The Planetary Significance of the Ukraine Debt Restructuring
September 13, 2015
Ukraine is a microcosm of the worst case scenario for the rest of the world. Broadly speaking, its problems are common to the rest of the world, just more deeply felt and the need for solution more pressing:
subject to a constant overhang of bizarre geopolitical shocks
at the rapier point of the commodity price collapse
Ukraine is particularly instructive because of how deep these problems run in its national economy. Let’s take stock of the solutions reached to date.
Whether it is merely time and chance in play or the common sense of the averaged Ukrainian voter, the country is not in the hands of complete, blithering idiots. The Poroshenko government and Natalia Jaresko in particular get it. This is a decisive advantage: just look at Greece in early 2015 if you want to see how complete idiots lead a nation to ruin. The core competence of the Ukrainian leadership and its finance minister in particular, is to the country’s definite advantage. Although the weight of necessity dominates any improvisational skill of these leaders, it is the interplay between the demands of the times and skillful improvisation in implementing the necessary solutions is what makes solutions meaningful.
Necessity requires a restructuring of the existing $18 billion sovereign debt pile. Outright default is not a real option as it will effectively lock Ukraine out of essential capital market financing and it will create nothing short of turbulence in its currency. It is also necessary to obtain concessions from creditors that make the debt serviceable, based on current conditions.
To this end, there was agreement on a sovereign debt restructuring. This deal is pretty much in the bag, as the government plans to complete necessary legislative procedures domestically and launch the exchange no later than Sep 15. Under the deal are 14 Eurobonds, including 11 sovereign Eurobonds and three bonds sold by a state infrastructure company and guaranteed by the state. The maturity profile is 2015-2023, and they are to be exchanged into nine new issues maturing in 2019-2027. Each new bond will have the same notional amount, mature on the anniversary of the issuance date and pay a semi-annual coupon. Each $1,000 of old bonds will be exchanged into $800 of new bonds. Interest on the old bonds accrued prior to the issuance date will be capitalized and added to the nominal value of the new bonds.
Ukraine proposed a 40% haircut on the nominal value of the debt. Creditors proposed no haircut, which was completely unrealistic from the start, by the way. Agreement was reached on a 20% haircut. Ukraine proposed a cut of the average coupon to 5%. It was agreed that the coupon on the debt was stepped up to an average 7.75% from the current average of 7.2%. Ukraine proposed a 10 year maturity extension on the debt, meaning a current 5 year bond would exchange for a 15 year bond. Agreement was reached on a 4 year maturity extension. There was a value recovery instrument linked to real GDP growth that is offered to creditor but not embedded in the bonds, so that it is a tradable instrument.
These deal parameters were very creditor friendly and much better than market expectation. As a result, the sovereign curve rallied by 15 points to 70% of par. Not particularly favorable to the Ukrainian position, but the needs of the times demanded it. Even though debt-to-GDP is only marginally impacted, the deal is beneficial for Ukraine. Here’s why.
First, the restructuring deal provides some breathing space for the economy. The maturity extension generates $11.5bn in balance of payments savings during the life of the IMF program (2015-2019) with a projected total balance of payments savings amounting to $15.3bn. This meets a key IMF technicality so that a broader $40bn Western aid package for Ukraine fully financed. Without the concessions, it never would have happened. Second, it unlocks capital market access by 2017, barring Putin is kept in check. A debt moratorium or outright default would guarantee that bond financing would come at prohibitive cost. There would be no possible economic recovery following this path.
Most importantly, the FX market will chill out. In fact, the deal already allowed the NBU to ease a number of its FX controls imposed early this year, increasing the cap on daily cash withdrawals from retail FX accounts. The regulator also relaxed restrictions on foreign currency purchases and access to FX in broad terms without bureaucratic hurdles. This is absolutely necessary for businesses and banks to normalize operations. Only then can the painful process of adapting to their new environment begin.
The new environment is quite different than the one faced even a year ago. Electricity consumption in Ukraine declined 18% y-o-y and electricity production declined 16.8% y-o-y. There is a dwindling trade with the Russian-led customs union. Disruptions in trade with Russia and falling grain, iron ore and steel prices were the major factors on the export side, while currency devaluation, domestic economic contraction and weaker oil prices drove imports. In 7M15, exports and imports declined by 33% and 37% y-o-y, respectively. Despite this collapse in trade, Ukraine still remains vulnerable to further negative terms-of-trade shock, as further declines in prices of major exports such as steel, grain and iron ore on the back of China’s economic slowdown may worsen the country’s C/A balance and external position.
From the perspective of the Ukrainian banking system, the economy appears to be stabilizing more than growing at this point. NPLs (overdue loans) increased to 17.9% of total loans, due to fresh net losses and the impact of currency weakness on F/X risk-weighted assets on balance sheet. NPLs (the narrowest definition used by the NBU) picked up in line with our expectation of problematic credit exposure continuing to materialize over time. The capital adequacy ratio stands at 12.4%, excluding banks placed into receivership. The combined capital adequacy ratio including banks in receivership is 8.0%.
To mitigate and assist in recovery, the Finance ministry put together a fiscal reform package to simplify the entire tax system and aid local businesses. The new initiative to cut payroll taxes for all businesses, streamline the system and phase out privileges is definitely positive. The reform’s key components include payroll tax rate cuts from 42% to 28%, making the personal income tax more progressive, and reforming VAT so it doesn’t disadvantage agriculture and new businesses. It also cuts taxes on gas production ventures to end dependence on Russia for its energy needs. There is also an objective harmonize excise taxes with EU levels. We’ll see if they can implement this plan in an even-handed and comprehensive way.
Even deeper than these reforms, corporates must adapt by following the pattern of the sovereign and restructuring debt. Businesses are already cutting operating costs and reducing debt. The whole economy is working through a debt re-work and cost right-sizing.
State rail monopoly Ukrzaliznytsya (UZ) published its 2015 financial plan approved by the government a month ago. Total freight turnover is forecast at 235bn tonnes-km this year, down 5% y-o-y due to the military conflict on the east. UZ plans to reduce its staff headcount by 17% this year alone. Factoring in planned salary indexation (+10% y-o-y), overall personal costs are expected to decline 9% y-o-y. On the debt side, UZ liability restructuring implies a reduction from UAH 42.8bn to UAH 37.5bn by end-2015, mostly on account of long-term debt (-UAH 5.6bn). Operating leverage measured by debt/EBITDA is expected to reduce to 3x this year from 4.7x in 2014.
The largest Ukrainian bank, Privatbank, launched a new offer to reprofile its $200m notes due September 23, 2015, proposing to extend the maturity from Sep. 23 to Jan. 15, 2016. The coupon will increase from 9.375% to 10.25%. Bondholders voting in favor of the offer by Sep. 2 will be entitled for a consent fee of $20 for each $1,000 of the principal. State-owned Oschadbank and Ukreximbank’s recently completed restructurings of $2.7bn in bonds had maturities extended by seven years and coupons increased by 0.8-1.25pp, with no nominal haircut. Finance & Credit Bank duly completed its recapitalization program agreed jointly with central bank in May. There was a UAH 2.5bn share capital increase to improve its liquidity position, ongoing debt restructuring, and a UAH 3.6bn reduction in related party loan exposure.
The key is for the successful sovereign debt restructuring to provide an anchor for a rally in the entire Ukrainian debt complex. Even though reduces public debt stock by only $3.6bn (20% of $18bn), representing 5.4% of the total.
But it creates a pathway for corporates to rework their debts and adapt their business models. Banks can convert the latest positive news flow on balance sheet strengthening into customer confidence and deposit inflows. The deal also makes possible a further reduction in FX restrictions and a quicker return to capital markets.
This will more than compensate for the modest impact of the debt haircut on the debt pile.
There is nothing divine in this, nothing even high-minded. It is the work of men navigating the nature of the uncertain and cruel world with skill. These recorded details should be studied by men in dire economic straights even though perhaps God takes little thought of such protozoan maneuverings.