Bond valuations now put fair valuation in the 75-85 cents range, generally, with an exit yield of around 10 percent. As I argued upon the announcement of the deal, the value of the warrants is pretty binary at this stage – they are either worth very little, or an awful lot at some point in the future, and perhaps much more than even the most optimistic market assumption therein. I can even imagine a positive scenario where bondholders eventually get paid out “the full nine yards” well, not quite, but I would say they could get the 20 percent haircut back, and change.
Like warrants, Ukraine and the bonds are in my view a binary call at this stage. You can quite easily construct both very positive and very negative scenarios – I know I am not really helping you therein. But perhaps by detailing the two narratives the reader can make their own call – it is then a case of paying your money, and taking your chance – I guess you can also ‘pick n’ mix’, and you end up in a muddle through middle scenario (which I actually don’t buy myself – I am pulled between the two camps at this stage).
So the constructive view is:
(+) Russia has done its worst with respect to Ukraine and effectively has failed to pull the country out of its new, post-Maidan, Western orbit. If anything, it has solidified support for this Westernising vent, as reflected in opinion polls which now show a remarkable turnaround in support for NATO membership – where support was previously in the single digits, it is now a majority. Indeed, Russian intervention in Crimea, and Donbas, has in many respects finally forged a nation, creating a real national identity, very distinct from Russia, where it was previously relatively weak. The deciding factor has been the loss of over 7,000 lives in the conflict in the east, which many Ukrainians see as having been at the least, fanned by Russia.
But surely Ukraine still faces the threat of Russian military intervention?
Well, according to a constructive narrative, maybe not as strong as perhaps some would argue. True, Russia has annexed Crimea, and the Russian-occupied separatist areas are now beyond the reach of the authorities in Kyiv.
However, despite Russia’s supposed military might and superiority, and the lack of Western support, looking at the map, Russia and its proxies have taken a relatively small share of Ukrainian territory – perhaps 6-7 percent or so, covering 3-4 million people. Putin has made much of being able to drive his tanks to Kyiv in two weeks, but he has not so far. Similarly, despite all the talk of a push by Russia to drive a land corridor to Crimea, it has not yet done this. In both cases, the opportunity had appeared to present itself when back in April 2014, and then August/September 2014, the Ukrainian military were on the back foot, and in some disarray after the annexation of Crimea, and then the military defeats at Illovaisk and then Debeltseve.
The obvious question is why not?
Therein a credible answer is simply that the Russian military lacks the capability for such a large-scale and then by definition open military offensive in Ukraine – it would need 100,000+ battle-hardened, and ready combat troops and a huge support infrastructure to drive long distances into Ukraine and hold whatever territory they take. Importantly, they would also now be facing a more experienced, and clearly determined Ukrainian force (50,000+) who have proven they are willing to fight. Russia would have to be willing to take large-scale casualties – and therein the reaction to the existing death-toll in Russia (several thousand perhaps if some media sources are to be believed) suggests that the Russian authorities are nervous over the domestic political impact. Meanwhile, Putin has proven himself to be hardly a risk-taker – on the Churchillian scale (some might argue he was rash, but prepared to take the big risk for the great prize of ultimate victory )– as the prize of huge victory also comes with the risk of defeat, as Churchill himself discovered in the battle for Crete. Putin is an “operator” by training (see Cliff Gaddy and Fiona Hill’s recent book, “Putin – the Operative”), and prefers to cloak his activities, always with an exit route clearly marked/secured, where the fallout is capped. A full scale military campaign in Ukraine would risk a second Afghanistan for the Russian military, and Putin is perhaps a shrewd enough (military) historian to understand the risks therein. So in the end, according to this view, Russia has itself fought itself to a standstill in Ukraine, and the longer the time passes, the fewer military options Russia has – as Ukraine rebuilds its military capability with the help of numerous now foreign military trainers. Indeed, perhaps what we are now seeing on the ground is an acceptance by Russia that its military options are limited – with the attempt in Minsk I&II to seek a diplomatic exit.
(+) Even beyond the military theatre, Ukraine has also done much now to reduce vulnerabilities to other Russian actions to disrupt/destabilize. In the gas field for example, energy efficiency/conservation measures, and efforts to diversify supplies, means that it has cut the need to import gas from Russia to perhaps only 3-4 billion cubic meters per year, and total import needs for gas, to perhaps 20 billion cubit meters or so, from 50 billion cubic meters+ 10 years ago, and double five years ago, when Ukraine signed the 42 billion cubic meters “take or pay” deal with Russia. Reduced consumption, imports and pricing reform is also yielding significant benefits to the balance of payments and the budget. Indeed, it is also not inconceivable that Ukraine could be gas self-sufficient on a five year view.
Russia remains an important trading partner, and particularly export market for Ukraine, albeit over the past year, exports to Russia have fallen off a cliff, more or less halving (to single digits as a share). But Ukrainian business is learning to live without access to the Russian market, and is being forced to look for new markets. Therein the experience of Georgia after the 2008 war and then Russian economic blockade could be particularly relevant – as Georgia similarly learned to live without access to the Russian markets, and it perhaps even helped to force change/reform and efficiency gains by Georgia.
(+) The West has shown its determination to support Ukraine, by providing over $25 billion in official financing, underpinned by the International Monetary Fund. Therein, lacking limited tools to counter Russia, a mantra often heard from Western officials is that we cannot let Russia win by allowing Ukraine to fail economically-financially. They could perhaps add in there the rolling out of the association agreement/deep and comprehensive free trade agreement from January 2016, which remains assymetric in Ukraine’s favor still. Obviously “fail” is a subjective term – the West said that Ukraine would not be allowed to default, but the on-going debt restructuring deal effectively amounts to that, albeit Ukraine is expected to quickly come out of default as a result of the restructuring on-going.
(+) Big bondholders have shown their support/commitment to Ukraine by agreeing to restructure $18 billion in external liabilities, including a 20 percent haircut, and meeting the IMF’s demand for a $15.3 billion financing contribution to Ukraine over the period of the agreement. The argument is that this deal has improved both liquidity and debt sustainability and pushed out potential external debt financing problems beyond the current term of the IMF.
The deal is generally viewed as very favorable to bondholders – and indeed, yet again the Ukrainian side showed a willingness to be investor and bond friendly, even against calls for a much more punitive approach. The mood music is even if this deal fails to ensure sustainability, the Ukrainian authorities, again backed by official creditors would be “generous” to bondholders in future rounds of restructurings.
Note also despite question of moral hazard being raised often in the past few months, the official Western sector proved unwilling/unable to force the issue this time around – bondholders escaped relatively unscathed in this instance, and some would argue that Western taxpayers’ money is again the subject of a generous bail-out of the private sector. Big bets by bondholders seem to have paid out again – or that is the hope, but I guess some would argue that as long as the large bondholders remain invested, that a strategy of riding on their coat-tails works/pays.
The hope also is that the generosity of this debt restructuring deal will keep large bondholders invested, avoiding a messy moratorium/default/restructuring and allowing Ukraine to re-enter international capital markets at an early convenience – perhaps by late 2017, and hopefully again supported by large bondholders. The early presence of cheap and available finance could hence further help the recovery of the Ukrainian economy.
(+) This is the best reform administration that Ukraine has ever had – Western standard, and trying to roll out best practice reforms to transform the economy – the reforms are revolutionary. The IMF EFF is ambitious in terms of its reform commitments, but across the board, more or less (aside from fighting corruption perhaps), reform targets are being met, from fiscal consolidation efforts, energy sector reform, to macro stabilization and banking sector reform. These reforms will quickly yield transformational change, for the better in the Ukrainian economy.
(+) From a low base, signs of macro stability are already evident. Economic activity indicators in recent months have shown some stabilization/improvement. The base is now very low – real GDP has dropped perhaps 20 percent peak to trough, and gross domestic product from $178 billion to perhaps $84 billion this year. Real GDP could surprise now on the upside, assuming relative peace/stability in the east – with high rates of real GDP growth, and REER appreciation seeing dollar GDP rebound – good for GDP warrants.
Remember that Ukraine has a large, relatively skilled and now very cheap workforce – per capita GDP of only around $2,000, amongst the lowest in the region. It has clear strengths in agriculture, metals, chemicals, IT, and if economic reforms bring real improvements in the business environment, foreign direct investment could flood in, and growth significantly surprise to the upside (great for holders of GDP warrants).
On the macro front we would add that the current account has also already moved from deficit into small surplus, FX reserves have stabilized, and are even growing again, and the UAH has stabilized. The fiscal deficit has been significantly reined in, and the single Treasury account has grown to the highest level since 2006.
With peace in the east, and if the current pace of economic reform continues – Ukraine can be the next Poland over the next decade – I really believe this line.
Okay, that is the constructive investment case – what about the negatives/risks:
(-) Russia is never going to leave Ukraine alone.
According to this view (which I share) tearing Ukraine out of its current Western orbit and back within Russian geopolitical/strategic control is the number one policy priority for President Putin. Ukraine is part of the Russian psyche, its history, tradition, culture, economy, language (dating back over 1027 years to the founding of “Rus”, in Kiev) – and Putin, and Russia/Russians simply cannot imagine Ukraine taking a quite different direction/path. According to this view Putin, simply will not and, arguably, cannot afford to let Ukraine go on a separate course to Russia. Why?
First, a successful market/Western oriented Ukraine, with rising real GDP growth, and prosperity would be a huge challenge to Putin’s current model for Russian development – the power vertical/sovereign democratic model. Allowing Ukraine to develop to being the next Poland in the region – a loyal ally there if the US, and NATO member – would simply present a huge challenge to Russia and Putin. Russians might actually want similar things – Western democracy, freedom of expression, a market economy, EU membership, etc).
Second, and related, over time Ukraine will develop/emerge as a military threat to Russia – or at least Moscow will perceive that to be the case. Note that 18 months ago, when Russia felt sufficiently threatened by developments in Kyiv to annex Crimea, Ukraine was not really a military threat to Russia. Therein it had no real ambitions to join NATO, its military doctrine was arguably shaped against potential threats from the West, had a weak military capability (as events in Crimea, Illovaisk and Debeltseve subsequently proved) and had a weak economy with little priority/ability to rebuild. As of writing, Ukraine now has real ambitions and popular support to join NATO, it has recently changed its military doctrine to accept the threat from Russia, and is now re-arming and training to improve and develop a much larger military capability. This may not be an offensive capability against Russia, but it is likely enough for Moscow to feel threatened and ever more encircled, especially when set against NATO steady enlargement east over the past decade or so.
Critically, the longer Russia holds back from further intervention in Ukraine, the more likely that Ukraine is to become stronger both economically and from a military perspective – and hence a threat to Russia.
The above would suggest that further Russian intervention is very likely, almost inevitable. Indeed, would Russia want to risk waiting until US presidential elections, when the next US president (Republican, Democrat, or even Independent) is likely to be much more willing than the current incumbent to arm Ukraine? The longer Russia leaves it, the more likely that its own military option will be taken away by the fact that Ukraine will be able to defend itself.
(-) Faced by a determined Russia, is the West really up to the task in countering Russia? Is Ukraine so important to their larger geopolitical interests (is fighting ISIS, and moderating the impact of the war in Syria more important to the US for example?) that they will help Ukraine stand up to the external adversary for an extended period of time? The facts on the ground suggest likely not. Western support has been pretty piecemeal – often too little too late, and often quite uncoordinated. Look for example at the painful process of securing agreement even on a relatively light Russia sanction regime. Or the slow response in putting together a sufficient sized financial package for Ukraine – it was already evident by September 2014, that the existing IMF SBA was too small, but it took five more months eventually to see the SBA beefed up to an EFF.
Similarly the Western sanctions response on Russia has been painfully slow in being rolled out, and arguably it only now rates at 3/10. In the end perhaps too many interests in the West are eager not to sacrifice relations with Russia, for Ukraine. Or that is a view at least.
So if the West is unable to prevent the inevitable future Russian intervention in Ukraine, then in the end it will be up to the Ukrainians themselves to secure their state – can they? Tough ask – possible, but what will the collateral damage be in the process, and how could that impact on political stability in Ukraine, the form of governance, and back to Western perceptions therein and potential for continued Western support?
(-) The track record of Ukraine on the reform front over the past twenty years or so of independence is so dreadful, in terms of the failure of its elites, why are things different this time around. Surely this will all end in failure? True – fair comment. Further, is n’t corruption endemic, entrenched and again likely to corrupt the political and policy elite and agenda – possibly.
Surely, even if Russia backed off its intervention in Ukraine, would n’t the narrow interests of its political elites, and oligarchs, just ensure in-fighting, weak government, and slow reform – akin to what happened after the Orange Revolution? Why is it different this time around? All fair points, which are hard to argue against. Some would argue that the current crew of reformers at the MOF, NBU and elsewhere are different. Hopefully.
(-) Macro recovery is more like a “dead cat bounce”, and the loss of productive capacity in Donbas, and the continued “frozen conflict” scenario will surely eventually weigh on the economy, and then political stability in Ukraine.
(-) Given the security/political risks, why would foreign direct investors invest in Ukraine – when the security of their assets in under threat. Therein we have already seen the wholescale withdrawal of energy majors, and many minors, from the energy sector. Surely this is just symptomatic of bigger issues in Ukraine. Ultimately all this will make Ukrainian recovery/rebound almost impossible.
(-) The recent debt operation really does not resolve underlying issues. At best, it buys time, kicks the can down the road, Greece-style. The debt ratio remains high, and the debt operation only scraped the surface in terms of reducing the public sector debt/GDP ratio (down by 4.3% of GDP even in the best case), which remains high at 90% of GDP this year. The IMF EFF is also very optimistic/ambitious in terms of its assumption as to REER appreciation, driving down lower the public sector debt/GDP ratio. Indeed, it is hard to square the existing debt operation with the IMF’s own criteria for an EFF – that debt is deemed sustainable, with a “high level of probability”. I think many people would really still question this in the Ukrainian context – albeit it is highly subjective, and the IMF and Western official creditors seem prepared to view it with rose tinted spectacles, essentially as it suits their geopolitical interests. Essentially the call is – is Ukraine the kind of credit, given its track record, and current challenges which is likely to be able to sustain a debt/GDP ratio of 90%? It is not a developed market economy, with deep local markets like Japan, and is not an EU member state with access to an almost blank cheque from fellow EU-member states with broader political interests. It will be very challenging. No doubt.
(-) On the debt issue it is still how the issue of potential holdouts is going to be dealt with – and what about the Russian $3 billion Eurobond. Is Russia going to be as difficult as possible with respect to this facility? – the assumption is that it will be. Will the bond be paid back at par in December? Can that be sold domestically in Ukraine? It would appear to be nigh on political suicide to do so. Can the IMF change policy to allowing lending into official arrears, where Russia plays the official holdout card? Will the debt deal get signed off by parliament next week – I tend to think so, but this is not a 100% probability, but more likely 80-90%, which still implies a chance of the debt deal derailing, and which is not being currently priced.
In summary/conclusion, I lay out the pros/cons above, or at least many of them. It seems very binary.
And, as noted above, in the end I suggest that it is for the reader to make the call. I tend think that Ukraine can be successful economically, the reform team can succeed, and the economy can rebound from a low base – and Ukraine can be the next Poland a decade – but it needs peace/security for that.
But for that reason I think the probability of future Russian intervention is very high. Is the West up to the task – likely not.
Can the Ukrainians ensure their own security? Possibly.
In the end my sense is Ukraine’s eventual outcome will be determined by Ukrainians themselves. Russia will act in its own interests, and the recent track record therein suggests a clear set of actions. But Ukraine has shown a remarkable durability, under the circumstances, and a nation has been forged from blood and sweat. The ruling pro-EU reform coalition has endured far longer than people imagined, and opinion polls still show strong and ensuring support for the Western orientation and for NATO/EU membership. That suggests that there is hope, but the challenges are still enormous.
