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Ukrainian Renegotiations

Wo aber Gefahr ist, wächst Das Rettende auch.

<Where the danger is, so grows the saving power.>

—Hölderlin, Patmos

I’ve been watching Ukraine more closely the last few weeks, more out of curiosity than any desire to put money to work there. Bond markets, cold and merciless things, do offer some reason for interest in Ukraine on a yield basis. There is an even bigger appeal, especially in corporate paper: positioning for the distressed renegotiation of terms. The current situation has distressed bonds so much that some issuers are already pushing for a conversion of existing debt into notes with extended maturities. I expect this to become more prevalent. If you play it right creditors can exchange current debt for an extended maturity note with decent pick-up in higher yield. If the price is right, you can come out whole and then some.

That’s a bond market for you: A shot of shared sacrifice chaser by an explicit take-everything-you-can-get-attitude. What comes out of this is always a toughened, more capable set of survivors. As in all ecosystems—and the bond market is an ecosystem—life adapts to changing circumstances. But once the renegotiations and the restructurings it entails are in place, there is a good chance for value and something good to come from all the pain.

Frankly, the situation is currently defined by military more than macroeconomic news flow. This news flow is a vile and rancid sausage indeed. The headlines: 1) Ukraine’s FX reserves are critically low 2) State finances require life support to avoid default 3) the global economy is anywhere from soft to flacid and this is not growth-supportive for Ukraine and 4) The country is being invaded by a large and aggressive kleptocracy.

There are always a few gems to find in the muck if you look hard enough. These gems include a commitment of $2 billion in loan guarantees from the US, and a commitment of about a quarter of that from the EU, which actually has a tremendous impact. The EUR 500m tranche of the EU Macro-Financial Assistance package and $130m of domestic F/X-denominated bond proceeds fully offset scheduled F/X debt repayments. Combined, these moves back up the boilerplate verbiage and suggest the West is not going to walk away from Ukraine. The USD and EUR loan guarantees will only go so far and probably not enough. Ukraine’s FX reserves are enough to cover about a months’ worth of imports.

Also, the Chinese market is opening up to Ukrainian exports. Ukraine is also keen to foster closer trade with China, by activating a $2.4bn CNY/UAH swap deal with China, to finance trade contracts. The NBU and the People’s Bank of China (PBC) signed the three-year extendable swap deal in June 2012 but have not activated it until now. The bad news is that China accounts for only about 6% of Ukrainian trade. Offsetting this, the CEEMEA region is in absolute implosion mode.

Finally, sometime in February it looks like official donors (read the IMF) will have an agreed-upon Ukrainian stabilization package and will offer bridge financing conditioned on it. This is a mixed blessing. IMF stabilization packages always bite hard, and this one will focus on phasing out gas subsidies and generating a primary surplus through austerity measures. Artificially low gas prices for heating utilities are a major part of the financial burden for the state-owned energy company Naftogaz Ukrainy, and through these subsidies, a major drag in the state budget. Get this: The company effectively sold imported gas to heating utilities at less than 20% of cost. Something has and needs to give there.

This is Ukraine in early 2015. Unlike its invading neighbor Russia, it’s not Europe’s gas station. It is on the precipice of default, meaning extremely short dollars and euros and facing margin calls. The economy and markets operate in an inhospitable environment far removed from the central banks (thermal vents) that generate USD and EUR energies. The society has to adapt. Generally speaking, Ukraine will look a lot like an East European Detroit given the country's severely declining birthrate, currency crisis and generally low, vodka-abridged quality of life. That said, some Ukrainians are, of course, very beautiful, life-affirming and totally rock a cardigan over a sundress on a breezy sunny day; some of them are mal-educated, broke, and angry.

Strictly speaking, not so different than the rest of us, right? The whole human hive on the surface sure looks like 50 shades of grey, stained concrete bunkers housing a cluster of bored, uninformed consumers serving merely to monetize their opinion about this or that potential good or service. It just goes to show that this seemingly grueling march from birth to death is merely a cover for something deeper. Innumerable babies being held, joyful weddings, fervent prayers, loved ones wept over all show that life is more than a big pile of data waiting to be assimilated and processed and then archived after our inbox gets full.

There is another pesky problem: Ukraine is also on the verge of full-scale war. For those of us in the comfort zone of wealth and ease, well, the worst news is when there is much less overall wealth and ease. In hard hit, war-torn areas, life is always reduced to the lowest common denominator. Hobbes called it life that is nasty, brutish and short. So it is vital that Ukraine reduces its public debt and do some balance sheet repair, and quickly. To do this, Ukraine can choose among five options, not mutually exclusive.

The first is to attempt to grow GDP faster than public debt in order to reduce the ratio. This is accomplished through deregulation, economic reform, and attracting foreign and domestic investors to buy inefficient assets on the cheap and make them run more efficiently. This is the track that the IMF always puts a country on and it seems to reap long-term benefits. This is probably not good enough to stabilize the debt ratio in the short-term. In the short-term, it fosters demand implosion and supply shocks which are not conducive for growth. The IMF will treat an economy better than a cold unfettered market would, but not much better.

The second option is another IMF favorite and is nowhere near as convincingly beneficial. Pursue fiscal adjustment (cost cutting) until the primary balance—the budget balance without debt interest payments—is positive. It is true that Ukraine needs serious fiscal retrenchment, but this heightens political risk from voters who can fall to austerity fatigue and welcome a banana republic or worse. In short, reducing the deficit too quickly can screw growth prospects and endanger the recovery not to mention social stability.

Another tried-and-true option is financial repression. This involves central bank and state-dictated measures such as interest-rate caps, direct lending to the government or regulation of capital flows. Another repressive technique is to rely on inflation by expanding the central bank’s balance sheet. Ukraine’s public debt is fixed in nominal terms, exempting any possible future linker issuance, so higher inflation means a lower real value for repayments. This will work in Ukraine’s local FX (money and interbank markets), but will likely only make external FX shortages even worse. This ends up destroying credit risk and increases reputation risk. And it screws over the populace. The subsequent political backlash and legal issues can make things even worse as far as securing financing in the future.

The radical option is to renegotiate (read: get better terms from creditors without formal legal action), restructure (read: have a court work out the renegotiation in good faith because debtors and creditors can’t agree on terms), or fully default (read: the situation is so low that debtors lose all and creditors get recovery) on the debt.

Ukraine corporates have no such tricks. They have to consolidate balance sheets and many have no choice but to try and renegotiate their debt as well. Metinvest succeeded in negotiating a maturity extension with its creditors, but to make the offer agreeable had to offer a 25bp higher interest rate (10.5%) and an amortization schedule. Iron ore miner Ferrexpo is now in the same position, offering the holders of its $500m 7.875% Eurobonds maturing on Apr. 7, 2016 an exchange for new amortizing notes redeemable in two equal parts on Apr. 7 of 2018 and 2019. The offer includes a 20% upfront cash payment and a coupon rate of 10.375% (250 bp over the current bond). Proposed covenants include new borrowing limits contingent on a leverage ratio (Debt/EBITDA) exceeding 2.5, and a cap on dividend payments of $60m annually. Ferrexpo’s outstanding bonds currently priced at 75 to yield 32%, the proposed exchange terms imply YTM of around 24%. Given that iron ore prices are in the toilet, we’ll see how that goes over. Creditor expectation is nearly unanimous that we will see a large chunk of the corporate sector try to renegotiate terms given the environment, which explains the absolute lack of liquidity in the debt market.

So financial repression is in clearly place and economic and especially bank results are an indicator of how screwed up the situation is. Global growth prospects, especially in Europe are dismal in the new normal, and even worse in Ukraine. Fiscal adjustment is simply (as we have seen in Greece and others) inadequate on a feasible scale without inducing an economic heart-attack. Inflation on a global scale, despite epic monetary stimulus in the external currencies, is going the wrong way. This leaves default or restructuring.

Empathy is alien to a bond market, but it isn’t stupid. Bond markets are indifferent to corruption, oppression, waste, intentional neglect and abuse. They are very fine arbiters of taking a deal when default looks unfavorable to a creditor. This is because bond markets are only concerned with credit risk and getting paid. They navigate from the present to the future by holding debtors accountable to the commitments they make now, and can be flexible based on changing expectations. They are the best tool we have for the work because future possibilities are not fixed, and markets update based on a high-frequency stream of information better than anything else. Markets are always in a state of, at best, self-organized semi-stability that occasionally has a violent lurch due to external shocks.

Figuring out what will happen is just throwing random statistics at giant socioeconomic dart boards of vague conjecture. We can merely play the odds based on the given information. There are always astonishing, wonderful, terrible things happening, unlike anything we presently imagine. We will keep on astonishing ourselves. That's just the way human energy moves.

Holderlin was right, man. The most interesting things happen when the tails of a return distribution create the most meaningful outcomes.

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