The prospects and possible outcomes of a Ukrainian default, explained.
What You Need to Know:
✓Upcoming debt payments, and Ukraine’s widening debt-to-GDP (now over 60 percent) ratio are raising the very real risk of a Ukrainian sovereign debt default;
✓Without significant foreign support, Ukraine could default should Russia demand repayment of a 3 billion USD loan in the spring;
✓The Ukrainian government denies that it might not be able to honor obligations to its creditors;
✓Economists disagree about the consequences of a default, with some arguing that Ukraine could weather a default and even emerge stronger;
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What is a Sovereign Default?
In laymen’s terms, a sovereign default occurs when a national government is unable to meet its financial obligations and payments due to its creditors. Sovereign defaults have existed since the rise of city-states and instruments of finance, with the first recorded defaults stretching back to the times of ancient Greece. In the past, defaults on debt by governments have even triggered wars, such as the French invasion and occupation of Mexico in the 1860s. It’s much more frequent, especially in modern times, that sovereign defaults will trigger all sorts of negative consequences, including the inability to access international credit markets, sharp drops in economic output, inflation, lost credibility, and financial crashes. It’s for these reasons that many look with trepidation towards the possibility of a Ukrainian default, especially given the country’s already severe economic contraction, political instability, and ongoing war in the east of the country.
Why Might Ukraine Default?
Even before the March annexation of Crimea by Russia and subsequent armed invasion in the southeastern corner of Ukraine, the country was in a dire economic position. The Eastern Ukraine conflict has severely worsened the situation. The national currency, the hyrvnia, has lost nearly half of its value over the past year, foreign currency reserves have slid to 7.5 billion USD, GDP output dropped nearly 7.5% in 2014, and the government predicts that output will fall more than 4% in 2015.
Falling economic output, the use of foreign currency reserves to defend the value of the hryvnia, and the war with Russia in the east have all put Ukraine on the edge. Ukraine’s ratio of debt to GDP has risen sharply from roughly 40 percent in 2013 to a forecast of well over 60% at the end of 2014.
The Russian-Ukrainian war, which according to the Ukrainian government drains $10 million from the state budget everyday, is also taking a toll.
In this environment, Kyiv owes roughly $11 billion in loan repayments over the course of 2015, including a $3 billion dollar loan that is due to Russia in December. However, Moscow can demand an early repayment of the loan if Ukraine’s debt to GDP ratio exceeds 60 percent, which has already happened. If Russia calls an early payment, this could result in other creditors demanding early repayment as well. Thus, without sufficient foreign financial support, the Russian government can potentially trigger a Ukrainian default as early as the spring.
Will It Happen?
International observers and financial institutions are saying that a Ukrainian default is nearly inevitable unless the situation in the country changes drastically or there is sufficient international financial support to prop up the Ukrainian government. The credit rating agency, Standard and Poor’s (S&P) recently downgraded their rating for Ukrainian long-term sovereign bonds from CCC to CCC- with a negative outlook, the lowest possible rating.
While experts are increasingly saying that a default is nearly inevitable without increased assistance from the international community or International Monetary Fund, the Ukrainian government is putting on a tough face and largely denying that Kyiv might be unable to pay off its financial obligations.
Some experts not inside the government agree that Ukraine can potentially sort out its public finances without declaring default. Watch:
Meanwhile, the Ukrainian government is asking the IMF and its international partners to extend their bailout support so that Ukraine can support itself financially. In its turn, the EU and US have extended their financial assistance to the country as a result of the increasing likelihood of default and enhanced Russian pressure in the east of the country. The U.S. recently pledged another $2 billion, with another $1 billion likely on the way. Meanwhile, the EU is offering another $2.1 billion. The Ukrainian government is also negotiating an increase in the IMF’s $17 billion bailout package.
Ukraine’s access to foreign bailout funds is largely reliant on Kyiv’s ability to reform its moribund and corruption-ridden economy. Foreign donors and the IMF demand concrete steps by the Ukrainian government before handing over financial assistance. After the October parliamentary elections, the IMF put its assistance on hold after the creation of a new coalition government took a month to form. So far, Ukraine’s pro-Western and ‘reformist’ government has not been up to the task when it comes to implementing such reforms as key spending cuts, rooting out corruption and prosecuting wrong-doers, and modernizing the government apparatus.
In addition, Ukraine’s tax reform and 2015 budget have been criticized as insufficient and unrealistic at best. Among other problems, the budget expects an increase of 30% in tax revenue, which CASE Ukraine analyst Devin Ackles describes as “laughable” in the face of a recession and armed conflict in the east. Watch:
Avoiding default will necessitate that the Ukrainian government undertake sometimes unpopular reform projects that bump up against entrenched interests, such as broad spending cuts, tax increases, and overhauling the Soviet-era bureaucracy.
Some, including American financier George Soros, have argued that that the West should take drastic measures to shore up Ukraine’s economy in the face of Russia’s aggressive behavior and Kyiv’s financial situation. Soros (quite quixotically) argues that the West should give Ukraine a bail out to the tune of $50 billion. Many others, including Ukrainian activists, have criticized the idea of throwing money at the Ukrainian government without concrete reforms in return.
What Could Happen in the Case of a Ukrainian Default?
A default on sovereign debt by Ukraine would almost certainly not be a welcome development in the wake of the country’s already precarious economic and financial situation, and especially because of Russian pressure in the east of the country. A default would likely throw the currency market into turmoil, trigger high inflation, cut output even further, and cause a financial crash. It also would undermine faith in the Ukrainian government and state just at the time when it is under assault in the east and criticized for its inability to take the reforms process seriously. The fact that Russia might have significant influence over default or debt restructuring negotiations are another problem.
However, sovereign defaults need not always result in doom and gloom, and a controlled default can be a wiser option than prolonging the credit crisis. While defaults almost always result in sharp pain in the short-term and various economic woes, many countries have been able to emerge from a default stronger and with better economic foundations. Many observers look to the experience of Russia’s sovereign default in 1998 as an example of a default that paved the way for reform and a stronger economic future. Watch:
Most assessments of the consequences of a default are not sanguine. Critics point out Russia’s leverage over Ukraine in debt negotiations, Ukraine’s poor bargaining position and credibility, and immediate economic ramifications as reasons to avoid default or re-negotiate its debt obligations with creditors. In peace time these would be difficult obstacles, and perhaps in a time of war nearly impossible. It’s for this reason that many analysts have said that Europe and the United States will take measures to prevent a Ukrainian default. Regardless of whether or not Ukraine will default, the country faces a tough economic road ahead.