The Imf Makes Investors Share Ukraine's Pain

It's using the country as a financial laboratory

Viktor Yushchenko had a blunt warning. Summoning officials from foreign investment houses to his office in early September, the Central Bank chairman told them Ukraine couldn't pay an estimated $2.1 billion in Treasury-bill and foreign-currency debt coming due by yearend. The International Monetary Fund threatened to suspend badly needed aid if the government dipped into foreign-currency reserves to pay investors.

The only way to avoid a default, Yushchenko said, was to convert the T-bills into longer-term bonds. Investors hollered, then swallowed hard, and went along. Since then, more than 70% of foreigners holding Ukrainian T-bills have voluntarily converted them, even though they are losing up to 50% of the bonds' face value.

Odd as it may seem, Ukraine has become the IMF's new financial laboratory. The longtime economic basket case has become the testing ground for the IMF's new approach to righting world financial markets: the bail-in. The novelty here is that the bail-in makes investors share the pain of rescuing sick economies.

LOW RISK. Of course, the IMF didn't set out to make an example of Ukraine: Officials say they're just enforcing the terms of their $4.7 billion in loans to the country, which require it to maintain minimum levels of hard-currency reserves. But Ukraine's showdown with its lenders marks the first time private investors have had to participate in the cost of fixing up a troubled economy since the 1989 Brady plan in Latin America. As a test case, Ukraine is low-risk because it isn't a big factor in world markets. But the example could set a trend as international institutions restructure the debt of countries in Asia and Latin America.

So far, the results in Ukraine look promising. By stretching out debt repayments, the country wins time to get its fiscal house in order. True, players such as Credit Suisse First Boston are protesting the debt swap, and Ukraine still could default. But investors need look no further than Russia to see how bad things might have been. Holders of Russian T-bills stand to recoup as little as 2 cents on the dollar after the Kremlin's August default. Ukraine's investors will get a better return, and they have been promised payment in dollars.

The new bail-in strategy attempts to resolve Ukraine's moral-hazard problem. Its economy has been in a funk since the fall of communism, with the government refusing to make key reforms such as privatization. Yet Ukraine continued to get IMF backing. That support, coupled with yields up to 200%, lured investors into the country's T-bill market. By the end of 1997, Ukraine had $4.5 billion in outstanding T-bills, half held by foreigners. "Brokerages were telling people Ukraine was a safe bet because the government had the backing of the IMF," says a Western adviser to the government.

But the debt pyramid soon crumbled. As emerging-market panic spread this year, investors fled Ukraine. A new $2.2 billion IMF loan package in July lifted investors' hopes--until Russia's default forced a 30% devaluation in Ukraine's currency, the hryvna. When IMF officials arrived in Kiev for late-August talks on releasing a $257 million installment of the new loan, the IMF was under attack for bailing out Asia and Russia. It was in no mood to cut Ukraine or its investors a break. So the IMF told the government it would have to demand concessions from investors. Under no circumstances, it warned, was Ukraine to tap its $800 million in reserves to pay them.

It's too early to declare the bail-in a success. Some foreign investors are furious over the government's handling of one deal, a special issue of $395 million in T-bills arranged by Merrill Lynch & Co. Half the bills maTured on Sept. 22, and the government says more than 60% of investors agreed to swap their holdings. But those who decline are being offered payment in hryvna--even though Merrill Lynch's offering said payments would be in dollars. Standard & Poor's Corp. has declared Ukraine's action a technical default, and investors are threatening to sue. That could trigger defaults on some of Ukraine's $10.5 billion in hard-currency debt.

Even if Ukraine makes peace with investors, that's only the start. Its agreements with the IMF call for far-reaching reforms. But Ukraine's government, under PresideNt Leonid Kuchma, has shown little inclination to push for change. Apart from T-bills, its stagnant economy has drawn almost no foreign investment. And that, say backers of the bail-in, is precisely the point. Emerging markets, they contend, won't pursue reforms until forced to prove themselves to investors. Now, countries like Ukraine may have to do just that.

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