Ukraine Should Consider Default

The world’s financial markets are preparing for Ukrainian default.  And so should Ukraine.

The history of Governments borrowing and then failing to repay their debts goes deep. The first known sovereign default was in the 4th century BC when several Greek city-states failed to honor their debts. When a country fails to pay its creditors on time, it is said to go into “default”. Most of the countries have at least one such event on their record. With some notable exceptions of Bourbon France (after the French Revolution), and repudiation of debts of the Confederation by the US (after the Civil War), the change of government does not excuse a state from handling prior debt. Defaulting countries tend to restructure their debt rather than simply refuse to pay anything at all—these are the so-called “haircuts”.

These days the D-word is stalking Ukraine.  Its economy looks worse than ever. In 2014 it has reportedly contracted by a tenth and its currency lost about 50% of its value. The inflation is now about 25% and the new government is running out of cash fast. Ukrainian bond yields increased to a record high: financial markets are preparing for a default.

And so should Ukraine–it should consider defaulting, and it should think twice about taking any ruinously expensive short-term debt to avoid default. The country has been taking more loans to service its foreign bonds, many of which were issued at short maturities and high rates.

It is hard to see how Ukraine’s shrinking economy can service its current debts. The longer Ukraine delays, the greater the pain will be when its credit finally does run out.  The government may be best advised to start talking with bondholders about “haircuts” now. Waiting and getting by with short-term debt is distracting the government from focusing on the economy. It may also result in only cosmetic changes to the system — as it did in Greece, which had avoided default thanks to the largest sovereign bailout in history, but has remained one of the least competitive economies in Europe, run by oligarchs.

The biggest payment comes in December, when Ukraine needs to repay a $3 billion bond to its perkiest creditor — Russia. But problems may arise sooner than that.  According to the terms of the $3 billion Russian bond, Ukraine’s debt-to-GDP ratio cannot exceed 60%. If it does, Russia may call on Ukraine to pay back the bond prematurely. Ukraine’s official state-finance statistics are released in March or April.

With this in view, it may make both political and economic sense for Western creditors to let Ukraine default. This may give them a stronger voice in the post-default restructuring: reforms so far have been slow and ineffective while the system of using the western funds remains non-transparent.  The West should condition any “haircuts” to the creation of trusted and transparent management from the ministerial level down to regions through all branches of power and 3500 state corporations.

Facing Russia pushing the envelope may also not be such a bad news for Ukraine. The modern international law does not provide it with a good forum for bringing territorial and other war-related claims. The ones brought to Strasbourg and the UN do not have much of a bite.  Should Russia bring its claim for the repayment, Ukraine may consider rejecting it. The only available legal remedy for Russia then would be bringing a claim to the English courts as the bonds are under English law. Ukraine should be ready to bring its numerous counterclaims and call for the full disclosure as to how that debt was negotiated by the Russian government and then President Mr. Yanukovich—increasing the political and financial pressure on both.