In June, government representatives from around the world came together to create the right conditions for Ukraine’s recovery and reconstruction effort, which should be led by the private sector. The Ukraine Recovery Conference included welcome commitments of support in the fields of commercial risk insurance, co-investment and guaranteed lending as well as technical assistance in supporting Ukraine’s candidacy for European Union membership.
While such official support is a prerequisite for the country’s successful recovery and reconstruction, commercial external debt remains in limbo following the debt service suspension agreed in August 2022. Consequently, market access for both the sovereign and, critically, the private sector remains closed off and the budget is overwhelmingly reliant upon official sector financing.
Achieving the Ukraine government’s stated priority objective of normalising the debt situation in the first half of 2024 and quickly re-establishing market access requires urgency and careful planning. This is going to entail some creative thinking about debt and debt sustainability, and a higher level of partnership and trust between official and private sector lenders.
Prudent fiscal and debt management over the 2015-22 period has meant that, 16 months into the conflict, Ukraine’s debt-to-gross domestic product is still below 80%, which is well below 2015 levels. While this ratio may rise a bit over the coming year, a dynamic, construction-driven recovery will create ample space to absorb new debt while lowering key debt ratios towards sustainable levels.
However, the damage done by Russia’s illegal invasion has created large multi-year financing gaps – $25-30bn annually under the International Monetary Fund’s baseline and downside scenarios – which will need to be filled by assumptions about debt relief, market access and reparations payable by Russia.
The IMF’s current financing arithmetic assumes that Ukraine will be able to re-establish access to international capital markets relatively soon after the end of the programme in 2027 (it took just two years after the 2015 debt restructuring). But the amounts assumed don’t even touch the sides of what is required when set against Ukraine’s reconstruction needs.
Who should pay?
There is broad recognition that official sector funding commitments alone will not be enough to plug the gaps. Attention at the URC was therefore rightly focused on the inevitable need for a major financial contribution from frozen Russian assets. Assumptions about this will clearly need to be incorporated into the financing arithmetic before the parameters of a debt treatment can be negotiated.
Conventional debt relief can play a relevant but ultimately limited role in closing Ukraine’s financing gaps. War-time bilateral lending, multilateral lending and domestic debt are likely to be excluded from any restructuring perimeter. All payments on legacy commercial and bilateral debt are already subject to debt service suspension. The stock of restructurable public debt – Eurobonds, mainly – accounts for less than a quarter of the total public sector debt stock, and its share is rapidly shrinking. The savings that can realistically be generated from a conventional debt treatment are therefore very limited.
The appetite of investment funds which hold the Eurobonds to commit new funding, on behalf of the predominantly western pensioners and individuals whose assets they manage, will be closely correlated to the treatment of the existing debt. Restructured bonds will also need to carry coupons to compensate holders for the cost and risk of holding them, which is likely to be a source of contention with official creditors, understandably reluctant to see payments on Eurobonds subsidised, in effect, by western taxpayers.
A private sector solution
How can the private sector provide the official sector with the reassurance that much more private funding will be available to Ukraine once a debt restructuring is complete?
One solution is to combine a conventional debt relief exercise with a new money component. Proceeds from new lending would ensure strong positive cashflows from the private sector over the IMF Extended Fund Facility programme period, provide liquidity for government liability management and make available a large pool of capital for financing the budget and reconstruction.
Creditors would provide debt relief via a combination of maturity extensions beyond the end of the programme and lowering debt claims to create space in the debt arithmetic for committed new lending. Collective action clauses would be invoked on the base terms, but creditors participating in such an exchange on a voluntary basis would receive future financing rights eligible for use in post-restructuring sovereign issuance.
FFRs would work like discount vouchers, allowing the investor to recoup the upfront haircut over time by purchasing new bonds at a fixed discount to the par issue price, but only in return for committing considerable new money alongside.
By the time Ukraine restructures its debt in mid-2024, the stock of sovereign Eurobonds will stand at roughly $24bn. Let’s assume that investors, in addition to extending maturities past the horizon of the programme, agree to exchange a $6bn upfront haircut for an equivalent notional amount of FFRs. Those FFRs would allow the ministry of finance to issue new bonds with a market-determined coupon. Investors would settle newly issued bonds at a pre-agreed percentage of 80% of their par value, with the remaining 20% settled in FFRs.
The stock of $6bn FFRs would be exhausted once Ukraine had issued $30bn of new debt, and this would raise $24bn of new money, or $6bn annually over a four-year period, of which perhaps a quarter would be required to service the restructured Eurobond stock. A secondary market in the vouchers would develop to allow creditors with lesser or greater appetite or capacity to lend to sell or accumulate rights. Secondary market pricing would also allow both creditors and the issuer to glean important signals about appetite for new issuance. The government might see an opportunity to lock in the principal reduction by repurchasing rights itself.
Combining upfront debt relief with credible new money commitments from the private sector would provide significantly higher certainty about financing assurances, reopen market access immediately and allow for the credible front-loading of upsized private sector funding assumptions that help close identified financing gaps and address official sector concerns about burden-sharing.
Reaching an understanding on the role that the offshore private sector will play in financing Ukraine’s public sector from 2024 onward – one that inextricably ties the resolution of legacy debt with new money commitments – is critical to restoring Ukraine’s credit rating standing and complementing future private investment initiatives in the real economy. Having that discussion sooner rather than later will only serve to reduce the scope for delays once a debt operation becomes practicable and strengthen the laudable objectives of the URC.
Timothy Ash is Senior Sovereign Strategist at RBC-Bluebay Asset Management, and Associate Fellow on the Russia and Eurasia Programme at Chatham House. Alex Garrard is a Founding Partner and Portfolio Manager at Amia Capital.