Still waiting for the recovery.

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Ukraine Shouldn't Hold Out for Haircuts

Leonid Bershidsky is a Bloomberg View columnist. He was the founding editor of the Russian business daily Vedomosti and founded the opinion website Slon.ru.
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With Greece missing one deadline after another to reach agreement with its creditors, it's easy to forget that a day of reckoning is also nearing for Ukraine. The government is supposed to reach a debt restructuring deal with private bondholders by June, but is no closer than when talks began in mid-March.

As in the Greek case, the parties seem to be speaking different languages. Both the ad-hoc creditors committee and the Ukrainian finance ministry issued harsh statements yesterday, accusing each other of various things that amount to an unwillingness to compromise.

The committee said in an e-mail it had not seen "substantive engagement" with its first proposal, made a month ago, and had submitted a new one that "balances the stated debt reduction interests of Ukraine and one of the investors' objectives of avoiding a principal reduction." That's a lengthy euphemism for "no haircut."

Ukraine's finance ministry, in turn, accused the creditors of trying to negotiate through the media rather than directly. It said the bondholders  were focusing "exclusively on the liquidity aspect" rather than "the debt sustainability objective."

This is a predictable deadlock and seems likely to persist. The problem is that for U.S. asset management company Franklin Templeton, which holds some $8 billion of Ukrainian debt, or about 80 percent of the total amount represented by the committee, agreeing to a haircut would be a reputational disaster.

Templeton's bond guru, Michael Hasenstab, made the big investment in Ukrainian debt at about 80 cents to the dollar, back when President Viktor Yanukovych was still in power. Hasenstab was hardly alone in failing to predict Russia's annexation of Crimea and the war in the east that followed, but even 13 months ago he went to Kiev to record a glowing video about Ukraine's prospects. It should be watched in its entirety as an example of how clueless top financial investors can be about the exotic bets they make.

In the video, Hasenstab praises the Ukrainian provisional government, which had just given up Crimea without a shot and was facing rebellion throughout the country's east, for doing "an exceptional job of tackling not just the short-term issues but really setting the stage for Ukraine to flourish over the next five to ten years." He also says this:

What attracted us was the universal consensus that it was not going to work. Now, just because the market doesn't like it doesn't necessitate that we do like it, but we do look for situations that are out of favor. When we go to the country, when we're on the ground like we are right now here in Kiev, it's a very different story that maybe is portrayed in the Western media or the conventional wisdom in the market. Being on the ground, understanding the situation, seeing the long-term potential -- that's why we invested in Ukraine.

That statement went well with footage of Kiev's pretty buildings and women in high heels, walking the streets as though they were part of a fashion show. It was also dead wrong. Ukraine was plunging into a vicious recession that still shows no sign of ending. Besides, the government that succeeded the one Hasenstab liked so much a year ago didn't take kindly to paying back debt. The international support it received -- a three-year International Monetary Fund bailout -- came with the condition that it should secure some form of  relief from Ukraine's  private creditors. 

The bailout terms call for $15 billion in savings on private debt in the four years through 2018. They also require the government to bring the ratio between public debt and gross domestic product below 71 percent by 2020, and to keep its gross financing needs to an average of 10 percent of GDP through 2025.

Herein lies a chance for Hasenstab to save face: He can argue that the terms don't directly call for a haircut. Sure, he and other bondholders can take a maturity extension. Last month, investors in the debt of state-owned Ukreximbank agreed to put off the redemption of its bonds by seven years, though in exchange for a coupon increase of 1.25 percent. A similar deal on its other bonds could allow Ukraine to make the required savings in the next few years, effectively freezing payments until it can get back on its feet. In the meantime, growth might restart and change the debt-GDP ratio. By 2020 a smaller haircut might be required. 

From Hasenstab's point of view, Ukraine shouldn't be pushing for a haircut now. The Ukreximbank deal lifted the price of the bank's bonds above 70 cents on the dollar. If Ukraine agrees to scrap its demands for a haircut, at least for now, the same might happen to the sovereign debt (the five-year bond now trades at 48 cents to the dollar). Hasenstab may then be able to recoup more of Templeton's investment without waiting for the next round of haircut talks, whenever that comes.

Ukraine could hold firm, in which case it will almost certainly have to tell the IMF mission in Kiev that it can't have a deal by June. The IMF could then decide to disburse the next $5 billion tranche of aid in June, or it could pass, figuring the Ukrainian government has to show its competence first -- if only by successfully negotiating a settlement with creditors.

Alternatively, Ukraine could help Hasenstab extricate himself from the mess he got Templeton into. Then, the IMF would happily release the $5 billion and life would go on. By 2020, no one may care too much about the IMF's excessive debt level requirements, and Ukraine may be a totally different country -- much better or much worse than today. It's probably wrong to reward Hasenstab for his hubris, but that may be the best option for Ukraine's chief negotiator, Finance Minister Natalie Jaresko. She needs breathing space more than she needs principal reduction.

Still, I believe the Ukrainian government will keep pushing, because the international support it has enjoyed in the past year has given it a strong sense of entitlement. And that's likely to lead to quite a number of missed deadlines.

This column does not necessarily reflect the opinion of Bloomberg View's editorial board or Bloomberg LP, its owners and investors.

To contact the author on this story:
Leonid Bershidsky at lbershidsky@bloomberg.net

To contact the editor on this story:
Marc Champion at mchampion7@bloomberg.net