Argument

The Other Front in Ukraine’s War for Survival

Ukraine needs a win in its negotiations with foreign investors just as much as victory on the battlefield.

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Brandishing a yellow hunk of metal from what he claimed was a public bus hit by a missile from pro-Russian separatists, Ukrainian President Petro Poroshenko made an emotional plea for western assistance during his speech at the World Economic Forum at Davos. His appeal didn’t go unnoticed. The increasing brutality of the war in eastern Ukraine is now prompting policymakers in Washington and elsewhere to debate stepping up assistance to Kiev’s military. Yet the future of Ukraine’s beleaguered democracy won’t be determined solely on the battlefield. Equally important, perhaps, are the delicate negotiations between Kiev’s new finance minister and a key player at one of America’s most powerful investment firms.

As Ukraine’s economy first began to collapse in 2013, Michael Hasenstab made a bold bet. Hasenstab, the star international bond manager of Franklin Templeton — one of America’s biggest financial firms with over $800 billion in assets under management — scooped up billions in Ukrainian government bonds, becoming Kiev’s largest private creditor. Hasenstab was acting as a so-called “vulture” investor, buying low and hoping to sell at a substantial profit later.

Ukraine wasn’t Hasenstab’s first big gamble. Since he began managing Franklin’s international bond department in 2001, Hasenstab has gained a reputation as a maverick who grabs risky stakes in countries buffeted by economic crisis. During the depths of the financial crisis, for example, Hasenstab’s big bet on Irish government bonds produced profits of approximately $2.5 billion as the economy gradually stabilized, doubling the value of the debt.

Hasenstab clearly has strong nerves. In 2013 he turned his attention to Ukraine, a country already known for rampant corruption, shaky finances, and chronic political instability. Yet Hasenstab spoke publicly of the country’s merits as an investment destination, explaining that it was a good risk due to its highly educated population and its ability to access international financial aid through the IMF.

Needless to say, things haven’t turned out as planned. After originally buying Ukrainian bonds at a cost of approximately 80 cents to the dollar, Hasenstab has seen their value plunge to 50. It’s not hard to understand why. “The war in the East, along with domestic political tensions and delayed reforms that have deferred the disbursement of foreign official financing, have put Ukraine at the brink of an economic collapse,” says Lubomir Mitov, chief economist for Europe for the Institute for International Finance.

The numbers bear out Mitov’s analysis. Ukrainian GDP contracted by 7.5 percent in 2014, and analysts are predicting a further 6 percent drop this year, while Kiev’s debt-to-GDP ratio is expected to rise to an unsustainable 90 percent by the end of the year. Meanwhile, Ukraine’s currency, the hryvnia, fell by almost 50 percent against the dollar in 2014, essentially doubling the cost of repaying its $10 billion worth of foreign debt due before the end of this year. Given that Ukraine’s foreign exchange reserves have fallen to only $7.5 billion, it’s clear that Kiev’s debt load is unsustainable.

Unfortunately for Franklin Templeton, the status of its Ukrainian bond investments just went from bad to worse. Even though the International Monetary Fund (IMF) granted Ukraine a $17 billion loan last year, Kiev has now requested additional cash from the IMF to tide it over (at the same Davos meeting attended by Poroshenko, in fact). Ukraine’s new finance minister, Natalie Jaresko, posted on Facebook that she’s planning “consultations” with the holders of the country’s bonds in order “to improve medium-term financial stability.” Translation: Kiev wants to begin talks with its foreign creditors on restructuring its foreign debt.

That trial balloon predictably spurred speculation that Ukraine is positioning itself to bail on its obligations. Yet the international financial community — above all firms like Franklin Templeton — needs to get real. Kiev has every reason to stick to its guns and insist that its foreign creditors share in the pain of its people. Indeed, the suffering of the country’s population is already immense. The average salary is barely $220, and with inflation running at 25 percent, the purchasing power of ordinary citizens has already been slashed. The government is also implementing a harsh austerity program agreed on with the IMF last year, and Jaresko’s ministry has drafted sweeping welfare spending cuts of nearly $30 billion. If Kiev is going to make these massive cuts, then at a minimum the IMF’s bailout cash should not be used to relieve foreign bondholders from the consequences of their own poor investment decisions at the expense of Ukraine’s people.

While Ukraine’s central bank governor, Valeriya Gontareva, recently fretted that Ukraine risked becoming a “pariah country” if it did not meet its obligations, she needn’t worry. If Kiev can reach a voluntary agreement with its creditors to restructure its debt prior to defaulting, the evidence clearly indicates international markets will likely be much more forgiving of Ukraine. In this respect, Jaresko’s decision to address a debt restructuring with Ukraine’s creditors sooner now is the correct one.

Creditors have also cited the case of Argentina as an example of what can go wrong when countries deviate from the terms of their loans. Since it defaulted on its international bonds in 2001, Argentina has been locked in years of litigation with holdout investors who have refused to accept Buenos Aires’ restructuring terms. Yet the IMF’s own research shows that this example is an outlier. It takes only 13 months on average for countries to agree on restructuring terms with their creditors, and in most cases economic growth rates double (or more) while inflation drops substantially.

Mitov believes that “restructuring is all but unavoidable,” and argues that Ukraine’s international creditors can significantly ease the financial strain on Kiev by agreeing to accept a combination of lower interest rates and longer payment deadlines. This, in turn, would provide post-Maidan reformers the breathing space to implement urgently needed political and economic change.

No matter what happens, of course, Michael Hasenstab will still be a key figure in determining Ukraine’s financial future. He could decide to play hardball and demand that Kiev meet 100 percent of its financial obligations to Franklin Templeton. In that scenario, Ukraine would almost certainly run out of run out of hard currency in the coming months. This in turn could cause the value of the hryvnia to plunge, causing inflation to soar, and perhaps even leading to the collapse of the financial system as people and companies rush to withdraw their savings from banks.

Luckily for Ukraine, Hasenstab’s interests in this crisis largely align with its own. As Bloomberg recently noted, a voluntary agreement between Ukraine and its creditors on restructuring could actually boost the value of Kiev’s debt. Even if Hasenstab takes a hit, it probably wouldn’t add up to the 70 percent loss that Goldman Sachs recently predicted could occur. And at least one thing is for sure: If Hasenstab, as owner of nearly half of Ukraine’s dollar-denominated bonds, agrees to restructure Franklin Templeton’s Ukrainian bond holdings, other private creditors will almost certainly follow his lead.

While Kiev may continue to suffer reverses on the battlefield, a path exists for Ukraine to reclaim control of its financial destiny.

REUTERS/Sergey Polezhaka

Josh Cohen is a former USAID project officer involved in managing economic reform projects in the former Soviet Union. He contributes to a number of foreign policy-focused media outlets and tweets at @jkc_in_dc.

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