Celebrating Independence – still
On Aug. 24, Ukraine celebrates Independence Day.
In recent years, and reflecting on events following the EuroMaidan Revolution, the annexation of Crimea and then the ongoing conflict in Donbas, the event has been an emotional affair.
Last year there was a large scale military parade through the streets of Kyiv. This was meant to show off Ukraine’s improved military capability, with some newer military equipment on display – the aim was to send a message to Russia that Ukraine had an improved ability to defend itself.
This was though followed soon after by the humiliating defeat of Ukrainian forces at the battle of Ilovaisk, which was subsequently subject to an inquiry over the conduct/efficiency of Ukraine’s military. This time around, and given the fragile security situation in the east, there appears little appetite to provoke Russia and there will not be a similar parade, but with a more civilian-centered set of events.
Perhaps symbolically, President Petro Poroshenko is then set to jet off to Berlin for discussions with Chancellor Merkel and President Hollande. Center stage in those discussions is likely to be progress in implementation of the Minsk II ceasefire agreement.
Merkel’s foreign minister, Frank Walter-Steinmeier, was in Moscow last week and appeared to have been told by his Russian counterpart, Sergei Lavrov, that the Western signatories of Minsk II need to do much more to ensure implementation of key parts of that agreement, particularly related to constitutional reform in Ukraine, including moves to a more federal structural of administration, with the devolution of powers to the regions.
The devil is in the detail
A constitutional reform bill, which includes the devolution of greater powers to the regions, has passed a first reading in the Verkovna Rada in Ukraine on July 16, was approved by the Constitutional Court on July 31, and is due to be debated for a further reading in an extraordinary session of the Verkovna Rada on Aug. 31.
Poroshenko will hence hope to tell his Western counterparts, that progress is being made, and that Ukraine is fulfilling its side of the bargain as per Minsk II.
The problem is that rebel leaders in separatist areas of the Donbas have rejected the current constitutional reform bill as not going far enough – the assumption is also that this reflects the view of Moscow. The rebels, and presumably Moscow, favor a much more far reaching constitutional reform for Ukraine, more akin to the Swiss style model, where cantons (oblasts in Ukraine’s case) have veto power over national policies, and importantly on such issues as NATO membership and European Union integration/orientation.
The problem (there are many with respect to Ukraine) is that any government in Kyiv simply cannot accept such a constitutional reform – it would be political suicide, primary as the domestic consensus is that the drive for such a reform of Ukraine’s constitutional structure is not aimed at improving governance, democracy or the representation of the population of the east, but stopping Ukraine’s Western orientation and reform efforts.
And an agreement seems illusive
So a constitutional reform bill looks set to be passed which is unacceptable to the rebels, and Moscow, and it will be almost impossible to implement in the east. Local elections which are due to be held across Ukraine in October will unlikely be held in separatist-controlled areas of the Donbas – or not under the jurisdiction of the Ukrainian electoral committee.
Holding elections in the separatist areas before year’s end was also a condition of Minsk II, which would then allow for Ukraine to retake control of its own borders by year end. Clearly this is not going to happen.
The security situation on the ground is difficult
The security situation on the ground seems to be deteriorating – that seems to be the message from “neutral” OSCE observers, with the casualty count stepping up significantly in recent weeks. This has been a common trait in the run up to summits/meetings related to the crisis in Ukraine, as the combatants look to improve their negotiating positions ahead of talks. The messaging from Moscow is that without an agreement over constitutional reform the security situation on the ground will deteriorate further and very significantly – the aim seems to be to put pressure on Western leaders to force Ukraine to concede to Russian/rebel demands over constitutional reform.
There have been reports of the build-up of large numbers of Russian troops and equipment across the border in Russia.
I think it has been quite notable this week that Ukraine has moved to trying to calm down talk over the state of the security situation in the East – evidently it wants to head off the prospect of Poroshenko being ambushed in Berlin, as proved to be the case in Minsk in February. The message from Poroshenko to Merkel/Hollande perhaps will now be that we can manage the current situation on the ground – albeit we still need continued Western support.
Poroshenko will be looking to reassure in Berlin
It will be interesting to see how Russia reacts should Merkel and Hollande secure no further concessions from Poroshenko over constitutional reform. Russia will then have to make a decision as to whether to further increase “pressure” on Ukraine through “other routes.”
Kyiv seems to think that it can call Moscow’s bluff on this one, as Russia has proved reluctant to be pulled into a fuller blown conflict in Ukraine, with a less than clear exit strategy. Putin will likely has to decide whether he wants to risk “doubling up”.Gas issues are now a sideshow.
The gas/energy angle was viewed as one such route for Russia to leverage its interests in Ukraine. However, with oil/energy prices dropping, and Ukraine reforming/rationalizing its own energy consumption and supply, its leverage therein also appears much reduced.
Ukraine likely has reduced gas import needs from Russia this year to the low single digits in BCM. Note that the EU has been working hard to “broker” better gas/energy relations between Russia and Ukraine, and has been looking to secure a Russia-Ukraine Gas Protocol for gas supply/pricing through to March 2016. Therein a meeting is set for Aug. 27 in Brussels.
Less is currently riding on this – Ukraine stopped buying Russian gas again from July 1, but has been pumping gas into storage from other sources, and is hoping to secure as much as 18 billion cubic meters in storage by the start of the winter heating season. Gas consumption is likely down to the low 40s in billion cubic meters, production is around 21 billion cubic meters, with the shortfall met from stocks/imports.
Debt restructuring talks will eventually take center stage
Then there is the ongoing debt restructuring talks with creditors. There has been hope of a “resolution”, so a deal to restructure or impose a debt moratorium, by the end of this week. Given the late hour now, this now looks unlikely and all this looks set to drag on to next week. Given the two sides are still talking/negotiating, one has to assume that the basis for a deal has been more or less thrashed out – how best to welcome in Independence day on Aug. 24 than by the Ministry of Finance delivering the message of a deal with bondholders, avoiding a moratorium and default? The message will also be sent that Ukraine is not going to pay (in full) the Russian $3 billion in bail bonds, which will be rolled into the broader private sector debt restructuring. Russia will then have the choice of either accepting that deal, a haircut, and large net present value reduction (we expect coupon reduction, interest grace period and long extension of maturity), rejecting it and not getting paid – being an embarrassing sovereign “hold-out” in a private debt restructuring, or trying to declare it official, and likely still not getting paid for an extended period of time. As of writing I assign a very low probability of the Russian bail bonds being pain in full and on time in December – I am tempted to say zero, but anything in Ukraine is possible these days.
The deal is likely to be favorable to bondholders
There has been little specific evidence/news as to the terms of the private sector restructuring. But as noted above, the expectation is a hefty coupon reduction, maturity extension (maybe 10Y bonds, with five-year grace period), plus some “modest” haircut.
The Ukrainian side seems to have started with a demand for a 40 cent cut in the original face value – if the media are to be believed – bondholders initially rejected this, then offered five cents haircut reduction, and the media is again suggesting a 12-15 percent haircut.
It could be 15 cent overall haircut reduction, but perhaps with 10 cents covered by GDP warrants – I am thinking aloud therein. Many will view this as hardly generous to Ukraine, and perhaps that the Ministry of Finance could have secured a much better deal given its strong initial negotiating position, i.e. with official creditors issuing increasingly strident calls for debt reduction (e.g. Nathan Sheets statement from the U.S. Treasury, and also the Laurence Summers call in the FT, etc..).
If the deal only settles at a 15 cents hair cut reduction, for example, this would only represent a few percentage points (3 percent I think) of gross domestic product towards cutting the ratio of public sector debt/GDP.
The net present value reduction will likely be much larger – maybe approaching the 40%. Therein is the key difficulty still – i.e. how does this really contribute to the IMF’s target of cutting the ratio of public sector debt/GDP from 94% assumed at the end of 2015, to something with a 70-handle by the end of the EFF. The only way then would be expectations of sharp real foreign-exchange appreciation – which is really then finger in the air stuff from the IMF, and hardly the basis of a credible DSA. Not sure how IMF shareholders can sensibly and prudently sign off on the next review on this basis – albeit perhaps geopolitics will come into play there.
But selling it at home and to the IMF might be a different story
The Ukrainian side will no doubt play on the fact that this was the best deal possible, given the time dimension, the frailty of the domestic economy and banking sector, and the desire to avoid a hard default with uncertain ramifications. They might also have in the back of their minds that if the hair cut achieved this time around is not enough, they can always come back to the table at a later stage. That is clearly the case – remember the Kazakhstan bank restructurings after 2008, albeit they left a dreadful and very bitter taste in most investor’s minds.
Given the experiences of Kazakhstan and Greece, et al., not sure that is an entirely convincing line. This deal should be about resolving underlying issues at the outset, and clearing the deck to improve chances of speedy market access in the future. It seems likely to be beneficial to existing bondholders, who might now be able to exit with their potential losses moderated.
But Ukraine needs bondholders, new and old, to put new money into Ukraine. The fundamental question is will this deal make it more or less likely that Ukraine will have improved market access in the future as a result. Therein I am not sure/convinced, and hear very difference and diverse views from the investor base (holders and potential holders) – but perhaps therein the bigger issue still is the security situation/geopolitical outlook and relationship with Russia.
Unless Ukraine’s borders are secured, and peace is ensured in the east, its ability to pay going forward will be less than assured. For official Western creditors that is the real issue, and actually far more important than the level of Western financing provided to Ukraine.
