Ukraine's bond restructuring talks are in high gear, and, as ever, Russia is the trouble du jour. Not only is it threatening to hold out in the bond deal and take Ukraine to arbitration, Russia also seems poised to block International Monetary Fund (IMF) disbursements to Ukraine using an arcane Fund policy on "lending into arrears." My hunch is that this last risk is overblown, and in any event should not drive IMF policy or Ukraine's restructuring strategy.
The latest controversy, wherein Russia argues that its $3 billion Ukrainian Eurobond is government-to-government ("official") debt to escape bond restructuring, is especially ironic. Just last year, Russia argued that the bond was commercial debt and refused to list it in the Paris Club of official creditors, presumably to escape official debt restructuring. In other words, Russia just wants its money back.
For its part, the IMF has a policy of not lending to countries in default on official creditors. Countries in default on private creditors used to be treated the same way; however, since the late 1980s, the policy has been relaxed to permit IMF lending so long as the debtor negotiates with its creditors in good faith. In 2013, IMF staff suggested relaxing the policy on official debt in line with the policy on private debt, but the change is yet to come up before the IMF executive board. Until it does, it seems like Ukraine cannot default on its bond to Russia for fear that it would block IMF funds.
But the bond does not mature, and does not need to go into arrears, until December 2015. There is an interest payment due on June 20, which is likely to be made in any case, since the bond restructuring will not close before then. Waiting until December may give the IMF staff and executive board enough time to change the policy on arrears to official creditors per earlier proposals (a change requires a majority). While it is undesirable for governance reasons, the policy change could even be approved at the same time as a disbursement to Ukraine. IMF lending policy was amended this way in conjunction with its financing for Greece, though few are anxious to relive the experience.
Waiting until December entails some risks. Ukraine's other creditors might balk at restructuring early in the year, without knowing what would happen to Russia's bond. Russia could also use its notorious debt-to-GDP clause to accelerate the bonds at any time before December or simply gum up the process of reforming the IMF's arrears policy.
An alternative would be for Ukraine to dispute the bond, for example, claiming setoff against Russia's missed lease payments on the Black Sea port of Sevastopol, which stopped when Russia annexed Crimea a year ago, and against Ukrainian state property left in Crimea. According to footnote 10 in the IMF's 2013 paper :
The LIA [lending into arrears] policy does not apply to arrears in dispute. Under this practice which arises from the Fund's duty of neutrality, where the Fund accepts a member's representation that the validity or amount of a debt claim is in dispute, such disputed claim does not give rise to arrears for all Fund purposes.
Although the bond has a no setoff clause, Ukraine could dispute the enforceability of the clause (war and such) along with the bond. It does not need to win, just to dispute in good faith, which should not be a high bar in this case. The IMF notably refused to intervene when Ecuador contested the legitimacy of its bonds using rather more controversial arguments. Ukraine could also test more exciting offset theories, like trading sovereignty or odious debt—though it might prefer the conservative route. The fact that Ukraine has not disputed the Russian bond until now could cut against it but should not be fatal. Making the bond unenforceable under English law would take some of the burden off Ukraine.
I agree with those who say that trying to draw policy distinctions between official and private debt based on the Russian bond is more trouble than it's worth. The bond was deliberately designed to be both official and private. It is private in form, official in substance, and can morph to Russia's advantage. Classifying it one way or another could implicate hard policy questions like the treatment of bond holdings by sovereign wealth funds and central banks, as well as trading in Paris Club claims. Because of their significance for other countries, these distinctions could prove contentious and become a costly distraction from the Ukraine program.
I suspect that the Russian bond will be renegotiated in the end, somewhere in the twilight zone between private, official, military, and political settlement. Until it happens, other creditors and Ukraine might be better off avoiding linkages between this bond and other financing. Just recently Russia threatened to take Ukraine to arbitration if it does not pay up. (Under the bond contract , it has the option of suing in an English court or arbitrating under the rules of the London Court of International Arbitration.) Since arbitration takes place behind closed doors, if Russia makes good on its threat, we may never know how the story ends.
A version of this essay was posted on Credit Slips.