How to Help Ukraine and Offset Russia's Advantage
As fighting with Russian-backed forces escalates in its eastern region, Ukraine has turned to mending its finances. In recent weeks Ukraine appointed a debt restructuring advisor and requested a new support package from the International Monetary Fund. While new outside funding is indispensable, relief from debt payments later this year would give Ukraine breathing space for reform and offer an opportunity to neutralize Russia's advantage.
Any day now, Ukraine's bondholders will be asked just how much less and how much later they wish to get paid. The catch is that the Russian government is among Ukraine's largest bondholders; it holds billions of dollars in Ukrainian debt and some of the best cards in the upcoming debt negotiation.
Among these is a $3 billion bond coming due at the end of 2015—a source of risk and target of opportunity for Ukraine and its allies.
The Russian-held bond is big: It amounts to a little less than half of Ukraine's currency reserves, and, coincidentally, is equal to the amount of aid just pledged by the United States to Ukraine. It has terms uniquely favorable for the creditor and found in no other Ukrainian bonds: Russia can demand early repayment and trigger default unilaterally. Meanwhile, Russia controls enough Ukrainian debt directly and through proxies to disrupt a restructuring vote among private creditors. President Putin showed off his intimate knowledge of Ukrainian bond contracts, unusual for a head of state, when he observed Russia's advantage in a recent interview on German television.
The way out of for Ukraine lies through London. Because Russia's $3 billion bond is governed by English law, it could be made unenforceable with a simple act of the UK parliament. Such an act would neutralize Russia's unfair advantage over Ukraine's other public and private creditors and make the debt unattractive in the secondary market, while preserving for Ukraine the possibility of repayment as part of a political settlement. Uniquely among sanctions, it could deliver direct financial support for Ukraine, while safeguarding the integrity of the London financial market and the English court system.
President Putin lent Ukraine $3 billion in December 2013 to help prop up his ally Viktor Yanukovych, then fighting for his political life amid street protests. The bond, bought by the Russian sovereign wealth fund in contravention of its own investment guidelines, was openly described as payment for political loyalty, designed to keep Ukraine "on a tight leash." This is not unusual among governments. What is unusual is Russia's refusal to do what other governments do when such investments go bad: restructure the debt alongside other governments in the Paris Club of government-to-government, a forum that has been in operation since the mid-1950s. Russia has been a creditor-member since 1997; it has also received debt relief from the Paris Club in the past. Despite the patently noncommercial character of the bond, Russia maintains that this bond should not be dealt with by the Paris Club.
The $3 billion Yanukovych bond puts Russia ahead of Ukraine's private creditors with a rather unique clause that lets it demand early repayment once Ukraine's debt exceeds 60 percent of its GDP. Russian officials note that this threshold has been breached, so that it could call for repayment at any time. In addition, Russia can keep its bond out of any deal Ukraine might offer to its private creditors for as long as it retains a blocking position (likely half of its $3 billion) in a restructuring vote. With at least $3 billion in holdout debt, and possibly more, if Russia's proxies or any other creditors block restructuring of Ukraine's other bonds, the remaining investors would have to absorb deeper losses.
A recent study (available here) confirms that reducing payments on the Yanukovych bond would substantially improve Ukraine's financial position amid ongoing military conflict and the attendant uncertainty, political and economic. Some commentators have advocated that Ukraine simply walk away from this debt as illegitimate, or "odious," but Ukraine bears considerable downside risk from this strategy compared to sanctions. Others suggest compensating Ukraine for the loss of assets in Crimea by subtracting their value from the debt to Russia. Again, the onus would be on Ukraine to stop paying and establish in court Russia's liability, along with the value of Crimean assets.
Yet others have expressed concern that sanctions involving debt contracts would be a threat to London's financial market and the rule of law.
Such concerns are unfounded. First, the real threat to court and market integrity comes from enforcing political favors dressed up as commercial contracts. Centuries of contract precedent bar enforcement for claims from creditors who slipped to the head of the line on the eve of the debtor's bankruptcy. Such debts are routinely disallowed or subordinated in bankruptcy precisely because they abuse the rule of law and sanctity of contracts. Such "fraudulent transfers" should not get a free pass just because there is no bankruptcy law for sovereign governments—nor should Ukraine's other bondholders or taxpayers in donor countries finance Russia's gaming of the system.
Second, sanctions often break contracts. Debt contracts should fare no better than blocked bank transfers or helicopter warship sales. Ironically, closing the courts to the Yanukovych bond would be less intrusive than banning such transfers or sales—Ukraine is free to pay if it wishes; Russia's undue leverage is diminished, but the debt remains.
Third, the UK parliament has passed similar laws before, in the early 2000s for Iraq and in 2008 for Heavily Indebted Poor Countries. Such laws simply recognize the political imperatives behind some sovereign debt. A narrow, principled and predictable sanctions framework is the best way to deal with this problem going forward. Closing English courts to the Yanukovych bond is a sensible and moderate place to start.