Ukraine struggles with separatists, protests, reforms – and an IMF debt deal on shaky ground.
By David R. Cameron*
Ukraine’s war with pro-Russian separatists in its easternmost regions of Donetsk and Luhansk, started soon after Russia annexed Crimea in March 2014, has cost more than 6,000 lives and displaced more than a million. The war also damaged or destroyed much of the housing stock, infrastructure and productive capacity in its industrial heartland and sent the economy into a freefall. The gross domestic product dropped by 7 percent last year and is projected to drop another 9 percent this year. Facing a projected balance of payments deficit of $10 billion this year, the country entered 2015 on the verge of bankruptcy and desperately needing assistance.
In March, the International Monetary Fund approved Ukraine’s request for $17.5 billion over four years through its Extended Fund Facility – which allows a longer payment period for structural reforms – something it had refused to do in 2013. That refusal led then-President Viktor Yanukovych to seek and obtain financial assistance from Russia, in turn prompting violent protests in Kiev. The parliament removed Yanukovych, and Russia, declaring his removal a coup d’état, took control of and annexed Crimea.
While the IMF agreed to provide $17.5 billion, it also estimated that Ukraine faces a larger external financing gap of $40 billion. The IMF called for a “debt operation” – a restructuring of the debt held by private sector creditors that would provide $15.3 billion toward covering that gap.
Thursday last week, after five months of stalemated negotiations, Ukraine announced it had reached an agreement with an ad hoc committee representing its largest external private-sector creditors to restructure their holdings. Finance Minister Natalie Jaresko announced the committee had agreed to a 20 percent “haircut” in the $18 billion of bonds held by the private creditors, a deferral of four years in redemptions and a reduction of the coupon on all debt to 7.75 percent. Together, those measures are expected to provide the $15.3 billion called for by the IMF.
The Ukrainian government, the IMF and the US government, which supported Ukraine in the negotiations, celebrated the completion of the “debt operation.” If not celebrating, the more farsighted creditors could at least console themselves that the “haircut” was only 20 percent rather than the 40 percent Ukraine had insisted upon throughout the negotiations. And they could also find consolation that the deal already increased the value of their holdings, providing a possibility of recapturing some of their losses if Ukraine’s GDP grows above an annual rate of 4 percent after 2020.
Agreement may have been reached but that should not mask the fact that, like much of the IMF program, the “debt operation” is misguided, a short-term fix that will prove to be costly over the longer term. The deal looks good for now; without it, Ukraine would have had to declare a debt moratorium that would have triggered a default. But with an economy in freefall and in need of substantial investment, Ukraine cannot afford to scare off potential investors.
Moreover, Ukraine does not in fact face a $40 billion external financing gap over the next four years. The cumulative balance of payments deficit over the four years is projected to be $12.3 billion. That will be covered, with $5 billion to spare, by the Extended Fund Facility. The remaining $27.7 billion of the projected gap consists of a buildup of official reserves to bring them up to the IMF’s metric standard for reserve adequacy. That’s a laudable objective. But rather than giving the country’s external private creditors a substantial “haircut,” the IMF should have encouraged Ukraine to do that through its economic and trade policies. The “debt operation” will inevitably reduce if not eliminate any incentive for the government to undertake those policies.
That is not the only disincentive created by the IMF program. Because of the magnitude of this year’s projected payments deficit, the EFF is heavily front-loaded: Ukraine will receive $10 billion this year and $2.5 billion in each of the next three years. As a result, it will receive a substantial portion of the assistance before it implements the many much-needed financial, fiscal, structural, administrative and governance reforms required as conditions for the assistance. While understandable given the projected payments deficit, the front-loading will inevitably reduce the incentive to implement those reforms.
At the end of 2014, the ratio of Ukraine’s public and publicly-guaranteed debt to its gross domestic product was 73 percent – less than the ratios in France, the UK, Germany and many other European countries. Largely because of a steep depreciation of the currency in February, which dramatically increased the amount in hryvnia of the public debt, two-thirds of which is denominated in foreign currencies, the ratio is expected to increase to 94 percent this year. That would still be sustainable if, as the IMF predicted, the economy grows by 2 percent next year, 3.5 percent in 2017, and 4 percent a year in 2018-20.
Such estimates are illusory. Ukraine won’t attain those rates of growth. The program commits it to reducing its overall budget deficit from 10.3 percent of GDP last year to 7.4 percent this year, 3.9 percent next year, and less than 3 percent in 2018-20. The economy will not grow at 3.5 to 4 percent a year in 2017-20 if fiscal policy is contractionary this year and during each of the next five years. The IMF may have learned little from its experience with Greece; prolonged fiscal contraction inevitably, without exception, causes prolonged economic contraction.
Six consecutive years of fiscal contraction will cause the economy to continue to contract, causing the deficit to exceed the target figures and require additional financial assistance. Before long – probably by late next year or in 2017 – it will become apparent, just as it became apparent in Greece only a year after its 2010 bailout, that it needs a second bailout – one that will no doubt be accompanied by another round of “haircuts” for the private creditors. As in Greece, Ukraine may well need a third bailout sometime thereafter.
US Secretary of the Treasury Jacob J. Lew, Treasury Under-Secretary for International Affairs Nathan Sheets, and other US and European officials supported Ukraine in its negotiations with the creditors and loudly applauded last week’s deal. Yet what is most striking is how little the United States and the European Union have actually done to support Ukraine financially. The EU has committed $1.8 billion this year and $700 million next year through its Macro-Financial Assistance program. Compare that with the hundreds of billions it has poured into Greece. The US has committed even less – only $2 billion in loan guarantees this year and nothing thereafter.
For all their rhetorical support for Ukraine in its conflict with Russia and its surrogates last year and in the recent debt negotiations, that support appears to have been, quite literally, nothing but cheap talk. It is as if the European and American governments have forgotten that they have a long-term economic and geopolitical interest in Ukraine.
*David R. Cameron is a professor of political science at Yale University and the director of Yale’s Program in European Union Studies.