Ukraine's Bond Restructuring: Surgery, Conspiracy, and Campaign
Debt restructuring is the second largest source of outside financing for Ukraine's new International Monetary Fund (IMF) program. The Fund itself brings $17.5 billion over four years; $9.6 billion comes from governments and other multilaterals (including Europe, the United States, and most recently, China), leaving $15.3 billion for the "debt operation." The jargon makes debt restructuring sound like a mix of surgery, conspiracy, and military campaign, which together pretty much sum up Ukraine's challenge.
First, the surgery. The IMF has been unusually prescriptive about the debt deal parameters, even as it tells Ukraine and its creditors to get there voluntarily ... by the first program review in June 2015. On top of $15.3 billion in cash flow savings (out of $19.9 billion in scheduled payments, see table), Ukraine has to get its debt stock under 71 percent of GDP by 2020, and avoid payment spikes long after the program ends. Gross budget shortfalls cannot exceed 12 percent of GDP in any given year and 10 percent on average through 2025. This is quite a turnabout from less than a year ago, when IMF staff and management described Ukraine's debt as "sustainable with high probability" subject to "uncertainties that come from geopolitics" (or: who knows, but keep paying for now). Over 2014, public debt went from 40.6 percent to 72.7 percent of GDP; it is headed for 94 percent in 2015—up from projections of 63.5 percent a year ago.
After a year like that, it is hard to blame Ukraine and the IMF for choosing to restructure now, rather than bank on more "high probability ... with uncertainty." Uncertainty is more commonly dealt with by kicking the sovereign debt can down the road. Asking for principal reduction up front in Ukraine breaks with tradition. Bondholders representing some $10 billion (not including Russia) said that they would just as soon not; the government said it meant what it said. The credibility of this decision hinges on official donors' resolve, more so than Ukraine's. Unless things turn around quickly, higher payments to creditors must come either from other creditors or the donors.
Second, the conspiracy. Ukraine's debt stock is extraordinarily concentrated. By most accounts, one creditor (Franklin Templeton) holds at least $6.5 billion, or more than one-third of the sovereign bonds outstanding. Russia holds 100 percent of a $3 billion bond, maturing in 2015. Russian banks are rumored to hold another $2 billion to $3 billion, which would be especially significant if they were to act in concert with the government.
A concentrated bond stock is a mixed blessing. On the one hand, Ukraine does not have to chase thousands of anonymous bondholders scattered about the world and reconcile a myriad of creditor priorities in its debt restructuring offer. On the other hand, it cannot have a successful restructuring without the participation, or at least acquiescence, of all the large creditors.
Large creditors have veto power over the deal both as a matter of arithmetic, as well as Ukraine's bond contracts. While these contracts have collective action clauses that permit creditors representing slightly more than half of each bond issue (75 percent of a 66 2/3 percent quorum) to approve new terms and bind the rest, these cannot work if the largest creditors balk. Word is that the largest creditors and groups of creditors acting in concert hold blocking positions in all the bonds. If they vote against Ukraine's proposal, it fails. On the bright side, if they vote in favor, the small fish are bound. This holding pattern makes the bond restructuring look more like a bank restructuring of old. However, if there are a few small issues not controlled by the elephants, they could cause a fair amount of trouble and get repaid.
The bond contracts do not permit Ukraine to hold a single aggregated vote across all its bonds, which could overcome holdout blocks in individual issues. Because they are governed by English law, Ukraine cannot use its domestic laws to change the voting rules retroactively, as Greece did in 2012 .
On the other hand, the contracts arguably leave scope for more coercive legal tactics, including domestic laws subordinating and withholding payments to contumacious creditors. Ukraine may well threaten to use them if the talks break down, which could prompt lawsuits in English courts—seeing as the contract provisions in question were likely intended to permit the operation of ordinary tax laws, not nuclear restructuring options. Lawsuits could gum up the restructuring, exacerbate uncertainty, and thus run counter to the core objectives of the IMF program. Nevertheless, Ukraine, its donors, and the IMF should not allow generalized fear of lawsuits to drive restructuring strategy. There is no way to eliminate all threat of litigation in high-stakes negotiations such as these. Default and aggressive legal tactics may be Ukraine's only options in the face of a veto threat from large creditors.
Third, the campaign. Many of us have written about the wacky Russian bond, most recently here and here. From the design perspective, it is a beauty—it gives Russia a mix of contract and institutional leverage that may well be unprecedented. While it is super-easy to get tied up in pretzels over its many hooks and pointy parts, it is better not to.
As a practical matter, Ukraine's leverage comes from its willingness to default. Russia has lots of ways of making it unpleasant. Trying to anticipate its next move is not worth the Ukrainian officials' scarce time and energy. Unless Ukraine's partners are willing to sanction the bond outright (an option that remains available to them if all else fails) and until there is a political settlement, the government should keep treating Russia as just another creditor.
A version of this essay was posted on Credit Slips.