Ukraine - to default or not

News this week that the Ukrainian state gas company, Naftogas, is reviewing its finances appeared ominous for bondholders expecting payment on a $335m Eurobond due July 19. $12m in interest is also due on the same instrument. The bond has a 5 day grace period.

The company had previously signalled it was going to pay and had the FX liquidity offshore.

Similar utterances have come from the Ukrainian MOF that they want to remain current - to do the right thing by bond holders - but obviously if Naftogas is having second thoughts about paying then there must be some doubt now about the sovereign’s willingness to pay a $1.4bn Eurobond due on September 1.

A Bloomberg article last week, from US based reporters (not Kyiv), had first raised the alarm bells for investors and it kind of suggested that the decision here is not been taken in Kyiv. It feels like Ukraine wants to pay but the UST is telling them to rethink.

Am I wrong?

Non payment is obviously a default and has serious long term consequences for Ukraine. But thinking thru some of the pro and cons of whether to pay or not, here goes:

Why it should delay payment/restructure?

1a) It’s a war stupid!

Look, Ukraine is at war, fighting for its survival, and its priority should be conserving cash to pay for arms, soldiers salaries and just meeting daily budget needs. Paying bond holders should be low on the list of priorities.

Fair.

1b) Why should Western taxpayers bailout greedy bondholder?

The old moral hazard line.

And the West has pledged $20bn to meet Ukraine’s budget financing needs, so why should this go out the back door in debt service payments?

Fair comment.

You could perhaps add that bondholders knew the risks in investing in Ukraine, and we’re told of invasion risks by Western governments. So they had time to exit.

Not sure the last point is entirely fair as before the war the Ukrainian government was telling the world that invasion risks were overdone. They were asking investors to have faith and stay invested. And again to be fair here investors participating in Ukrainian Eurobond issuance between 2014 and 2022 were helping fund Ukraine’s defence. They were backing the good guys! And if they had exited en masses before Feb 24, Ukraine would have been the loser by losing market access at an absolutely critical time - when it needed cash to build its military capability.

1c) It’s already in the price

With the Ukrainian curve trading down in the 25-45 cents range a restructuring is mostly in the price. Eventually if the MOF offers bond holders 60-70 cents in the dollar few would really complain. At this stage they would likely bite the governments hand off. True but Ukraine will still suffer the black mark of default and pay higher longer term borrowing costs as a result.

But what’s the counter argument? Should Ukraine just pay?

2a) A Ukraine default is a win for Russia

It would be somewhat ironic if just after the US Treasury forced Russia into default, partially to secure a PR win, it then allows, perhaps even forces Ukraine into default. This would be a massive PR defeat for Ukraine and the West. I can just see the Russian press “Ukraine is not a serious state, it cannot pay its debts, and it faces macro financial instability - it cannot pay its way, but is dependent on Western bailouts”.

Whichever way you look at it, a default is a failure, a black mark on Ukraine’s credit ratings and profile. Investors will remember and it will cost Ukraine over the long term in higher borrowing costs

2b) Lost market access

Once in default it will take time for Ukraine to negotiate to come out of default. No debt restructuring talks can proceed until the war ends, the IMF comes in and does a macro framework and DSA. Restructuring talks thereafter could easily take 6 months - they took 5 months in 2015. And thereafter it will take time for Ukraine to rebound up the rating scales and for yields to compress enough to make market borrowing worthwhile. I think it could easily be a couple of years before Ukraine can retap international capital markets. And that is time wasted when the country’s huge reconstruction needs should be a priority.

Remember here that Ukraine’s reconstruction needs are enormous, the Ukrainian side have suggested $750bn. There is no way the Western taxpayer can pay this - it will need burden sharing with the private sector. But the private sector will hold back as long as the whiff of default remains.

Default will delay reconstruction and make it more difficult.

2c) The numbers are small

As the MOF has previously argued, it’s external market debt service due this year is light in the bigger scheme of things - around $2bn to year end. This pales into insignificance when compared to Ukraine’s monthly $5bn deficits, and still circa $15bn in FX reserves.

Is restructuring really worth it?

2d) Collateral damage

A default would risk broader macro financial stability.

The NBU has done a valiant job in maintaining macro financial stability albeit with the loss of $12bn in FX reserves. But surely a sovereign default would risk accelerated capital flight, pressure on the currency and banks, and further depleting FX reserves. Likely it will make a difficult situation critical. And while the MOF has still had local market access via War Bonds, a default would likely close off all market access for the MOF, including domestic.

Not paying the $350m from Naftogas and the $1.4bn sovereign Eurobond in September will likely be more than outweighed by accelerated capital flight, higher borrowing costs and lost market access.

2e) Why should bondholder ms pay for Russian actions?

Well Ukraine is not responsible for the war, and should not have to pay for it, but really neither should bond holders. As noted above, they were backing the good guys, Ukraine, before the war and they still want to do that.

This then gets into the realm of thinking outside the box. There is talk about Ukraine accessing some of the $300bn+ in frozen Russian assets for reconstruction. So why should n’t some of this money be earmarked to ensure Ukraine remains current on its debts and avoids default.m? I have previously argued for some Brady bond type structure where Russian frozen assets are used as collateral to underpin its debts and future financing. This ensures default is avoided and keeps borrowing costs low.

And if that is the intention, then surely it makes sense to keep Ukraine current on its debts to avoid default until the point that Russian assets are freed by the West for Ukraine’s use?

The above would ensure Ukraine avoids default, keeps market access or is able to regain market access early, keeps better ratings and has the prospect of speedy improvement in ratings and in lower borrowing costs. Indeed, if Russian debts were guaranteed by $300bn plus in frozen Russian assets why could its ratings not be Investment Grade, not default settings? Again Ukraine would benefit from lower borrowing costs, access to more private sector capital for the rebuild and thus benefitting from higher investment and long term growth and recovery.

2f) This is all a distraction

Policy makers in Ukraine should not be fretting on default at this stage, or have the prospect of possible long running debt restructuring talks. So much is unclear at this stage so why make definitive decisions now - kick the can/buy time. Indeed, it’s still possible the war ends in the next few months, limiting the GDP hit and hit to its debt/GDP ratio. It’s entirely possible still that the debt to GDP ratio is well below 100% at year end and then improves quickly as the economy rebounds with reconstruction spend. So why commit to a default now when it might not be needed anyway?

The focus should be on the war.