Ukraine reaches deal with private creditors, but what about that Russian Bond?

By now many of you have surely read about the deal reached by Ukraine and its Franklin Templeton-led group of creditors. In short, the parties agreed to (1) write off 20 percent of Ukraine’s debt, (2) extend repayment dates by four years, (3) increase the coupon payment to 7.75 percent, up from 7.2, and (4) issue the creditors a GDP-linked obligation that will pay out a percentage of annual economic growth above 4 percent after 2021. The agreement has been a long time coming and represents a compromise between the two sides’ earlier negotiating positions: as recently as last month, Ukraine insisted on a 40 percent debt write-off while the main creditors had begrudgingly admitted that they might be willing to stomach a 5% haircut to principal. (If you’re interested in the background of the debt dilemma that Ukraine has been wallowing in for the past year or so, check out FT Alphaville’s series of articles on the saga, penned by the exquisite Joseph Cotterill.)

But with this important deal reached, the next big question concerns how to treat the $3 billion bonds issued in December 2013 (the “Russian Bond”), which should be repaid in just under four months’ time. According to Russian President Vladimir Putin himself, the bond appears to have been purchased by one of Russia’s sovereign wealth funds. In addition to the simple reason that Ukraine is loathe to hand over $3 billion to the government that it accuses of fanning the flames of war in Donetsk and Lughansk and of unlawfully annexing Crimea, whether the Russian Bond is considered official bilateral debt between Russia and Ukraine seriously alters each side’s bargaining position.

If the Russian Bond is deemed to be official bilateral debt, Russia might have the ability to hijack the entire IMF bailout plan. This is because of the IMF’s policy of “non-toleration of arrears to official bilateral creditors.” Under this policy, if Ukraine were to fall into arrears on such official sector debt (i.e., not pay according to the terms of the Russian Bond), disbursement of much-needed IMF funds could be put on hold. That would give Moscow major leverage in any one-on-one debt negotiations.

On the other hand, if the debt is treated as a private sector obligation, then the IMF’s non-tolerance of arrears is softened substantially: “[L]ending into sovereign arrears to private creditors . . . should be on a case-by-case basis and only where: (i) prompt Fund support is considered essential for the successful implementation of the member’s adjustment program; and (ii) the member is pursuing appropriate policies and is making a good faith effort to reach a collaborative agreement with its creditors.” Thus, non-tolerance of private sector arrears can (at least in theory) be suspended as long as those very subjective criteria are met, which means that Ukraine’s IMF bailout wouldn’t necessarily be immediately in danger if Kyiv refused to pay back all of Russia’s money on time.

Ultimately, I am not convinced that the Russian Bond will be considered official bilateral debt: (1) Russia, apparently, did not declare the bonds as official debt with the Paris Club (which is the group of creditor countries through which official sector debt restructurings are orchestrated);[1] (2) the bonds are transferable, a hallmark of commercial, private sector debt; (3) under normal circumstances the sovereign wealth fund thought to hold the bonds would be considered a separate legal entity from the government; (4) it would be inherently unfair to give the bondholder both the extra contractual/enforcement protections of a commercial bond as well as the political influence bestowed by official creditor status; and (5) the stated purpose of the bonds was for “general budgetary purposes,” which is exactly the same in all of Ukraine’s other eurobond issuances.

That being said, it is certainly worthwhile to point out that there are some arguments in favor of classifying the Russian Bond as official debt. First, even though the debt was structured as a regular commercial bond offering, it did not reflect commercial terms. The interest rate of the Russian Bond was 5% annually while the market rate for Ukrainian debt at the time was around 12%. Such a discounted rate looks rather like politics-infused bilateral lending normally considered official debt. Second, one of the Paris Club’s six foundational principles is treatment of every issue on a case-by-case basis. This argument could be used to argue in favor of classifying the Russian Bonds as either official or private sector debt, but it’s worth noting that at the very least it allows the Club freedom to act without fear of setting a problematic precedent going forward. What’s more, the ultimate decision as to classifying the Russian Bond as official sector debt lies with the Paris Club, which is neither constrained by formal rules governing the decision nor free from political bias/motivations.

Bearing all of the above in mind, it is tough to say with any certainty how the Russian Bonds will be treated, but my opinion is that the Russian Bond will not be restructured under the Paris Club format. Russia (or whichever entity holds the bonds) will be treated like any other private creditor. Therefore, any debt relief on the Russian Bond will hinge on whether Russia’s holdings can be forcibly lumped together with those bondholders voting to accept the restructuring terms. If it can’t Ukraine’s Finance Minister Natalie Jaresko may find an even more contentious round of negotiations ahead of her.

[1] Annual Report 2014, Paris Club, 69 (in which Ukraine’s debt to Paris Club creditors totaled $1.4 billion as of Dec. 31, 2014, which means that Russia — a Paris Club member — did not report the $3 billion in eurobonds issued by Ukraine and reportedly purchased by one of Russia’s sovereign wealth fund as bilateral debt owed to Russia).

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