be on the positive side, assuming a rapid rebound in the economy based on: low base, huge reconstruction spend, innovation and remarkable durability shown during the war, continued need for high defence spending. And the experience of 2014/15 was exactly that of a rapid rebound in dollar GDP.
Reconstruction costs will be massive for sure. World Bank and KSE estimates from last July put these then at $350bn. A year on, and they might be double that so $700bn plus, maybe as much as $1 trillion, more than five times Ukraine’s pre war GDP.
That is a huge number to finance, so it is entirely fair to ask the question who is going to pay?
The options are:
a) Ukrainian tax payers;
b) Ukrainian oligarchs;
c) Western tax payers;
d) Western creditors/private sector;
e) Russia.
Having fought the war so valiantly, for us - for the defence of Western liberal market democracy - morally I don’t think Ukrainian tax payers should pay, and indeed, they just lack the means to pay. Per capita GDP is now down to something around $3000.
Given the past history of graft and state capture, Ukrainian oligarchs should pay, but their net worth is now likely much diminished with much of their industrial asset base in the east now in ruins. Hard to see them having the hundreds of billions of dollars needed for reconstruction.
Western tax payers have already paid perhaps has much as $100bn to fund the war, and Ukraine’s defence, and it’s hard to think with war and Ukraine fatigue setting in to imagine them stumping up hundreds of billions of dollars in Ukraine reconstruction costs. And spending hundreds of billion of dollars of Western tax payers money on Ukraine reconstruction risks playing very badly on domestic politics in Western democracies - it will surely be exploited by populists such as Trump, so that will play back to the advantage then of autocrats like Putin.
The irony would surely be if Ukraine wins the war, but winning the peace imposes such a cost on Western tax payers that we see democracies in the West tumble at the hands of populists resulting in long run wins for autocrats like Putin. Ukraine, and the West, wins the war in Ukraine but loses the war of regimes.
Recognition I think that the Western tax payer is in no mood to pay the huge sums for Ukraine’s reconstruction has driven Western governments to obsess with the role of the private sector in Ukraine reconstruction, assuming that the private sector will miraculously take up the baton from governments. It could, but unlikely to the tune of $750bn to $1 trillion. It worries me that these are cheap words from Western governments, assuming a private sector money tree will appear to fund Ukraine reconstruction. A reality check is needed here.
Various factors will need to be in place to ensure succesful private sector involvement in Ukraine:
First, the war needs to end, and sufficient security guarantees put in place to assure that a resumption of hostilities will not happen to threaten any such private sector investments.
Second, that the right institutional setting is put in place in Ukraine, and to manage the reconstruction effort - see my earlier write up about the importance of creating a sovereign wealth fund like structure for Ukraine to manage the reconstruction effort, act as an agent for reform and also a structure to partner with foreign privete capital and actually borrow on its own behalf for reconstruction - an Agency for Ukrainian Reconstruction and Accession (to the EU), but AURA for want of another accronym.
Third, Ukraine will need early market access, which means that the issue of its debt sustainability and treatment will need to be resolved quickly. An entity like AURA could potentially fill a gap herein, assuming the sovereign’s access to markets might be limited for a period after the ending of the war.
On the third issue the challenge will be securing an agreement which frees space from debt service in the early years of reconstruction, while ensuring a speedy conclusion of negotiations with creditors. The latter would pressure for a relatively friendly deal. Ukraine can try and negotiate for a hard restructuring which wipes the slate clean of debt, with hefty write downs, but I doubt creditors would be quick to agree any such proposal. And failure to agree to a speedy debt treatment would limit market access and then access to funds for the private sector to lead the recovery and reconstruction effort in Ukraine. Likely investors would hold out for a more favourable, light treatment, arguing that if faced by pressure for a harsh treatment that they would prefer to wait, assuming a quick bounce back for Ukraine which could present a much improved macro framework and much easier debt sustainability picture a year or two down the line. See the argument also below - in the end Western creditors are not responsible for this war, why should they pick up the bill when Russia is clearly responsible and there are $400bn in frozen Russian assets in Western jurisdictions. Private creditors likely will tell Western government that they are not agreeing to any debt treatment for Ukraine unless they sort out the issue with frozen Russian assets.
And this brings us to the fifth potential source of financing for Ukraine’s reconstruction, Russia.
Russia is clearly responsible for the war in Ukraine and is directly the cause of the huge economic, and human losses in Ukraine. Natural justice would suggest that it should be made to pay some kind of war reparations, as Iraq did to Kuwait, after the first Gulf War.
I have heard an argument that the West, and Ukraine, should be careful in pushing for reparations from Russia, with the example being brought up of Weinmar Germany after WWI. We should be careful not to bankrupt Russia, for fear of causing social and political instability in Russia which could have dangerous longer term consequences for regional stability.
The above arguement is stretching it a bit, well actually a lot. Russia is a rich economy, compared to Ukraine, and is in no way bankrupt as was Weinmar Germany after WW1. It has a GDP of $1.8 trillion, and a per capita GDP over over $10,000. It has sovereign assets of over $600bn, and around two thirds of these are actually frozen in Western jurisdictions. And it’s balance sheet is relatively clean, with a public sector debt to GDP ratio of only 20% - assuming the war ends early, and Russia agrees to repay reparations, Russia could easily borrow to fund these reparations. And note here that Russia has huge annual commodity export earnings - from energy alone, around $250bn.
Russia clearly can pay. Making it pay is another question, but the presence of around $400bn in frozen Russian assets in Western jurisdictions provides an attractive potential source of funds to pay reparations in a timely manner.
Lots of arguments are being made as to why frozen Russian assets should not be confiscated, in effect, and formally transferred for the use of Ukraine’s reconstruction. Core arguments here are that any such action would be an attack on the sanctity of private property rights in the West, sovereign immunity, and would be a risk to the stability of Western financial systems as it could see the mass exodus of the capital of more authoritarian regimes from Western financial systems, fearful of similar treatment.
All these arguments are entirely understandable and might be valid in a normal, peacetime situation.
However, we are not in a normal situation. Russia is at war with Ukraine, and has declared war on the West by its actions - invading Ukraine, attacking the West thru the energy channel, cyberattacks, actually using WMD on the streets of NATO members. Putin and the Russian state media openly calls this out as a war between Russia and the West. This is a war between autocracy and Western Liberal Market Democracies. We are at threat - Putin is trying to attack our very democratic systems by backing far right and far left political movements to bring about political change which would be terminal for the very system of Liberal Market Democracy.
And we should ask ourselves, if we are unable to use frozen Russian assets to help in Ukraine’s defence and win the peace, then where exactly will the money come from? The reality is it will not come, Ukraine will not have the funds to defend itself and us, and the risk is that Ukraine loses, and Russian tanks will move further West to the border of NATO.
So this is an existential battle, and the bean counters in the UK and US Treasuries that seem to be blocking actions to transfer frozen Russian assets to Ukraine need to wake up to the reality.
This is now a national security issue and as, occurred in the UK during WW2, needs must, assets have to be confiscated, requisitioned, whatever to win a war in an existential battle for our survival with Russia. People will understand - extraordinary circumstances require extraordinary measures.
Now on the specific points raised above:
First, this idea that transferring frozen Russian assets to Ukraine would somehow diminish the sanctity of private property rights in the West. Well, the alternative is that money is taken from Western tax payers and private creditors (via a forced restructuring of Ukraine’s debts) to pay for Ukraine’s reconstruction. So actually HMT/UST would be making a determination that Russian property rights are more sacrosanct than those of Western tax payers and creditors. It’s fine to force Western creditors (pension funds) to take a 50% hit, write off on their credits to Ukraine, but we have to go out of our way to ensure that the $400bn in Russian assets are paid back to Russia. HMT/UST would seem to be acting in a perverse way here, forcing the transfer of wealth/property rights from Western tax payers and creditors to the Russian aggressor. Perverse, and absolutely immoral. Who exactly are the HMT and UST worki for?
Second, sovereign immunity. Well we already have the precedent here of Iraqi reparations to Kuwait. But it’s beyond doubt that Russia was responsible for the damage to Ukraine, and it should pay. Would the same arguments of sovereign immunity be made in the case of NAZI Germany? And remember here that Putin is waging genocide against Ukraine - he has made it clear that this is not about NATO enlargement but that he has a problem with Ukraine, and Ukrainians’ identify. Ukrainians are being killed by Russian bombs because they are Ukrainian.
Third, this idea that transferring frozen Russian assets would somehow damage the West’s credibility as a safe harbour for international capital, and that somehow all this would damage its reputation.
On the reputational issue, the question has to be asked, how were these kleptocratic funds allowed to filter into Western financial systems in the first place. Where was the KYC when for a decade or more it has been clear what the Putin regime was. What reputation are we defending here? Remind the London Laundromat perhaps.
And on the concept that by formally transferring these assets to Russia, other autocratic regimes would pull their capital out of Western jurisdictions - I would assume that regimes intent on invading other countries and conducting war crimes have already done that. And we should not be a harbour for such capital in the first place. But I would imagine that these regimes have ready gotten the message from the first freezing of Russian assets, which have already been put beyond the use of Russia. I don’t see a huge difference here now with transferring them to the use of Ukraine - at least when viewed thru the prism of similarly autocratic regimes. The warnings have already been given and the likes of China will already have reduced exposure in Western jurisdictions - the money has already left. I guess the other point is that if such regimes don’t want their assets frozen and then confiscated to pay for reparations, then don’t invade other countries, don’t conduct war crimes and genocide. Simple.
On the issue of sovereign immunity, I think there is a fear of tit for tat confiscations. The reality though that is that this is already happening - looking at the number of Western business that are now being forced to sell up in Russia, and forced to pay taxes to the Russian state, and being paid paltry sums to exit the Russian market. Their assets are in effect already being confiscated. So in confiscating Russian assets in the West we would only really be reciprocating Russian actions.
But ok, let assume the bean counters in the HMT/UST - the Yes Ministers, “the computer says no” crowd stalls formal confiscation of Russian assets for the use of Ukraine, or delays their transfer, what can be do to help Ukraine with its more immediate financing needs?
Some innovative ideas have come out of the EU - talk that while the underlying frozen Russian assets cannot be transferred to Ukraine, but the investment returns made in these asset can.
Let’s think a bit more innovatively:
First, Requisition Bonds.
So building on the above idea that while underlying frozen Russian assets cannot be transferred to Ukraine but the returns can, the assumption is that frozen Russian assets are invested in US Treasuries or other “safe” assets. Let’s assume $400bn in frozen Russian assets is invested in 30 year US Treasuries at 3.8%. That yields a $15bn annual return which could be transferred to Ukraine. Nice but it does not really hit the sides on a $1 trillion rebuild cost. How about then investing in the EMBI+, so buying an index of higher yielding EM bonds? That would likely double the return and have the other huge benefit of helping the global south reduce its financing costs - and the global south has been badly impacted from the cost of living crisis caused by Putin’s invasion of Ukraine. So $400bn at an average 8% yield, would generate $32bn in annual investment funds for Ukraine.
But why limit ourselves just to a USTs or an EM index? Why not invest these frozen Russian assets in sovereign bonds yielding the highest return, what about in Egypt yielding 14%, or Pakistan at 30%?
Going down the same route, how about investing these frozen Russian assets in Ukrainian sovereign bonds, currently yielding around 50%? Practicalities there though are that there is not enough liquidity. So how about launching a new Ukrainian issuance programme, a Requisition Bond series. Ukraine issues $400bn in new Requsition bonds which are bought using Russian frozen assets. They can pay a 5% coupon, or even 10%. Ukraine gets the money for reconstruction, the property rights of Russia are respected, as Russia still technically owns these instruments, and might even get paid a coupon - paid into an escrow account and paid to Russia after the war ends, and with formal agreement over reparations. Ukraine can then decide in the future whether it wants to honour these liabilities, or to restructure them depending on the evolution of the political and economic settlement with Russia.
Second, Brady bond style solutions
Other options include allowing Ukraine to issue further debt securities using frozen Russian assets - this would enable it to borrow at reduced rates, and might actually allow for more favourable debt restructuring. Imagine, for example, that Ukraine’s outstanding debt stock is restructured, with haircuts compensated fully with collateral provided in the form of frozen Russian assets. The West can write wording to the effect in sanctions legislation covering Russian sovereign primary and secondary sanctions that Russia can only re-access international capital markets when these liabilities to Ukraine, and creditors of Ukraine, are first paid. Creditors are in effect given a first call on frozen Russian assets in proportion to whatever debt relief is eventually given to Ukraine.
All the above options do not erode, or denude Russian property rights but they solve the problem of how we meet the immediate financing needs for Ukraine of winning the war and ensuring a succession reconstruction.