Ukraine Update: Like Sticks Snatched From the Fire

The country needs peace to enable deeper integration with Western Europe to a large degree via Poland and get away from the vampire Putin.

  • The effects of market reform will lead to further inflation and poor growth in 2015, but it will accelerate balance sheet repair:Short-term pain for long-term gain.

  • The economic dislocations have led to some to some rules of bond pricing being broken.

The world’s wildest bond market looks a bit more interesting. Ukraine 2015 came in a bit after the cease-fire--may be no more than just accretion gains as the bond got a few more days closer to maturity. But for months you saw nothing but selling, now some stability. That got me thinking: Maybe the market is pricing in far worse rework terms than the facts warrant. Still, some serious cajones—or ovaries—as the case may be is needed here.

Ukraine yield curves 2-14-2015.jpg

I am emotionally connected to the Ukraine story, which in investing usually leads to a fate close to death. But it is getting more tempting for a few reasons.

First, the West has no intention of letting Ukraine fall back into Putin’s grubby little hands. Second, Ukraine has the most capable leadership in place since the Wall fell. Finally, you are seeing some price misallocations. I shall elaborate in what follows.

The curve stabilization means existential risk has subsided a bit. Default risk remains real and inevitable. In fact, an IMF package does not exclude a possibility of Ukraine restructuring on its FX debt. As long as the restructuring is limited to maturity extension, financial markets will accept and consider it as necessary and logical in comparison to the poor recovery value in the event of a straight-up default. Depending on what they get in aid from the IMF, maturity extension should be manageable and take place in 2Q 2015. The IMF doesn’t play, it is game over.

Here’s the necessary balance sheet data from what I gather.

ukraine finding needs.jpg

This shortfall of $2 billion makes creditor friendly terms possible:

  • No haircut

  • Full repayment of local currency debt

  • Re-profiling of external debt in consultation with creditors ex-Russia

  • 10-30% haircut in adverse conditions

In the worst case, expect a 50% haircut, capital controls and FX payment centralized through National Bank of Ukraine. Just don’t see this happening.

This worst case is not impossible because the Ukrainian economy is collapsing. It is a largely dollarized economy with multiple exchange rates. In short, Ukraine is a tough ecosystem to thrive in.

Consumer prices increased 3.1% m-o-m in January, bringing the 12-month inflation rate to 28.5%. This is due to continuous rapid growth in food prices marking their sharpest monthly spike since early 2008, as producers continued to pass increased costs on to end consumers. Fuel prices jumped as the decline in global oil prices was offset by UAH devaluation and increases in domestic taxes.

The hryvnia plunged in the first week of February (-24% YTD to UAH 25:USD based on grey non-cash market rates) and will continue to fuel inflation in the coming months. In addition, consumer inflation will be driven by further utility tariff hikes, particularly gas and heating prices, which are IMF requirements.

The National Bank of Ukraine’s (NBU) gross foreign reserves slid 15% m-o-m (-$1.1bn) to $6.4bn in January, equivalent to 1.3 months of 2015E imports. NBU reserves remain at a critically low level, reflecting Ukraine’s precarious external position. Given upcoming F/X debt redemptions ($0.6bn per month) and additional monthly F/X needs of $0.3-0.5bn to pay for imported gas, Ukraine stands to run out of reserves in six months without new external financing (or even earlier, by end-April, if Russia succeeds in accelerating a $3.0bn Eurobond due in December 2015). The NBU issued a press release in which called for a single exchange rate system and transparent exchange rate policy.

The National Bank is preparing for a banking shake-out which has the whole banking sector pretty spooked. The causes are 1) replacing multiple exchange rates with a unifying its official exchange rate and 2) replacing the heavily regulated interbank market rate (quoted at UAH 16.15:USD) with the actual market rate (UAH 21.50:USD) and 3) the economy is running poorly-run banks into the ground. All of this came to a head this week when a decent sized bank called NadraBank effectively went into receivership.

It is unclear how this is going to shake out. Ukrainian legislation on bank resolution provides for several post-receivership scenarios for troubled banks, including a sale to a new investor, transfer of part of or all assets/liabilities to a different bank, or liquidation. Nadra Bank effectively went into receivership, and the NBU is considering various options for its major shareholder, Dmytro Firtash, a local oligarch with a range of chemical, gas, media and other assets. The NBU has already offered to restructure the UAH 3.3bn loans drawn from the NBU in March-April 2014. Liquidation is the most probable option is for Nadra given its small retail deposit base (UAH 5.4bn or 1.3% of total assets. Recently Nadra Bank also offered its bondholders a debt-to-equity conversion scheme. Given it is likely going belly up and on NBU life-support, this is off the table.

The effect is that bond market dislocations are clear. The real star in Ukraine is MHP, a poultry producer that is priced way rich to the sovereign at the front-end, given its FX cashflows. This is wild, as a corporate rich to the sovereign breaks the rules of the game that the bond guys have laid out. Kyiv muni bonds cheap are cheap to the sovereign. The yield to maturity for the biggest bank in Ukraine, Privatbank, is wildly cheap reflective of the fears about the war, the economy, and the banking system in particular. It is rare for the largest bank of a nation to trade so wide to the sovereign.

Ukraine corporates.jpg

This whole thing still looks like trying to land a 747 on a tiny air-strip wedged in a mountain pass. So much is conditional on the coming debt re-works, sovereign and corporate. There is absolutely no slack available for the sovereign to step in and assist any of these guys. As it should be.


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