Ukraine’s Financial Future: Between Default and Prosperity

Sourse: Kennan Institute Focus Ukraine

In the next five years, Ukraine’s aggregate payments for external liabilities will amount to more than $40 billion. However, the net reserves of the National Bank of Ukraine stand at $5 billion. On the basis of such a ratio, the risk of Ukraine defaulting on its debt is high. Can Ukraine overcome this risk?

My response to the above question is based on a study of the increased risk of a crisis around Ukraine’s external debt in coming years. Let’s look at the context in which the Ukrainian government would face such a risk.

The events of 2019, when the presidential and parliamentary elections are to take place, may worsen the situation. Political changes cause social tensions and restrict the activity of foreign investors, which could be a crucial factor in reducing the risk of default.

More than likely, the IMF would again provide assistance to Ukraine in order to help prevent a default, should the government meet the IMF’s conditions. But the electoral situation may limit Kyiv’s readiness to impose austerity measures.

To reduce the risk of default and the country’s dependence on external donors, Ukraine must attract foreign investments amounting to $15–20 billion per year. This should become a priority for Ukraine’s economic policy for the next year.

The Risk of a Default Reaches a Critical Level

In the next five years, Ukraine will have to pay more than $40 billion on foreign debt.[1]

In 2018, debt repayments and debt servicing will amount to as much as $6.5 billion, while in 2019–2021 the figure will be $8.5 to $10 billion annually.

The payment schedule shown in the figure does not include additional payments to holders of restructured bonds issued in 2015, should Ukraine’s GDP growth exceed 3–4 percent per year. In the estimation of the Ukrainian Institute for the Future (UIF), with economic growth of 4.0–4.5 percent per year in 2022–2027, the amount of compensation to Ukraine creditors will amount to $2.5 billion (based on the value recovery instrument agreed on during talks on the restructuring of Ukrainian debt in 2015). In a recent interview, Prime Minister Volodymyr Groysman said that he considered economic growth of 5 percent annually to be achievable, which means that the amount of compensation to creditors could be even higher. In that case, the risks to Ukraine’s financial system and economy would also be greater.

How Will Ukraine Meet Its External Obligations?

The costs to meet obligations on external liabilities ultimately rest on the budget of the country. The state budget is formed in Ukrainian hryvnia, while debts are denominated in foreign currency, which must be bought on the interbank market or converted from the international reserves of the National Bank of Ukraine (NBU).

NBU reserves are not static. They increase or decrease depending on either:

External payments position: reserves grow when the flow of currency into the country from exports, loans, and investments exceeds the outflow and decrease when the volume of imports and payments on external loans exceeds inflows; or
The use of IMF resources: receipt of new loan tranches or the repayment of old debts owed to the IMF increases or decreases bank reserves.

As of the end of September 2017, the reserves of the NBU stood at $18.6 billion, of which the NBU’s own aggregate reserves (excluding IMF loans) totalled only $5 billion.

Payments for external liabilities only in 2018–2019, including debts owed to the IMF, will amount to $15 billion. In 2020–2021 Ukraine will have to pay almost $20 billion more.

Simple arithmetic shows that without new external loans and IMF tranches, NBU reserves will not be enough to meet obligations to external creditors in the next three years.

Even if global prices for raw materials rise sharply, leading to an increase in Ukraine’s foreign exchange earnings, which is not currently the forecast, the NBU will not be able to accumulate sufficient funds in its reserves.

Why Ukraine Should Avoid Defaulting on Its Debt

Primarily, default would lead to the loss of Ukraine’s international reputation and the trust of external partners, a critical reduction in Ukraine’s position in competitiveness ratings, and an outflow of foreign capital from the country.

If default is permitted, Ukraine would most likely be isolated to some extent from the external financial world. Ukrainian companies and the government would not be able to enter foreign borrowing markets for several years. There would be an outflow of foreign investment, and the Ukrainian economy would be deprived of much-needed resources.

In the short term, a default would also lead to a slowdown in economic growth, an increase in unemployment, and devaluation of the hryvnia. Based on the experience of other countries, the national currency could see its value halved. For example, after default, the Argentinian peso fell by 67 percent, the Mexican peso by 47 percent, and the Russian ruble by 40 percent.

Default would definitely be a blow to the Ukrainian economy.

Is Default Inevitable?

No doubt, the Ukrainian government will do everything to prevent uncontrolled or so-called spontaneous default. So events will most likely develop according to one of three presumptive scenarios:

Restructuring. Should the government be unable to pay its debts, it would conclude an agreement with creditors to partially write off the debt and delay payments on the remainder, as happened in 2015, which was, in fact, a technical default. Such a restructuring would not lead to the collapse of the financial system but could create additional risks for the Ukrainian economy in the future. For example, in the case of the restructuring in 2015, in exchange for writing off part of the debt, creditors received cost recovery tools. Disbursements on them are tied to the dynamics of the GDP: the higher the growth of the economy of Ukraine, the higher the payments will be.

Attracting new loans in foreign currency. Ukraine can place the Eurobonds and attract resources to pay for the urgent loans. As the September 2017 auction showed, there is a demand for Ukrainian securities. And there is a good chance that the Ministry of Finance will be able to attract planned volumes on external markets. But the greater the risk of default, the more difficult it will be for Ukraine to do so.

The Ukrainian government can also attract more IMF loans. Their advantage over Eurobonds is their cheaper maintenance cost. The IMF extends loans at 3 percent per annum, and rates on Ukrainian securities are 7–8 percent. The reverse side of the “cheap” credit from the IMF is the need to meet IMF requirements for the proper use of funds. IMF tranches are used to repay existing debts to the Fund or to replenish reserves rather than to develop the economy.

Help from the IMF also includes the receipt by Ukraine of “macro-assistance” from the EU or the placement of bonds under U.S. guarantees. These loans are tied to the program of cooperation with the IMF, and their rates are similarly low. But proper use, as a rule, means covering the budget deficit.

The Ministry of Finance may also decide to issue domestic bonds in foreign currency. This tool allows absorption of free cash from businesses and the population, but it is unlikely to become a full-fledged alternative to external loans. There is also a question of distrust of the state and the populace’s lack of understanding of what is entailed in buying and selling currency bonds, along with the banal fear of everything new or unusual.

In addition to the above, it is important to understand that new borrowings will be directed solely at repaying old debts. They will not form the basis for economic growth. From year to year Ukraine will have to increase its debt burden in order to close old debts and cover the growing budget deficit. And I doubt this path will lead to any prosperity for Ukraine.

Attracting foreign direct investment (FDI). The optimal scenario is to attract a volume of FDI that will allow Ukraine to get by without the IMF program and external government loans. Ukraine’s need for external investment, according to the UIF’s assessment, is $15–20 billion per year over the next five years. These amounts would allow external loan payments to be made and NBU reserves to be replenished at least to the amount necessary to cover 3–3.5 months of future imports.

In recent years, the volume of FDI in Ukraine was about $3 billion per year. Against this background, figures of $15–20 billion appear unrealistic, although in 2007–2008 Ukraine did manage to attract $9–11 billion in FDI per year.

Let’s compare this with the investment indicators of other countries. In 2014 the volume of foreign investment in Italy was $14 billion per year, while for Chile the figure was $20 billion and for Mexico it was $24 billion. In 2016 Poland realized $14 billion in FDI and Turkey $12 billion.

Simple math shows that a sum of $15–20 billion is 13–14 percent of Ukraine’s expected GDP during 2018–2021. The share of FDI in Singapore’s GDP, to take one example, exceeds 20 percent, which is $60 billion. If Singapore managed to attract that amount of FDI, why can’t Ukraine?

Recommendations

In the situation such as I have described, the Ukrainian government should follow seven recommendations that my colleagues at the UIF and I have assembled. By doing so, the government will avoid technical default while also achieving the greatest benefit for Ukraine.

Create favorable conditions for attracting FDI: $15–20 billion annually during 2018–2021.
Realize transparent privatization of state property: $1.4 billion.
Reform the energy sector and simplify procedures for obtaining permits and contracts to develop mineral resources: $2–3 billion annually.
Introduce a tax on capital withdrawn from business (replacing the tax on dividends and the like): $1–3 billion annually.
End the moratorium on land sales and open up land sales to non-residents: $7 billion in investment annually.
Boost the activities of special economic zones, the export-processing areas in particular, to transfer production to Ukraine from China and the EU: $2–4 billion annually.
Develop an import substitution policy and promote exports: $2–3 billion annually.

So, why is FDI an alternative that will allow Ukraine to avoid default, with maximum benefit to the economy and citizens?

Foremost, investments from outside bring foreign exchange earnings into the country and are key to the stability of the hryvnia exchange rate.

Second, investments are a resource for modernizing the economy and creating new industries, sectors, enterprises, and jobs. Unlike loans, investments create a base for economic growth and will allow Ukraine to actually outgrow the national debt—to reduce its debt to GDP ratio to a sustainable level. And if there is stable, steady growth of the economy, the salaries and incomes of the population, receipts to the state budget, and the overall well-being of citizens should benefit.

The possibility of Ukraine defaulting in the next three years is high. This is why attracting FDI must be a priority for the Ukrainian government. Only direct investments will let Ukraine avoid default and lay the groundwork for future growth, and duly pay off loans.

[1] Ministry of Finance of Ukraine (payments on servicing and repayment of Ukraine’s national debt as of June 15, 2017).