Ukraine Faces Default Risk as Russia Puts Neighbor on Notice

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The economic pressure being applied by Russia is threatening to push Ukraine to the brink of default, putting the burden on the U.S. and its allies to keep the war-ravaged nation afloat.

The question of Russia calling a $3 billion bond, which Prime Minister Dmitry Medvedev this week said will “soon” be decided, is pushing the government in Kiev toward debt-restructuring talks with other creditors, according to economists from London to New York. Such a request by the Kremlin would trigger a sovereign default for Ukraine, said Regis Chatellier, a strategist at Societe Generale SA in London.

Medvedev’s comments highlight the economic front in the conflict as the fighting in Ukraine’s easternmost regions flares up and policy makers in Moscow struggle to contain a currency crisis in Russia. As Ukrainian government bonds trade below 60 cents on the dollar, the Kremlin’s latest weapon is the debt that Russia bought as part of a 2013 rescue package signed with the nation’s then-leader, Viktor Yanukovych.

The prospect of Russia demanding early redemption “could be the catalyst” for a wider debt overhaul, Nicholas Spiro, managing director at Spiro Sovereign Strategy in London, said by e-mail. “Restructuring of some sort is practically a foregone conclusion given the severity of the deterioration in the financial and economic environment.”

Bonds Slump

Ukraine’s benchmark dollar-denominated note due July 2017 traded at 59.3 cents on the dollar today at 2:25 p.m. in Kiev, from above par six months ago and compared with an all-time low of 57.6 cents reached last week. The notes yield 34.9 percent, according to data compiled by Bloomberg.

Bondholders may be saddled with losses of as much as 70 percent in a restructuring, Goldman Sachs Group Inc. said in a Jan. 12 report.

Medvedev’s warning adds urgency to Ukraine’s efforts to obtain fresh funding after the European Union said the country needs $15 billion on top of a $17 billion International Monetary Fund program to stay afloat.

Ukraine’s government is confident that it will obtain new credit to pay off debt and ensure the release of current bailout payments, Finance Minister Natalie Jaresko said in a Jan. 8 interview.

Critical Situation

“We are indeed in a critical financial situation,” said Jaresko, a 49-year-old former chief executive officer of Kiev-based private equity company Horizon Capital LLC. Further aid will probably mean that a restructuring of debt held in foreign denominations won’t be necessary, she said. “We’re not currently looking at that.”

Ukraine needs to overhaul its economy and finances faster that the IMF program requires, central bank Governor Valeriya Gontareva told lawmakers in Kiev today. Policy makers are considering raising their key interest rate after inflation accelerated to a six-year high of 24.9 percent in December, she said.

U.S. Vice President Joe Biden spoke with Ukrainian Prime Minister Arseniy Yatsenyuk about “progress in assembling a broad package of international financing that will support Ukraine,” the White House said Jan. 14 in an e-mailed statement. The U.S. has pledged as much as $2 billion in loan guarantees as long as Ukraine’s government adheres to the IMF’s demands.

International lenders will probably prevent a Ukrainian default by extending maturities on some of the nation’s debt, Eurasia Group analysts led by Alex Brideau said in an e-mailed report Jan. 13.

Economic Tailspin

Ukraine’s debt is moving to the forefront of Russian President Vladimir Putin’s drive to assert his influence over Ukraine, a crucial route for Russia’s westward energy shipments. The conflict has triggered the worst stand-off with the U.S. and its allies since the Cold War. Russia denies accusations it’s behind the violence that the United Nations estimates has left more than 4,800 people dead.

The escalating crisis has ravaged Ukraine’s economy, spreading across swathes of its industrial heartland and starving banks of funding. Gross domestic product may shrink 6 percent this year after an estimated 7.5 percent contraction in 2014, according to Moody’s Investors Service.

Foreign reserves dropped to $7.5 billion in December, the lowest in more than a decade, as the central bank dipped into the stash to help the government pay off Russian energy debt and buy natural gas.

“The uncertainties regarding Ukraine’s solvency have substantially increased,” SocGen’s Chatellier said by e-mail.

‘Creditor Rights’

Russia says it has the option to demand immediate repayment on the notes because Ukraine’s debt rose above the equivalent of 60 percent of economic output, breaching levels set in the securities’ covenants. Medvedev said Jan. 14 that the government in Moscow will make a decision on the debt soon.

“We don’t want a Ukrainian default, worsening the plight of the Ukrainian economy,” Medvedev said. “Still, debts have to be paid, both government as well as those of companies.”

His comments echoed similar remarks by Russian Finance Minister Anton Siluanov on Jan. 10 and Andrey Bokarev, an aide to Siluanov, on Nov. 27. Putin earlier said his government wouldn’t use the redemption clause.

“Russia is within its creditor rights to accelerate,” Eric Fine, a New York-based money manager at Van Eck Global, which oversees $30 billion including Ukraine debt, said by e-mail. “The Ukrainian economy, its relationship with other official lenders and asset prices” would suffer if an early redemption request were to be made.

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