A potential silver lining in Ukraine
March 13, 2014

Although the upcoming referendum on CrimeaaEUR(TM)s possible secession from Ukraine is stoking tensions between Russia and the West, Ukraine may see some upside in the form of aid from the International Monetary Fund and other funders, assuming that compromise prevails over conflict. Such funding, accompanied by a dose of potentially harsh economic discipline, could quickly pivot the economy from illiquidity to stability.

Despite all its difficultiesaEUR"highlighted in a recent blogaEUR"Ukraine is not facing insolvency. Indeed, with a solid commitment by its current and future governments, it is reasonable to expect real GDP growth to approach 4 percent by 2016. But this will not come easily and would require significant fiscal tightening (but far less than Greece suffered through in recent years), further currency depreciation, and higher gas tariffs for households. In return for the initial pain that adjustment would inflict on UkraineaEUR(TM)s people, the IMF and EU will likely have to disburse roughly $30 billion over the next few years to put the economy on a sustainable growth path. Much of that cash would go to paying down debt.

Although it could take some time to settle the geopolitics around Ukraine, possibly resulting in the aEURoeFinlandizationaEUR? of the country in the shadow of its powerful neighbor, it is in no oneaEUR(TM)s interest to allow Ukraine to become a basket case. Russia does not want to take on the responsibility, and the cost, of trying to nurse UkraineaEUR(TM)s economy back to health. Europe has no desire to see instability in Ukraine, reflecting its dependence on Russian natural gas that flows through the country. Moreover, European leaders would like to avoid increasing military expenditures to reinforce border areas just as the continent is showing signs of recovery after a prolonged bout with recession and subpar growth.

The spreads on Ukrainian sovereign and corporate bonds and other market technicals indicate that investors presently see an even chance of a restructuring of UkraineaEUR(TM)s external debt. Fitting a survival probability curve to current Ukraine bond prices suggests a recovery rate of between roughly 70 and 80 percent. Using this range yields an implied 50 percent probability of a debt restructuring.

If the IMF moves quicklyaEUR"a mission visited Kiev last weekaEUR"and Ukrainian authorities cooperate in a meaningful adjustment program, a debt restructuring can be avoided. Under a plausible scenario, public debt to GDP could peak at just under 60 percent in 2015 and fall to 56 percent by 2018. However, if the geopolitical situation should take a turn for the worse, the next blog piece on Ukraine is unlikely to contain a silver lining.