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Weaponizing Ukraine’s National Debt

Monday August 15th, 2016   •   Posted by Craig Eyermann at 6:21am PDT   •  

36597643 - war in ukraine concept isolated on white background As much as we focus on the U.S. national debt, there’s a lot that we can learn from other governments whose national debts have surpassed their people’s ability to even hope to pay back their nation’s creditors.

A very strong argument to be made that the nation with the worst problem arising from its excessive national debt is Ukraine. The Economist explains how just one portion of its $18 billion national debt has put the nation at extreme risk:

Russia lent Ukraine $3 billion in December 2013. The bond was arranged by Western law firms (including White & Case and Clifford Chance) and is listed on the Irish stock exchange. The bond was essentially a bribe to Viktor Yanukovych, Ukraine’s now-ousted president, who was dithering between European and Eurasian integration. Senior Ukrainian officials say that the government itself never saw the money; most probably it was spirited out of the country by Mr Yanukovych’s cronies.

Since its issue, the bond has caused Ukraine big problems. A bizarre clause in the bond says that if Ukraine’s debt-to-GDP ratio exceeds 60%, Russia can demand early repayment; that might, in turn, trigger an automatic default on Ukraine’s other international bonds through a so-called “cross-default” clause. The government’s debt is well above the 60% threshold (it is touching 100%), thus enabling Russia to precipitate a default if it wants to. It has not yet done so. But repaying the bond would be very tricky for Ukraine, which has only about $12 billion in foreign reserves. Repaying Russia would also go down badly with the Ukrainian public.

How has Russia reacted to Ukraine’s debt-restructuring deal? Not well, you will not be surprised to hear. Anton Siluanov, Russia’s finance minister, says that Russia will not even talk to Ukraine regarding the restructuring of that bond. Russia now argues that the debt is an “official-sector” loan (not a private-sector one) meaning that it is not subject to the debt deal. By arguing this, Russia causes other problems, even if it does not get repaid. The International Monetary Fund is not supposed to lend to a country if it is in default to an official creditor. But Ukraine is desperately dependent on IMF funds to stay solvent; it is expecting another tranche of cash sometime in the autumn. Timothy Ash of Nomura, a bank, says he is “not sure that a clear strategy has yet been worked out” by the IMF. Ukraine’s debt saga is far from over.

That story is from September 2015. Since then, Ukraine’s debt saga has gone from bad to worse. In December 2015, Ukraine pulled the trigger on the national debt gun that’s pointed at itself, and defaulted on paying its $3 billion liability to Russia just before the bill came due. Bloomberg reports:

Ukraine said it won’t repay $3 billion in bonds due to Russia, moving a step closer to a court battle amid a new wave of economic tension between the two ex-Soviet neighbors.

Prime Minister Arseniy Yatsenyuk said Kiev is imposing a moratorium on the note due Dec. 20, which Russian President Vladimir Putin bought two years ago as part of an abortive bail-out for Ukraine’s former leader just months before he was toppled. Russia said on Friday it will wait until a 10-day grace period on the bond expires on Dec. 30 before starting legal action.

Legal action came quickly. Business Insider describes how relations have deteriorated between borrower and creditor:

Russia and Ukraine are embattled in full-blown economic war.

The latest step taken was by Russia, which confirmed in a statement on its Ministry of Finance website, that it is suing Ukraine for allegedly not paying back $3 billion (£2 billion) worth of debt.

This is the latest in a line of tit-for-tat disputes, bans, and lawsuits since the Ukrainian peninsula of Crimea was “reunified” with Russia by way of well equipped, organised, and trained “self-defense units,” who were actually Russian special forces, nearly two years ago.

In May 2016, the court actions involving Ukraine’s debt argument with Russia took a very unusual turn. The Duran describes a dramatic reversal in Ukraine’s legal arguments:

It has taken a while for Ukraine to file its Defence. As is usual in court cases Russia granted Ukraine at least one extension of time to enable it to do so. The reason given for the delay was apparently the change of government in Kiev following the forced resignation of Ukraine’s previous Prime Minister, Arseny Yatsenyuk.

In the event the Defence Ukraine has filed is one that has no precedent in legal proceedings of this sort. Ukraine claims it should be relieved of paying the debt because Russia’s alleged military aggression against Ukraine means Ukraine should be under no obligation to pay it.

The first thing to say about this Defence is that it essentially admits the debt. Ukraine is no longer saying the debt itself does not exist because it was a collusive arrangement – a bribe if you will – paid by Russia to Ukraine’s former President Yanukovich. Nor is Ukraine claiming the debt should not be repaid because it is intrinsically onerous.

These defences, if they were ever considered, essentially collapsed the moment the IMF recognised the debt as valid and said it was public debt – ie. debt owed by Ukraine to Russia as a sovereign state – not debt akin to that which Ukraine also owes to its private (mainly Western) creditors. Since the debt has been recognised as valid by the IMF Ukraine is no longer able to dispute it.

In light of this the Defence Ukraine has filed – claiming it should not be required to pay the debt because of the aggression Russia has allegedly committed against it – was realistically the only Defence possible if Ukraine was to defend the case at all.

Since then, the court case over its debt to Russia has faded as the nation’s problem appears to have gone from worse to perilous. According to CNN, a new series of Russian military troop movements along Ukraine’s border with Russia, including within the Crimean peninsula controlled by Russia, has put Ukraine on high alert:

Ukraine is ordering its troops to be on the “highest level of combat readiness” Thursday, amid growing tensions with Russia over Crimea.

The order comes after Russia accused Ukraine on Wednesday of launching a militant attack at “critically important infrastructure” near the city of Armyansk, Crimea, according to Russia’s state news service TASS.

But Ukrainian President Petro Poroshenko refuted the claims, calling them “insane” and suggesting Russia’s aim was more military threats against its neighbor.

The spat has seen tensions between the countries rise to their highest level since Russia annexed Crimea in 2014.

On Friday, August 12, 2016, Russia proceeded to up the stakes by positioning air defense missile systems in Crimea. Russia has announced that from August 16 to 19 it will hold military exercises in Crimea to “simulate the effect of an enemy attack using WMD” (Weapons of Mass Destruction).

Geopolitics appears to be playing a role, with Russia’s saber rattling having the immediate strategic goal of preventing Ukraine from joining NATO and keeping it within its sphere of influence. Russia’s leaders are clearly playing all the cards they have at their disposal. In that context, the battle over Ukraine’s debt owed to Russia may be just one front of a much larger conflict.

The situation reminds us of a key historical danger: Military conflicts sometimes arise whenever one nation becomes too indebted to another, as Investopedia‘s Stephen D. Simpson explains:

Countries that rely on other nations to buy their debt run a risk of becoming beholden to their creditors and having to trade sovereignty for liquidity. Although it probably seems unthinkable today, there was a time when countries would actually go to war and seize territories over debts. The well-known Mexican-American holiday Cinco de Mayo actually doesn’t celebrate Mexican independence, but rather a battlefield success over France in an invasion launched by France over suspended interest payments.

Actual military action over debt may no longer be tenable, but that doesn’t mean that debt cannot be a tool of political influence and power. In disputes over trade, intellectual property and human rights, China has frequently threatened to reduce or cease purchases of U.S. debt – an act that would very likely drive up rates for the U.S. government. China made a similar threat to Japan over territorial disputes related to the Senkaku/Diaoyu islands in the East China Sea.

Readers also need only look at what has happened to Greece and Spain to see how excessive debt imperils national sovereignty. Due to its inability to pay its debts and a desire to remain in the eurozone, Greece has had to accept various external conditions from the EU regarding its budget and national economic policies in exchange for forbearance and additional capital. Since then, unemployment has soared, civil unrest has grown and Greece is effectively no longer in charge of its own economic future.

While Russia appears to have far greater aims than than simply collecting loan repayments from Ukraine. The trade of sovereignty for liquidity is a key lever that Russia has at its disposal. In that sense, Russia’s position of acting as a creditor to Ukraine gives it another weapon to use against the much smaller nation, putting Ukraine at a greater disadvantage than it would be if not for its fiscal liability to Russia.

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August 2016