Ukraine Is Too Corrupt for Debt Deal to Work
Ukraine is reportedly close to a deal with its private creditors, who may accept a 20 percent haircut. This is an uneasy compromise that would solve little, because the government continues to fail where it really matters: cutting corruption and bringing the country's huge shadow economy into the tax system.
Ukraine's private creditors, led by asset manager Franklin Templeton, are talking with U.S.-born Finance Minister Natalie Jaresko about restructuring $19 billion of debt. Ukraine's $17.5 billion bailout agreement with the International Monetary Fund requires a deal that would save the government $15 billion over four years through 2018, bring its debt-to-gross-domestic-product ratio below 71 percent by 2020 and keep its gross financing needs to an average of 10 percent of GDP through 2025. The creditors initially told Jaresko that an immediate haircut wouldn't be necessary to meet these conditions: rescheduling and coupon reductions would be enough. The minister, however, demanded a 40 percent haircut and threatened a moratorium on debt repayments otherwise.
The Ukrainian government's argument was one it has repeated ad nauseam at home and abroad. "We are at war with a nuclear state, namely Russia," Prime Minister Arseniy Yatsenyuk said in June. "There is no other way than to accept our terms, restructure the debts and allow Ukraine to get out of a difficult economic situation."
If the two sides meet each other halfway as reports suggest, dealing Templeton's bond guru Michael Hasenstab his first major defeat, Ukraine will get some immediate relief. It has $1.1 billion of sovereign bonds maturing in September and October, and these payments would probably be delayed. However, the $3 billion Eurobond owned by Russia, which comes due in December, won't be affected: Russia insists the loan must be treated as official, rather than private debt -- and Ukraine has been faithfully paying the coupons on it.
It is also unclear whether the 20 percent face value reduction -- a cut of $3.8 billion -- is going to help bring Ukraine's debt-to-GDP ratio down to 71 percent from the current 94 percent. The IMF program projects Ukraine's 2020 GDP to reach 3.2 trillion hryvnias, or $134.2 billion at the projected exchange rate for the end of 2020, up from 1.5 trillion hryvnias ($97 billion at the year-end exchange rate) in 2014. This projected economic growth is supposed to close most of the debt-to-GDP gap; the contribution of the restructuring deal to meeting the IMF's 71 percent target would be much smaller.
The IMF's growth forecast is probably overoptimistic. The fund expects the economy to shrink by 5.5 percent this year and then start growing, hitting a 4 percent plateau in 2018. The Bloomberg consensus forecast of bank economists puts this year's expected decline at 8.7 percent. Actual data for the first two quarters suggest even that may be hopeful. On a non-seasonally-adjusted basis, GDP was down 14.7 percent year-on-year in the second quarter of 2015. Hardly any business is growing in Ukraine. In July, industrial production was down 13.4 percent year-on-year. Exports in January through June reached just $18.5 billion, compared with $28.62 billion in the same period of 2014.
The other shaky assumption in the IMF forecast concerns Ukraine's currency. The fund expects the hryvnia to weaken slightly, from 22 per U.S. dollar at the end of this year to 23.8 in late 2020. Yet the hryvnia is only protected from a much steeper immediate drop by capital controls, which the IMF itself wants Ukraine to ease. The Bloomberg consensus forecast is for the currency to hit 24 per dollar in 2016 already, further throwing the fund's math into disarray.
On Monday, President Petro Poroshenko predicted that "economic growth is going to be restored in the next few months, simply thanks to the absence of military escalation." Business, he said, was "adapting, finding new markets to replace the Russian one that is completely closed to us." It would appear that Poroshenko doesn't follow his country's official statistics. In the first half of 2015, Russia was still Ukraine's biggest export market, consuming $2.3 billion worth of Ukrainian goods. That was almost 60 percent less than the year before, but hardly closed. Meanwhile, exports to nine out of Ukraine's other top 10 markets also fell, which doesn't suggest much adaptation.
Ukraine does have one reliable growth engine: its shadow economy. According to a recent paper from the economy ministry, in the first quarter of 2015, when the official economy was in freefall, the shadow sector increased its share of official GDP by 5 percentage points year-on-year, to 47 percent. That is a modest estimate based on an average from several methods, some of which are not particularly relevant to Ukraine. Measured by consumer spending and retail trade, the informal sector has swelled to 56 percent of GDP.
The two reasons for this expansion are corruption and tax evasion. The Ukrainian government is making a visible effort to combat graft -- many official agencies have switched to transparent electronic procurement systems, and the newly formed National Anti-Corruption Bureau promises to send its first cases to court by the end of this year. Even so, businesses still complain of bureaucrats' depredations, the national prosecutor's office is locked up in a struggle between reformers and veterans used to the old ways, and the country's notorious judicial system remains unreformed. Changes to the tax code are in the works, but these are insufficient to induce businesses to start paying payroll taxes instead of offering employees unofficial cash salaries.
Bringing the shadow sector into the reportable, taxable economy would be far more important to growth than the proposed debt write-off. Given the nominal first-quarter GDP of $15.7 billion, the unofficial turnover (assuming a 47 percent shadow economy) reached $7.4 billion in those three months alone. Even the war in eastern Ukraine, the government's perpetual excuse, means less to the nation's future than this, much quieter war with the sizable part of the country's population that cannot imagine living by the rules.
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