Ukraine - some thoughts around burden sharing

Sides are still circling around expected negotiations on potential debt treatment for Ukraine. The assumption still is that these will need to await better clarity over the blocked $61 billion in US support to Ukraine still stuck in Congress. This could still take weeks, months, if it ever happens.

There is still no claririty around why the early push by the IMF/Government of Ukraine (GOU) for debt treatment, while the war is still on-going and there is a real lack of claritity around the macro framework and therein the DSA - both are largely finger in the air efforts by the IMF.

One can speculate:

First, I guess with the debt service suspension running out in August, there is a desire for some clarity, and a desire to avoid potential for damaging PR around a default. Some kind of decision - extension of the debt service suspension or some form of restructuring, is perhaps better than no decision and a default which would be a PR negative for Ukraine and its Western donors.

Second, there is perhaps a recognition that once the war ends, the private sector will be a key partner in fast tracking the recovery and reconstruction effort. If Ukraine is still in default at that time, this will delay market access and the private sector contribution to the recovery and reconstruction effort. So getting the process of debt restructuring out of the way now clears the decks, and removes one potential hurdle early.

Third, perhaps there is a sense that all the uncertainties over the macro outlook creates an opportunity for the GOU to push for a larger NPV debt reduction now - rather than wait whereupon the macro outlook might be much better when the war ends. The logic here suggests the opposite incentive for private creditors who might then perhaps prefer to wait for that improved situation before moving to agree any debt treatment.

Fourth, well it’s just what the IMF does in its programmes where debt is deemed unsustainable, and the Fund always asks for burden sharing to the private sector. Partly here it is also about trying to present a maximum package of combined Western support for Ukraine - the financing contribution - which is set at $122-140 billion for the period to 2027 under the EFF, and including a $14.8 billion contribution from the debt treatment, which helps pad out the overall headline number and helps the PR narrative and especially when there are so many uncertainties around the official financing envelope. The Fund is trying to present a story that the numbers add up, at least in terms of the estimated financing gap, and therein the contribution from the private sector is seen to help - albeit I would argue in the larger scheme of things it does not touch the sides.

This is all well and good, but this IMF programme is so unusual compared to other IMF programmes as it has been extended to a country in full scale war and with huge uncertainties around the macro outlook, hence the macro economic framework and also the official financing picture. Western governments have provided “financing assurances” to cover budget and balance of payments needs of over $107-125 billion for the period to 2027, but already around one fifth of this is now in doubt given, as noted above, US funding is stuck in Congress and longer term uncertainties therein over US support if Trump wins the US election - Trump has threatened to cut off all support for Ukraine. So the question then is who will fill the financing gap left by the potential drop off in US support? Unclear, but these are huge numbers.

I would also argue that there is a fundamental flaw in how the IMF thinks about the macro and financing and DSA for a country at war. Herein the IMF has used a traditional budget/BOP financing eqution, as it normally does on any of its programmes. It assumes all else being equal, in particular, that the security situation is assured, and that in Ukraine’s case there is a reasonable assumption of an end to the war, which leaves the state sustainable from a security perspective. But for Ukraine one cannot just look at the budget and balance of payments needs, one has to extend this to look at the total cost of sustaining the country in war, which includes its military needs, budget and BOP needs. And herein the costs are much higher than the IMF’s assumed budget and BOP financing needs for the period to 2027 of $122-140 billion. At present the West is providing around $100 billion of budget, BOP and mitiliary financing for Ukraine per year. This breaks down to roughly $40 billion of budget/BOP support per year and $60 billion in military support. The $100 billion is the annual run rate of keeping Ukraine in the war. Unfortunately, while the US is assumed to only provide around one fifth of the funding under the EFF, it is providing more than half the military support package. US support overall is running at around $40-45 billion per year, and critically in the military sphere it is not just in the funding total but the technology mix that the US support is simply irreplaceable. It’s not as though any other NATO member could step in to provide the armaments mix that the US is able to provide, and it is that armaments mix that Ukraine needs to defend itself and remain sustainable. If the US support is pulled back, the sustainability of Ukraine in the war, and the very sustainability of Ukraine as a sovereign independent state is at risk. It shows the IMF macro assumptions, and DSA are really based on a very partial and incomplete analysis of the story. The IMF has done what the IMF does, produce a classic budget/financing gap analysis.

Now returning to likely future talks around debt debt treatment, while governments and creditors might differ on typical contributions to any such deal, like haircuts, coupon reductions and maturity extensions, they both share a mutual interest in ensuring that any such deal ultimately reduces the exit yield for the country. For a country going through such debt treatment this ensures an improved macro outlook, improved debt sustainability and linked therein reduced borrowing costs. For creditors a lower exit yield helps increase the NPV of any deal, sweetening the impact of haircuts, coupon reductions and maturity extensions.

For looking at this particular discussion around debt treatment the question has to be whether/how any such deal will cut the exit yield for Ukraine, and ultimately improve its credit worthiness and longer term borrowing costs.

The challenge herein as I see it is, as is, the IMF EFF, and its macro assumptions and then DSA, do not really add up, when one considers the wider financing needs of Ukraine - that $100 billion annual ticket - and what happens if the US steps away. Even assuming the IMF macro assumptions and DSA, as is, are reasonable forecasts (I have my doubts) when assuming a steady security state, if US support drops off a cliff Ukraine will face an existential military - security crisis, which threatens the sustainability of the state, and will blow the IMF assumptions apart.  Ukraine could suffer serious battlefield losses, losses of large swathes of territory, and loss of much productive parts of the economy. It’s financing needs then might be multiples of the numbers suggested by the IMF.

In this bigger scheme of things, the $14.8 billion financing contribution from the debt treatment now being considered does not really touch the sides. One could actually argue that Ukraine could, in any event, secure most of this financing contribution by simply extending the debt service suspension to the end of the EFF, in 2027, as per the Paris Club.

The key question then is can this debt treatment, if agreed, change the dial in terms of ensuring that Ukraine’s bigger picture financing equation adds up - not just the $122-140 billion cumulative as assumed by the IMF for the period to 2027, but the $100 billion per year tab as long as the war continues. Only if that bigger financing gap, left by the US walking away from funding Ukraine, is filled as a result of any such debt treatment, can the exit yield fall. Now with only around $30 billion in debt within scope for this particular restructuring, more aggressive treatment therein again does not touch the sides.

As I have long argued, Ukraine’s financing numbers only add up if it is given access to the $330 billion in immobilised Russian assets in Western jurisdictions, and not only the interest earned on these assets, but the underlying assets. The $3-4 billion in interest earned annually on these assets does not really touch the sides. This is just window dressing.

Private creditors need to be open in arguing to the G7 that its pointless undertaking any debt treatment unless the hard reality is accepted that the current Ukraine financing model is not sustainable, and especially not if the US steps away. So how is the financing gap going to be covered, as this is the only way that the exit yield can be reduced post any restructuing?

Now on the frozen Russian asset issue lots of arguements are used as to why it should not happen. I will address these later. But first the debate has to be turned on its head. I would ask those who have argued against the use of immobilised Russian assets for Ukraine how they plan to fund Ukraine without resort to the use of these assets. And the answer is as above - the numbers do not add up. As is Ukraine faces the prospect of not being adequately funded in war, and faces the prospect of defeat. And this will impose much larger costs on G7 nations and the Western alliance. It means Russian tanks moving West, likely an extra 1% of GDP on annual defence spending by NATO ($100-200 billion a year more just for Europe), it risks economic, political and social instability in Europe because tens of millions of Ukrainians will move West, and it will surely cripple the euro, and the whole EU model. Plain and simply it presents a systemic risk to Europe.

Blank faces, the opponents of using immobilised Russian assets have no answer as their arguments are really just academic semantics. But ensuring Ukraine is victorious in this war is real politik, the harsh security reality. Needs must.

So what about the arguements against? They are various and I will address, and dismantle them, one by one.

The legality?

The arguement goes that there is no legal basis for freezing, seizing and allocating the $330 billion in CBR assets in Western jurisdictions and sovereign immunity protects these assets.

Well, work by Zelikow, Zoellick and Zyskind around the countermeasure arguement suggests that there is indeed a legal basis for such action. States only benefit from sovereign immunity where they are acting in accordance with international law, Russia clearly is not, and while it is out of compliance with international law countermeasures can be applied against it including seizing its assets overseas.

In the US, in any event, the Executive Order, has proved affective in seizing the assets of sovereigns in the cases of Iraq and Afghanistan. It has been tested in law.

And if laws don’t exist then politicians make laws and they need to get on with it. In war, extraordinary actions are taken in the national interest. The war in Ukraine is a systemic event for Europe, needs must.

What is clear from the above is that issues around law and the use of immobilised Russian assets are not the problem, but the lack of political will is. And this relates to a decades long problem of the West failing to read Putin and failing to take the threat seriously. If Putin presents an existential threat to Europe and Western liberal market democracy (which he is) then politicians need to pull their fingers out and act. We need leadership on this issue. Legislate where you have to do, but get on with it or think about what the consequences of a Ukrainian defeat will be, because if we don’t use frozen Russian assets Ukraine will lose this war.

Just on the issue of law, one arguement against is that such action damages the perception of the sacrosanct status of the rule of law in the West. I would argue that this is a pretty fanciful and fairy tale perception of the reality. Where was Western rule of law when the hundreds of billions, perhaps trillions of dollars of Russian assets were accepted into the Western financial system? At least for a decade it was clear what the Putin regime was - autocracy, kleptocracy and a facist state. These monies were made in a corrupt system and yet the West invited the assets in no questions asked, and actively laundered them. Rule of law? Let’s not be high and mighty now.

Risk to reserve currencies?

So the argument goes that if Russian assets are seized and allocated to Ukraine other autocratic and non Western regimes would think their assets are also vulnerable from such action and they will withdraw their assets from Western jurisdictions causing long term damage to the status of reserve currencies such as the dollar, Euro, pound et al. The argument is also that it could cause global market instability.

First, these assets have already been immobilised, and the message sent to Russia by G7 states that it is never going to get them back. I don’t hence see much difference between immobilisation, as has already occurred, and freezing. And despite the move to immobilise there is zero evidence that the likes of China, the Gulf or India et al have moved assets from Western jurisdictions.

Second, given we are talking about literally up to $5 trillion of such “at risk” assets, there is a lack of alternative liquid markets where the likes of China could invest.  Most of these states do not trust each other so are unlikely to spread these assets between themselves.

Third, you could argue that from immobilising and seizing these assets that a positive message has been sent to the likes of China, not to invade other countries, commit war crimes and genocide. So they should conclude that if such states do not conduct such actions then their assets will be safe in Western reserve currencies. That’s a positive message to send surely?

Finally, I have to add that the irony of ECB board members warning of the risks to the Euro of seizing Russian assets. I would argue that the consequences of not seizing them and inadequately funding Ukraine as a result, is much worse for Europe and the Euro - it risks a systemic crisis in Europe and the collapse of the Euro for points I raised above about increased defence spending and huge out migration of Ukrainians.

Retaliation by Russia?

Another arguement used against seizing Russian assets for Ukraine is that in so doing Western business interests and assets will suffer tit for tat action by the Russian state.

Counter to this:

First, Russia is already doing this, seizing Western assets in

Russia and forcing fire sales at peppercorn prices.

Second, there is extensive lobbying now by Western business stranded in

Russia, not to make their plight worse. But let’s not forget that Western business stranded  in

Russia now made bad business decisions in the first place. They often ignored the advice of their own governments, and a track record of bad actor actions by Putin and reaped windfall profits for a long time, why should they now be bailed out, in effect by Western taxpayers? And why should their interests be put above the interests of Western national security. They should not.

The issue of Euroclear comes up here given that a weight of Russian CBR assets appear to be deposited in Euroclear in Belgium. There is fear of flight of assets from Euroclear (unlikely see arguements above) and potential for legal cases against Euroclear. The reality is that these legal cases are only likely to be lodged in Russia and hence unlikely enforcible in the West. And even then, if Euroclear is globally systemic then risks around should be indemnified by G7 - it’s a trade off here of the systemic importance of Euroclear vs the systemic consequences of the defeat of Ukraine. I would say national security trumps everything here.

What about equity and burden sharing?

The latter point raises an interesting issue around burden sharing.

If Russian assets are not seized because of lobbying by Western business interests stranded in Russia, or still with Russian business interests, the consequences are that Western taxpayers and Western creditors (pensioners, thru debt relief) will be asked to cover Ukraine’s financing needs. How is this fair or equitable? The interests of companies that made bad investment decisions, and helped fund Putin’s state for too long, are now being put ahead of Western tax payers and pensioners.

Similarly, if you think about it, in not seizing Russian assets to make Russia pay for the war in Ukraine, and the damage it has done to Ukraine, the result is that Western tax payers and pensioners are being made to pay. The interests of Russian taxpayers are being put ahead of those of Western taxpayers and pensioners (creditors). That should be a political scandal in the West. Why not?

Why are the interests of Russian tax payers sacrosanct above those of our own tax payers.

Now going back to the current topic of debt treatment, the IMF MO is to ask private creditors to share the burden in supporting a country in debt distress. Often private creditors have been part of the problem - they have lent into deteriorating credit stories and sustained bad macro/policy outcomes. In the case of Ukraine this is not the case as Russia is the cause of Ukraine’s problems and in fact private creditors were the good guys in lending to Ukraine in the run up to the full scale invasion helping Ukraine fund its defence, while back then Ukraine was still an improving credit story. What changed is Russia invaded Ukraine - Russia’s fault, it is responsible and should be made to pay first. But remarkably the IMF is asking Western taxpayers and private creditors to pay, but not the guilty party, Russia. How does that work? How is that fair/equitable and morally sustainable?

This is not a classic IMF case of burden sharing. Surely the starting point for the G7 and IMF here should be to make Russia pay, tap immobilised Russian assets for Ukraine, then focus on broader debt relief.

In conclusion, it is hard to see any near term debt treatment succeeding in reducing exit yield without all stake holders being honest about the financing challenges facing Ukraine. Any debt treatment therefore surely has to leverage the use of, as yet only immobilised, Russian assets to be part of the solution as they are the only way that Ukraine’s broader financing needs (budget, BOP and military - the $100 billion pa price tag) can be met, to ensure victory but also to ensure an equitable and morally correct outcome. Ukraine has to win this war, and to achieve that outcome Russia has to pay. The best service that private creditors can do for Ukraine at this juncture is to call out the holes in the IMF/G7 financing assumptions and call for it to be filled by resort to the use of as yet immobilised Russian assets.