For what feels like years the Eurozone has been focused on preventing the debt crisis in Greece from jeopardizing both the Euro currency (Euro Area) and the European Union itself. The thinking is that because there is no legal mechanism for a country to leave the Euro Area, the consequences could be catastrophic. A Greek exit could endanger the overall stability of this economic zone, potentially paving the path for other debt-burdened countries to exit as well. (For related reading, see article: If Greece Leaves the Euro, Who's Next?)

But is this debt crisis really the biggest threat to European stability? Perhaps the economic crisis accelerating in Ukraine, which is neither a member of the Euro Area nor the European Union, is really the bigger threat to the EU. Economic collapse and a debt default in Ukraine could open the door to wider social unrest and regional conflict that would hand Russia a moral and perhaps military victory on Europe’s doorstep. (See article: Why And When Do Countries Default?)

Ukraine’s war in its eastern regions with Russian-backed separatists is undoubtedly taking a toll on the Ukrainian economy, despite a ceasefire agreed on February 15. For example, Standard and Poor’s, a credit rating agency, reports that they expect Ukraine’s GDP in 2015 to be USD $99 billion, down 22% from 2014. Meanwhile the Economist magazine ran a story in which they speculate that Ukraine’s GDP may soon shrink to as little as USD $70 billion due to the loss of key industries in the country’s eastern provinces. Finally, Bloomberg reports that the IMF estimates that Ukraine's 2014 GDP shrank by 7.5%, with the slump accelerating in the fourth quarter, falling 15.2%. On top of this, the country’s foreign exchange reserves are quickly being depleted, and are down to around $6.4 billion as of February 2015 from around $36 billion in 2011, according to the IMF and the National Bank of Ukraine. No matter how one looks at it, Ukraine’s economy is being destroyed by the conflict. So what is the West doing to help?

IMF Rescue Package

In December 2014 the IMF told member countries that Ukraine has a $15 billion funding gap in its budget, according to the Financial Times of London. The newspaper goes on to report that analysts at Dragon Capital in Kiev estimate Ukraine has total external funding needs of around $45 billion over the next three years.  So in early February 2015 the IMF unveiled a new 4-year, $17.5 billion financial aid package to help the Ukrainian government meet its financial obligations. This money, in conjunction with $9.2 billion from bilateral creditors and from other international financial institutions such as the EBRD (European Bank for Reconstruction and Development) and World Bank and the implicit assumption that private bondholders are also willing to play their part, brings the total aid package to around $40 billion. The table below shows the breakdown by contributors. (For related reading on the IMF's efforts, see article: Can The IMF Solve Global Economic Problems?)

IMF Bailout Program (February 2015)  
$17.5 billion IMF Funds
$9.2 billion Bilateral Loans, incl.
     $2.0 billion      United States
     $2.2 billion      European Union
     $4.0 billion      EBRD/World Bank
     $1.0 billion      GR/JP/CN/PL/NO
$13.3 billion Private Sector Involvement (PSI)
$40 billion Total
Source: IMF, Bloomberg  

The inconvenient truth that no one wants to discuss, of course, is the mandatory participation of private creditors in this deal, known as private sector involvement, or PSI for short. Without PSI the aid package is quite a bit short of the overall pledged amount of $40 billion.

Private Sector Debt Restructuring

An article in the FT published at the end of February says that “Ukraine could be headed for one of the largest debt restructurings in history”. In a separate interview with the FT, Natalia Jaresko, Ukraine’s finance minister, said the country plans to begin talks with foreign creditors in March and is indicating that it plans to complete talks in June, before the IMF’s first bailout review. So what is the government’s game plan? The Ukrainian government says they want a “fair and equitable process” for all creditors and will not make any voluntary early repayment to anyone, not even to Russia, which supplied the country with $3 billion when Victor Yanukovych was president and is due to be paid back in December, according to Bloomberg. In comments to Bloomberg Ms. Jaresko said, “I can’t confirm that this will only be a reprofiling or that this will be a restructuring.” Reprofiling is industry speak for an extension of debt payments, whereas restructuring usually means an overall reduction in the amount of debt that needs to be repaid by reducing bonds’ coupons or their face value.

Goldman Sachs says investors are underestimating losses in the country’s planned debt reorganization, according to Bloomberg, but doesn’t elaborate on why. The article goes on to say that there are a variety of ways Ukraine can reduce its debt burden, including using the super-majority voting procedures embedded in the terms of the current bonds to change the conditions, or offer new securities with different terms. These new terms are likely to be unfavorable for investors and are a likely source of value destruction.

Debt restructuring will not be easy, and could take longer than anticipated. For example, US asset manager Franklin Templeton holds around 40% of Ukraine’s bonds traded on the market, according to the FT. This means it has the power to block a restructuring deal under majority voting procedures. On the other hand, Ukrainian bondholders are diverse enough that it is possible a minority of 25% could also block a deal under the now standard collective action clauses.

(Read more about Ukraine Private Sector Debt Restructuring.)

Ukraine Debt Situation

The country’s debt situation is not simple. Credit metrics such as debt-to-GDP are increasing rapidly as the economy contracts. For example, the International Institute of Finance (IIF) estimates Ukraine will have total external debt of $128.9 billion in 2015. If its GDP for 2015 is $99 billion, as S&P suggests, this is a debt-to-GDP ratio of 130%, roughly where Greece was in 2009 when the financial crisis there first started. If we use the Economist's 2015 GDP expectation of $70 billion, then debt-to-GDP shoots up to 184%, which is where Greece was in 2011 during the peak of the Eurozone financial crisis. (For a better understanding of the significance of a country's GDP, see article: What Is GDP And Why Is It So Important?)

If we examine the country’s funds flow using IIF data we can see the crisis in Ukraine unfold. Private sector financing essentially stopped in 2013 as the war of rhetoric with Russia escalated, while no official flows were yet coming into the country. As the crisis grew in intensity, private creditors fled, taking $9 billion with them, and the IMF stepped in by distributing $4.5 billion under its original program.

Source: IIF

In 2015 the IIF expects private creditors to take out another $6 billion while official sources prop up the country with nearly $17 billion in fresh cash, doubling their share of Ukraine’s total external debt to over 20%.

Source: IIF

Where does all this leave the Ukrainian people? As with most debt, IMF bailouts come with conditions. In the case of Ukraine, the IMF is urging the government to restructure its economy and end energy subsidies to preserve cash. The FT reports that under IMF pressure, Ukraine raised domestic gas prices 50% in 2014 and wants additional price increases to ensure costs of gas are fully covered by April 2017. They also say that some protests regarding the rising cost of living are already beginning in Ukraine. Inflation at the beginning of 2015 was nearing 30%, with the cost of gas and water utilities up 35%. But this may be the wrong time to be making such demands on the government because of the unique circumstances created as a result of the military conflict with Russian separatists. A more pressing need is ensuring the country remains politically intact and does not create a stability and security headache for the EU.

The Bottom Line

The EU has spent a lot of time, money and effort to ensure the Greek financial crisis does not threaten the stability of the Eurozone, but a more pressing and immediate threat to the stability of Europe in general may come from outside the European Union. Ukraine’s economy is rapidly deteriorating under the weight of war and the IMF’s rescue package for Ukraine may prove inadequate if it is impossible to convince private sector creditors to accept restructuring. As Timothy Ash, head of emerging market research at Standard Bank so aptly put it in a recent FT article, “[The IMF] can’t plug a hole that keeps changing size.” If Ukraine isn’t stabilized soon, the EU will have more to worry about than just Greece.

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