California Firm Props Up Ukraine’s Failing Finances

November 14, 2013
Anthony T. Salvia
Director, American Institute in Ukraine

We are on the eve of the Vilnius “summit” and the wrangling over Mrs. Timoshenko and her fate is going down to the wire. It is by no means clear how it will turn out, but two things we do know – MEP Elmar Brok, who is widely believed to speak for German Chancellor Angela Merkel in this affair, wants Julia released and all charges against her dropped as a precondition for a deal.

The Americans have upped the ante: the US State Department recently decreed that not only must Julia be set free, there must be no restrictions placed on her political activities.

All of this tends to complicate the President’s 2015 re-election campaign – already effectively underway.

Another wild card is the economy. Mired in recession (along with many of its Western export markets), Ukraine is experiencing negative growth. It is running large budgetary and current account deficits. Its foreign exchange reserves are dwindling fast – down 7.4 % over the past year. According to Moody’s, the ratings agency, Ukraine has enough reserves to pay for just 2.3 months of imports – the lowest level since 2006. Fitch, another ratings agency, has downgraded Ukraine’s creditworthiness to B-, which is “junk bond” territory. Talk of default is in the air.

“They face a currency and funding crunch, it’s as simple as that,” Paolo Batori, a senior strategist at Morgan Stanley, told the Financial Times of London. “…Ukraine is simply not equipped to deal with another wave of outflows. It needs the help of a third party, whether that is Russia or the IMF,” he said.

Enter Franklin-Templeton, a big, California-based “money management” firm, which is holding $5 billion in Ukrainian debt, making it the nation’s largest creditor. Although it has held most of this debt for some time, it purchased $117 million of additional Ukrainian bonds with a maturity of ten years as recently as last summer.

This loan does not begin to meet Ukraine’s cash needs. It is stop-gap funding. Ukraine’s problems are structural. As the risk premium on holding Ukrainian debt is high (it hit 10% last week), the firm’s bold bet could reflect a belief that structural reform and/or a reversal of Ukraine’s economic fortunes – with a positive impact on state solvency – is in the offing.

What would justify such a belief? Several factors come to mind, but all are fraught with uncertainty. They include the recent announcement of a deal with Chevron for development of Ukraine’s shale gas potential; growing Chinese and global demand for Ukrainian agricultural products; attainment of associate status in the EU through the signing of the AA/DCFTA, which in turn would pave the way for resumed IMF lending.

Of these factors, the most transformative for Ukraine is its possession of 25% of the world’s supply of black earth. It is plays its cards right, Ukraine will become the Saudi Arabia of food.

The most fraught is associate status in “Europe” and a possible resumption of IMF lending. Despite a rising stock market fueled by “quantitative easing” (i.e., rampant money printing), Europe remains mired in intractable recession. Earnings for the third quarter of 2013 are down 50% in Italy, 22% in Austria, and 20% in France and Germany.

In Germany, the presumed locomotive of Europe, exports are down 0.9%, and imports are down 1.9%. Industrial production fell in September (though it rose slightly in August), and still has not reached its 2007 level (i.e., before the onset of the global financial crisis in 2008). The same applies to industrial orders.

Thus, it would be rash to expect the signing of the EU-Ukraine AA/DCFTA (if it happens) to usher in a materialist nirvana. There is no reason to expect Ukraine to rise as Europe sinks.

Nor is Brussels likely to come up with the cash Ukraine needs to help it meet its current fiduciary obligations, let alone the €165 billion in new spending (the equivalent of Ukraine’s entire Gross Domestic Product for one year!) Prime Minster Azarov says will be required over ten years to comply with thousands of pages of onerous EU regulations.

One thing EU associate status could do for Ukraine is pave the way for resumed IMF lending. But that would be a mixed blessing to put it mildly. In exchange for cash infusions, the IMF will demand reduced subsidies to domestic consumers of Ukrainian gas, a devaluation of the hryvna, and/or a raising of the retirement age so as to curb spending on pensions.

The Wall Street Journal reports Kiev is working on plan to cut subsidies to Naftogaz, but President Yanukovich stated emphatically as recently as November 8th his opposition to raising gas prices on domestic consumers.

Yanukovich already faces the prospect of a liberated Mrs. Timoshenko playing an active role in the 2015 presidential campaign; the last thing he needs is to campaign on a platform of higher gas prices, reduced pensions, and a devalued currency – as the country continues to languish in recession.

And then there is the matter of how the President’s tilt towards Europe is playing among his political base. According to Oleksandr Yefremov, head of the POR’s parliamentary fraction, there is mounting opposition to Kiev’s policy on the part of the machine-building industry, which exports more than 70% of its product to Russia. He says his fraction will not support the passage of any laws that might be proposed to enable Mrs. Timoshenko to travel to Germany for medical treatment.

As the drama of Ukraine’s “euro-integration” unfolds, it is hard to escape the impression that this is a train wreck waiting to happen – even more so if the agreement is signed.