Wednesday, March 11, 2015

Ukraine Bailout Risks Putting IMF Credibility On The Line.

The IMF may not be the most loved international entity. While it can be credited for executing many sovereign rescues, more recently in Europe, where countries like Romania, Greece, Hungary and Ireland found it necessary to ask for IMF help, it is also known for producing much misery in the process. It is quite obvious if one follows the policies it pushes on the borrower, that the loan comes with a wish list made up by those who do the lending through the IMF. The interests of those who draft that wish list tend to be in contrast to the interests of the country that is being bailed out.

While its policies are much criticized, reality is that it has been an important ingredient in maintaining a degree of stability on the international sovereign debt markets. Bond investors know that there is an extra layer of protection provided by an entity that is willing to lend whenever investors decide to freeze out a sovereign entity out of the markets. This leads to lower perceived risk and it leads to lower interest rates. Lower interest rates allow governments to tax less, invest more, thus facilitating more global growth.

For this reason the bailout that is about to be offered to Ukraine should worry us. It is no secret that the IMF is making a political decision here and not one based on fundamental guidance. Ukraine's situation is such that it does not meet the preconditions that are usually demanded in order to guarantee to some extent a return of the investment made by IMF contributors. In fact, the situation there is so bad that in my view the loss of this bailout money is almost 100% guaranteed. I simply do not see how Ukraine will be able to pay this money back. What I do see, is a pattern developing which will push the IMF and other entities participating in this bailout to keep sending in more money in order to avoid a collapse, which will make the ultimate loss more severe.

In fact, this is more or less in part what is happening right now, given that last year's bailout proved to be insufficient. It will not be long before the current program will also be seen as inadequate. For one thing, the program is built on the assumption that Ukraine will be able to restructure its debt, pushing maturities further out and most likely getting bondholders to agree to a haircut. Such a deal is not guaranteed by any means. Aside from that, pushing the maturity out means that Ukraine would have to deal with those bonds just as they would be required to pay back the IMF-led bailout funds as well. The ability to do that would depend on Ukraine stabilizing and achieving a relatively healthy rate of economic growth, which has no chance of taking shape. There are simply too many obstacles in the way.
First of all, there is Ukraine's economic dependence on Russia. About a quarter of all Ukrainian exports were headed to its Eastern neighbor. 

Many of the goods it is exporting even now are intermediate components used in Russia's defense industry. Russia has already started the process of cutting its reliance on these goods. For Ukraine, it can mean a loss of well over a billion dollars per year in trade. Odds of being able to find new customers for its intermediate and finished defense products are not very high. Aside from this, Exports to Russia of all sorts of products totaled $17 billion per year before the crisis started (link). That will be equivalent of 17% of Ukraine's GDP this year. Most of this source of much-needed foreign currency and source of jobs for Ukrainians will in my opinion shrink dramatically in the coming years.

There are also Russian companies invested in Ukraine which are likely to gradually move away. Russia also announced in January that it wants to end its reliance on Ukraine as a gas transit route, which will deprive Ukraine of as much as $3.5 billion per year in transit income. I believe that this is also likely to happen by 2020, even if the EU will try to obstruct. If Russia fails to get gas to Europe via an alternate route such as through Turkey, it will simply work to divert some volumes to other markets, or perhaps make use of it internally.

One of last year's two gas deals with China involves exports of 30 Bcm (1 Tcf) per year from the same Western gas fields that currently provide gas to Europe. That is almost 40% of the volume that flows through Ukraine to the European market. In the event that the EU would find itself without the gas flowing through Ukraine, I believe it would consent to allowing for the Nord Stream pipeline from Russia to Germany to be used at full capacity, which would divert a further 20 Bcm of gas from the Ukraine transit pipeline. Russia should have no difficulty finding other uses for the remainder, or it might even consider slowing the pace of extraction from those fields, given that most of the domestic market is also being supplied from them.

War in the East: Damned if it continues, and damned if it does not.

The current ceasefire seems to be holding for now, but in all honesty, I personally have doubts that it will continue to hold for long. On one hand there are the Russia-backed rebels who see an opportunity to create a new state made up of ethnic Russian majority regions in the East. They currently control only a small portion of the Donbass region, so it is tempting for them to keep fighting. The Kiev government on the other hand may be tempted to find a military solution to the situation in the East, especially given the very loud and aggressive voices in the US, calling for an intensification of the conflict through weapon supplies to the Kiev government. These calls are in fact an incentive for Ukraine to undermine the ceasefire, because more and more people believe that the US will send weapons if the ceasefire collapses.

An intensification of the conflict would most likely lead to a greater degree and spread of the destruction, regardless of who would prevail. The arming of the Ukrainian army would give Russia the excuse needed to do so openly as well. This would most likely include the introduction of air power, which will allow the rebels to attack targets far from their current front line. All of this will make it very hard for Ukraine to maintain a viable economy. It would therefore be left with no other choice but to default on its debts, including the money owed to the IMF and other contributors.

While, the IMF itself declared that it wants to see an end to the hostilities in order to ensure that the Ukrainian situation is such that it will allow for re-payment, peace in the East may not necessarily be more beneficial. While the current conflict is causing an economic disruption to a significant part of Ukraine's economy, and is costing the Kiev government a significant amount of money, it also has some benefits from Kiev's point of view. It allows the government to continue to play the nationalist card and gives it a scapegoat for the increasingly harsh living standards many Ukrainians are experiencing.
Ukraine's minimum wage was about $150/month in 2013. It has now fallen to about $60/month due to the currency depreciation. It could fall further still, once the IMF deal is implemented and Ukraine's central bank allows the currency to weaken. It went down to as low as $40/month last month, when the local currency, the hryvnia experienced a sharp sell-off.

Aside from the low wages, there are pension cuts, government layoffs and the economy will most likely have a hard time functioning given the central bank's move to raise interest rates to 30% last month, which will lead to more layoffs and stagnated wages in the face of high inflation. The IMF also asked for energy subsidies to be removed, which will among other things increase the cost of household heating by almost 300%.

Up to now, the government did a pretty good job of appealing to the population's patriotic and nationalist sentiments, in order to deflect criticism in regards to the state of the economy. If the conflict in the East dies down however, it is hard to see how they will be able to continue to blame the state of the economy on the conflict and on Russia. The IMF-imposed austerity programs will be what people will be feeling directly, not the effects of war on their lives.

The government has so far done a decent job of preparing for this. It in fact installed tools of media control and laws which allow the state to go after anyone they deem to be inconvenient. The West will most likely be silent even as the Kiev government will resort to more and more repression in order to prevent a popular revolt. We already know this will be the case, because there was little reaction in the Western world, even as the Kiev government introduced media control laws in December, which seem quite repressive and extreme (link).

Having control of the media and the ability to detain people for things that would be seen as unjustified in most free and democratic states, should help prevent a mass revolt for a while. Increasing economic despair will however push people to revolt eventually, regardless of attempts by the government to keep a lid on it. What makes the situation particularly dangerous is the fact that there are many relatively independent militia groups currently fighting in the East on behalf of the government, which belong to groups that feel they were shut out from the reigns of power last year. These militias often display their new-Nazi allegiance openly as is the case with the Azov battalion which is currently one of the pillars of defense for the strategic city of Mariupol (link).

While these groups came in handy for the government in its quest to try to regain control of the rebel areas in the East, because these groups were in fact the only reliable fighting units at its disposal, given the lack of fighting spirit within the regular army, these groups may in the end prove to be more dangerous for the current government than for the ethnic Russian rebels. When the fighting will stop and people will gradually turn their anger at the government due to the economic situation, groups such as the Azov battalion and others will most likely seize the opportunity to try to install themselves into power.

Ukraine as a state lost its future the day after Yanukovic was ousted and the new government decided to make the repeal of historical minority rights its number one priority. That was the moment when they set their own house on fire and there is in my view little hope of going back. The IMF is pouring a lot of money into a country which no longer possesses the minimum level of social cohesion needed to keep it together. There are ethnic tensions, as well as social and ideological tensions, which are made even deeper by the Russia-West proxy fight for control of that country. In the end, there is a chance that Ukraine can be salvaged and saved from descending into failed state status. But this salvage may involve allowing for a complete write-off of all government debt in order to remove the extra burden, while the Ukrainian economy returns to viability. This of course will mean that the IMF will not get its money back either.

Implications.

As is the case with all investments, contributors to the IMF fund expect to get their principal back, together with interest, as well as indirect benefits from the terms of the bailout. There are currently two states which have been bailed out in the past few years, which look increasingly unable to pay back the bailout funds. We know that Greece is unlikely to be able to avoid eventual default and the IMF will be part of that default. Ukraine is now the second candidate.

While most people who experienced the IMF recipe for a return to sovereign financial health will feel reason to rejoice if the fund takes a hard hit, the global economy will in fact end up more unstable as a result. Significant losses incurred on IMF loans will cause contributors to become more stingy with their contributions, leaving the IMF in a position of weakness when it comes to being able to secure the funds needed to execute a bailout. This in turn will mean that bond investors will feel less secure about the risk involved in investing in sovereign debt around the world, given that an extra layer of protection will be removed.

What this means is that even as the world is increasingly entering a period of low inflation, which is causing interest rates to also decline significantly around the world, there will be upward pressure on interest rates due to risk perceptions. The end-result will be a situation where inflation is relatively low and interest rates relatively high, which will make global debt more unsustainable This cannot but further hurt a global economy, which is already suffering from a very significant decline in growth rates since the beginning of the 2008 crisis.

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