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24 February 2016

The IMF Steps into Russia and Ukraine’s Bond Battle

The impact of the IMF’s response to Russia and Ukraine’s bond dispute 

Sovereign-to-sovereign loans have always been political. Multinational funds and governments are not keen to give out multi-billion future shaping loans without an incentive. Notably these incentives are often not simply potential returns. The International Monetary Fund (IMF) has historically avoided involvement in inter-state conflicts, and for good reason. However, the IMF was unable to do so in Russia and Ukraine’s ongoing bond dispute. This examination of the IMF’s response sheds light on the impact the conflict has had far from the battlefields of Donbas, in the boardrooms of central banks, treasury departments and financial institutions across the world. As the military conflict has heightened global security risks, the financial conflict between Russia and Ukraine has created new risks for international financial markets as well.

On December 8, 2015, the International Monetary Fund announced it had tweaked its rules to allow continued funding for countries behind on debt to official – i.e. sovereign – creditors. On December 16, the IMF ruled a $3 billion Ukrainian Eurobond held by Russia was an official intergovernmental loan, not private debt as Kyiv insisted. The bond came due four days later and, taking advantage of the IMF’s December 8 decision, Ukraine refused to pay. 

The dispute is far from over. First purchased from Kyiv by Russia’s National Welfare Fund in December 2013, the bond was to be the first of a series of loans totaling $15 billion. The loans were aimed at blunting the threat the Euromaidan protests posed to President Viktor Yanukovych's regime and his pro-Russian path.

However, the Kremlin’s move backfired. Its intervention in the protests granted further credibility to those calling for a European future in Kyiv. On February 22, 2014, Yanukovych fled Kyiv amid mounting violence and defections from even long-standing loyalists, and the revolution culminated in Ukraine’s legislature. Afterwards Moscow’s aid package was unsurprisingly cancelled. The sale on Irish markets of the British-law governed bond to Moscow, however, was irreversible.

The structure of the bond was noteworthy and novel, even to those with decades of experience in sovereign debt markets. Russia retained the right to resell the bond, including to private investors, and its lawyers also wrote in a special clause allowing it to demand repayment if Ukraine’s debt-to-GDP ratio exceeded 60%, with Ukraine’s debt-to-GDP ratio at around 40% at the time.

Yet Moscow also controlled sufficient levers to make such a spike in debt a reality. After Ukraine’s revolution, the Kremlin did so by instigating of political turmoil in eastern Ukraine, unilaterally annexing Crimea, and cancelling the Kharkiv Accords that granted Ukraine substantial discounts for Russian natural gas imports. Ukraine’s debt-to-GDP ratio skyrocketed to 71.5%. Although Russia was directly responsible for, at the least a large share of, the increase, it did not call the bond.

For those who argue that Russia sought to bankrupt Ukraine, or at the very least force it into a state of default in which it was unable to access credit even from the IMF, the failure to prematurely call the bond stands in stark contrast. Doing so, at least before the aforementioned December 8, 2015 IMF rule change, would have allowed Russia to bar Ukraine from international markets. True, Russia would have been even less likely to receive payment if it had done so than it is today. Mitu Gulati convincingly argued Russia could have done so by reselling the bond or parking it in a Russian bank, highlighting the significance of the fact Russia did not call the bond.

Russia certainly had incentives not to call the bond early. Adam Swain argued that Ukraine’s repayment of the bond would itself weaken Russia’s influence over Ukraine. Ukraine’s legal arguments for excusing or deferring its obligations vis-a-vis the bond also are not without merit, as Mark Weidemaier asserted, and Russia may have hoped Kyiv would cave before the forthcoming court battle.

However, the Kremlin may have avoided calling the bond early in the hope that it would not push the IMF towards making the decision it did on December 8. The fact that the IMF can now loan to countries in arrears to official creditors is something Moscow, and many others, would have preferred to avoid. Although Finance Minister Anton Siluanov quickly insisted Russia would remain a key member of the Fund, the decision even prompted suggestions from some Russian officials to leave the IMF.

Why was the IMF’s decision, little noticed outside financial press and by Russia watchers, so significant?

Most importantly, the decision was not limited to Russia and Ukraine, but instead was a general removal of the fund’s rule on “non-tolerance of arrears to official creditors.” Simply put, states that fail to repay debts to other states are still eligible for IMF bailouts. Prime Minister Dmitry Medvedev termed this the opening of Pandora’s Box.

The IMF’s lifting of the requirement that countries it grants loans to not be in arrears to official creditors will have a lasting impact on sovereign debt markets for years to come, particularly in how sovereigns, and sovereign-backed funds such as the Asian Infrastructure Bank or the European Bank for Reconstruction and Development, grant their loans.

For example, it is no longer unforeseeable that developing countries could receive IMF aid even if they fail to repay debts to China. In recent years China disrupted the market for sovereign loans by tying its credit to preferential access rather than the implementation of economic reforms, as the IMF and West have long demanded. While the revised policy does require the debtor sovereign to continue to negotiate in good faith, the Fund itself determines whether it has done so. Therefore, the IMF can now effectively push through liberalizing reforms, even at the expense of a powerful sovereign such as Russia, or China, so long as lip-service to negotiations continues.

The IMF’s decision also gives commercial banks, at least those with majority state-ownership, reason to worry. While formally announcing on December 18 that Ukraine would not repay the bond, Prime Minister Arseniy Yatsenyuk also cancelled repayment on $507 million of Ukrainian sub-sovereign debt to Russia’s majority state-owned Sberbank. While a restructuring agreement was reached on February 11, 2016, effectively on the same terms as those Ukraine agreed with private bondholders, the International Swaps and Derivatives Association (ISDA) did not comment on the announcement, yet alone state a credit event occurred. Neither did any of the three major credit ratings agencies downgrade Ukraine. Given the cancellation neatly fits ISDA’s definition of a credit event, this could set the precedent that the IMF’s decision also applies to sub-sovereign entities.

The IMF’s policy that non-payment by a sovereign of arrears to other sovereigns no longer prohibits them from receiving IMF support raises the risks associated with the Fund. It increases the risk of future debt disputes between sovereigns, and may drag the IMF into them, risking international support for the Fund. The Russia-Ukraine dispute is at present the only precedent. The lack of a response to Ukraine’s brief cancellation of its Sberbank commitments means the risks associated with sub-sovereigns have risen as well. As a result, markets will tread more warily when handling such debt. Much as Russia’s invasion of Ukraine has recast the global security environment, their financial war has reshaped the global financial environment as well.

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