from Macro and Markets and Strengthening the Framework for Sovereign Debt Restructuring

Financing Ukraine: Time for an Honest Assessment

August 28, 2014

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Russia’s invasion of Ukraine (“incursion” is far too polite a term) represents a major intensification of the conflict and should cross all red lines the West has established.  The logic of the earlier, incremental approach—put modest sanctions in place, and let the threat of worse create a chilling effect on investment and trade—has reached a dead end.  Whether President Putin seeks a stalemate within Ukraine or something more menacing, full sectoral sanctions (including, importantly, Russia’s access to payments systems) should now be put in place as a firm signal of western resolve.  The real cost-benefit to be done is not the costs on the West compared to Russia. Rather it is those relative costs contrasted against doing nothing and risking a situation that brings us closer to either armed conflict or acceptance of a new rule that states can redraw boundaries by force. German President Merkel has signaled that further sanctions are on the agenda for the September 30 EU leaders summit, and I expect the Obama Administration will move with them if not before.

While military developments will dominate the headlines in coming days, Ukraine’s economic collapse should not be forgotten.  Another necessary piece of the West’s response is enhanced economic assistance. The IMF meets tomorrow to conclude their first review of their program for Ukraine.  They will, no doubt, forgive the slippages and missed commitments and conclude the review, which will clear the way for disbursal of at least $1.4 billion.  The Fund has also signaled today their willingness to move money forward from the back part of the program –“recalibrating” the program—in order to meet a widening financing gap.   This could include boosting the next disbursement, or combining the next two reviews, in order to get more money out the door to Ukraine in coming months.

The bottom line is that the Fund must acknowledge a major revision to its outlook for Ukraine.  That makes sense, as the original program assumptions (see below) were wildly unrealistic at the time and are a dead letter now.  The deterioration of economic conditions since that time is significantly due to Russian aggression, but not entirely. The legacy of past economic mistakes and even modest austerity is contributing to a deep economic recession. I suspect that the worsening on the situation on the ground likely makes even these new assumptions a receding hope. A  realistic forecast would show a widening fiscal hole and unsustainable debt dynamics, even assuming Ukraine remains whole and free.

That means that the real message from tomorrow’s IMF Board meeting will be that the program is badly underfinanced, and will need a substantial rethink in coming months.  That means either substantially more bilateral assistance from Europe or debt restructuring.  Markets still do not price this outcome.  Many market analysts note that there is only one sovereign-backed Eurobond maturing this year, a $1.6 billion Naftogaz bond due at end September, and that the IMF program already in principle provides the financing to pay this bond.  Why then make waves ahead of parliamentary elections scheduled for October 26 and given the uncertainty of Russia’s actions?  I have sympathy for this argument, but at the same time, the Fund’s internal rules require it to assert that the program is adequately financed, which means looking forward two years.  Further, there may well be strong political as well as economic benefits for the Ukrainian government of a more full-throated effort to bail in its creditors.  Honesty (and credibility) requires the kind of warnings that will make headlines in coming days.  It is hard to imagine that we do not begin to have the debate.

Original IMF  Program (5/14) Current Market Estimates
GDP Growth in 2014 -5.0% -8.0% to -10.0%
Public Debt/GDP in 2018 61% 70%–80%
Exchange Rate (per USD) in 2014 10.5 13.9 (current rate; 16 in black market)
Fiscal deficit/GDP in 2014 -8.5% -10% to -11%