Ukraine, De-Corruption, and the Cold-Eyed Lizard

"Having done what what men could do, they suffer as they must."

--Thucydides

Like a poor imitation of Thucydides, I continue the effort to document the contemporary history of the Ukrainian transformation to a reasonably free, market-oriented, non-vassal state. First it has to go through a serious re-work of an unsustainable debt. At approximately the same time it has to limit the power of the nation's oligarchs. Lastly it has to resolve the problems associated with a flimsy banking system. It so happens that Ukraine is working through all three challenges at the same time. It sucks, but what is to be done but crack on.

The pressing question is the economic backdrop providing context to these problems and the national transition. Namely: on a scale of one to Bruce Jenner, how much of a confused disaster is the Ukrainian economy? The answer: Nowhere near the Bruce level, but it is pretty bad. That said, there is some morning light breaking throught the dark clouds now.

Before a really shiny day is possible, there is a lot of debt to restructure. When it comes to Ukrainian sovereign debt, it makes no sense to talk on a yield basis about the term structure anymore. The market has already front-loaded the probability of default on the credit curve, inverting the more immediate term. The default risk is tangible, so the likelihood of future cash flows is very low. Each bond price reflects the sole recovery value anticipated. Bonds assume a percentage of par based on recovery across the curve, so all bond converge to the same value.

The market says that Ukraine is effectively in default. When a country is in default, prices for all its issuance converge to a common price. The bid-ask spread as an indicator of liquidity indicates not much action, with and the appetite (on the run 17s) and apathy (off the run 18s) focused in the belly.

Ukraine bond prices.jpg

The market may be emotional and cruel, but it isn’t stupid. Ukraine Eurobonds stay weak, traded at 40% of par on average as markets rumor Ukraine might seek a 50% haircut on its external debt. Mid yield on Ukraine-2015 (due this fall) stands at 267% as its price now stands at 45% of par. 45% of par is a pretty reasonable recovery assumption, based on the rumor that the Ukraine government will request of creditors a 50% haircut.

Also, last week Russian Finance Minister Siluanov said Russia will not restructure Ukraine's debt and seeks accelerated repayment, as debt-to-GDP ratios exceed covenants. One shouldn’t begrudge the cold-eyed lizard (Putin) for wanting his money back and cash in his chips. Who knows if he will get it, but it is in fact this is a good thing: it indicates breaking links between the two countries. It is a fact that debt makes slaves, and Putin is a monster. Getting as far from him as is possible is a good thing in the long term.

It is a good thing for another reason. The oligarchs that have limited Ukrainian efforts to de-corrupt the country have been able to do so by playing Putin against Kyiv. These flank attacks will be much less frequent with Russia breaking financial and other ties to the oligarchs. We actually have a case of this coming to the fore between the largest oligarch Igor Kolomoysky and Poroshenko. Here’s the story.

The government replaced the CEO of oil transportation monopoly Ukrtransnafta and proposed legislation allowing a change in management at top oil producer Ukrnafta was met with severe resistance from Kolomoysky’s Privat Group, which under previous Ukrainian administrations had gained de facto control of both these companies despite the state being a controlling shareholder. Igor Kolomoysky is both the owner of Privat Group and is Dnipropetrovsk region governor. Privat also controls Ukraine’s largest bank and one of the largest domestic TV channels, among other assets. This had implications for the security situation in the east, given Kolomoysky’s strong political clout in the Dnipropetrovsk and Odessa regions. Both had relatively strong pro-Russia sentiment before the invasion.

Despite his strong political leverage and financial and PR might, Kolomoysky tendered his resignation as Dnipropetrovsk region governor and President Poroshenko accepted it. This indicates a behind-the-scenes settlement that changes the rules of the game for everyone. Poroshenko gaining the upper hand in this conflict means that the state is capable of keeping oligarchs in check and institute a level-playing field in the economy.

Natalie Jaresko did a nice flank attack of her own, working to reclassify the $3 billion Russian debt as unofficial private sector debt with the IMF. If it is not official debt, then that clears the way for a selective default on Putin, as the Fund’s “policy of non-toleration of arrears to official bilateral creditors” is of no effect. She also subtly firmed her stance with bondholders with respect to intransigence.

Get all the bad news out of the way and move forward with a cleaned-up balance sheet. That’s the whole point of a restructuring.

The next step is growth. The Ukrainian economy is massively affected by two massive price swings, one good and the other bad. The oil price collapse has limited the economic implosion to some extent. The steel price decline has been less pronounced but still painful. That said, GDP is down double digits over the last six months and inflation is running about 30%.

Growth will be hard with the banking system in such bad shape. I would say that the money market, the place of constant and chronic borrowing here and there is still in disrepair given that it is anchored by an overnight rate over 20%. This is being taken care of via a self-organizing map consisting of wind-up, consolidation and recapitalization.

On the recapitalization front, Privatbank, the largest Ukrainian bank by assets, announced a $225m share capital increase to be completed by end-June 2015. The capital injection is in line with the Ukraine’s commitment under the IMF program to have its top-15 banks recapitalized by end-1H15 based on results of last year’s stress tests. Privatbank already increased its capital by UAH 1bn in 2H14, so equity would reach $1.1 bn. Finance & Credit Bank completed a $26m share capital increase, boosting its equity by 22%. Dilution isn’t over by a long shot.

On the wind-up and consolidation stuff, the National Bank of Ukraine liquidated VAB Bank following its four-month receivership. First Ukrainian International Bank (FUIB) announced the completion of legal procedures to merge with Renaissance Capital Bank. The enlarged bank’s total capital did not change but regulatory capital increased by $13m at current F/X rate. FUIB expects the merger on the operational level (consolidation of networks, products and services) to be completed by end-2015. The consolidation due to the current challenging environment in the domestic banking sector making it more difficult to maintain two separate banking operations. More consolidation is coming. Hopefully foreign participation will have a fair opportunity.

In all, things are seldom as good or as bad as they seem at first glance. Hope does play a role because sovereign debt depends on both the ability and the willingness to sacrifice. The latter depends on keeping hope alive. And things are getting better, simply by virtue of resetting the system that is Ukrainian society. I don't have the energy to tell anything but the homely and terrible truth.


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