Five Financial Questions for Ukraine

There is an interesting debate going on in Western capitals over financial support for Ukraine.  The possibility of political change, coupled with Russia’s decision to suspend disbursements on its $12 billion financial package, has created an opening for meaningful economic reforms and renewed ties with global financial bodies.  There are compelling political arguments for the West to respond with a financing program that makes it economically viable for Ukraine to choose the EU Association Agreement that it rejected last year.  But the economics make a deal hard to put together.  For now, the ball is in Ukraine’s court—tensions remain high and Western aid will require at a minimum a technocratic and reform oriented government be put in place.  But should that happen, here are five economic questions on the table.

  1. How big is the hole?  Ukraine has significant fiscal and external imbalances.  For some time, and against the advice of the IMF, the government had tried to peg the exchange rate at just over 8 hryvnia against the dollar.  Last week, with foreign exchange reserves plunging to around $17 billion (around 2 months of pre-crisis imports) and reports of significant deposit flight, the government abandoned the peg, imposed capital controls, and is now managing the exchange rate down. That is good for long-run competitiveness, but doesn’t preclude the need for substantial upfront financing.  In December, the IMF identified a current account deficit of over 8 percent of GDP and a fiscal deficit of 7 ¾ percent of GDP.  The underlying fundamentals look to have deteriorated since then.  Optimists will argue that market access would return quickly with improved policies, but there would be significant risks to any lightly funded program.  A financing gap on the order of $15 billion seems reasonable.
  2. Who pays?  Western officials are understandably hesitant to be caught up in a bidding war with the Russians over aid, but discussions look underway to try and boost the package on offer to Ukraine. Until now, the reported European package is quite small, less than $1 billion.  The EBRD should expand lending, but their exposure to Ukraine is already stretched.  Some creativity may be possible using structures that encourage private sector cofinancing.  One idea would be to expand the IFC’s A-B loan program, which provides a degree of seniority to cofinancing partners.  In addition, the IFC’s focus on trade and energy efficiency–critical issues given strained relations with Russia–should easily be scalable.  The US government should ask Congress to reprogram available funds (perhaps the “Chobani affair” at the Olympics makes that possible!).  An IMF program is a must, but will it be a large access program that could be needed to fill the financing gap? That would be a tough call for the IMF, which in their last review criticized the government’s past ownership of the reform program and argued that “arrangements with lower access focused on critical areas may have better prospects.”
  3. Russia’s role?  The financing need will depend on how Russia reacts, both in terms of trade sanctions and energy pricing (Russia is the dominant supplier of energy to Ukraine).  To the extent that market access gains can be accelerated when the EU Association Agreement is signed, they should be.  And Russia is in principle constrained from retaliation by its WTO obligations (the US and Europe should take a strong, united stand on this point).  In the end, some understanding with the Russians seems required.
  4. A sustainable reduction in subsidies?  The IMF rightly has taken a strong stance on the need for a substantial increase in energy prices, on the order of 40 percent, but how fast does that have to happen?  In my view, the increase could be done gradually, as long as there is “stickiness” in that the increases are not reversed.  It would help a lot if future increases had automaticity (e.g., indexed), a narrow safety net was constructed to protect the poor, and the policy had popular support.  That’s a tough job, but worth the effort.  Of course, a gradual adjustment requires more financing in the near term.
  5. Burden sharing?  The toughest question, and most important for markets, is whether economic assistance will be conditioned on a private sector involvement (PSI).  There is a hot debate now underway about whether the rules of the game for debt restructuring need to change, in cases where debt sustainability is uncertain.  Ukraine’s government debt is not high by international standards—on the order of 45 percent of GDP.  Instead, the case for a reprofiling of debt here rests on the old-fashioned need for financing.  If there is a residual gap, will the Europeans up their contribution so external creditors can get paid?  Should they?  If, as noted above, there are good reasons for the IMF to limit its role, attention may turn to the debt.  Over the next two years, Ukraine has around $2.1 billion in external bonds falling due, including $1 billion in June 2014.  It might be attractive to push off payments, but care will need to be given to the precedents that could be set and to managing the risks of contagion. Tim Ash has a  good analysis as to why the risk of default may be underestimated. Reprofiling that debt–perhaps with a menu of options including new money from “friends of Ukraine”–backed by meaningful reform would send a powerful message and could draw broad popular support.

This piece is cross-posted from Macro and Markets with permission.