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14 October, 2011  ▪  Maria Minska

The Bond Game

The government is trying to get off the IMF needle but is not prepared for the pain of withdrawal. Ukraine’s sovereign debt and fiscal load are set to grow in 2012, and default may become a reality in 2013

The country was recently stirred by news that was more overwhelming than unexpected: Ukraine was several hours away from a technical default. The Ukrainian Week has written on numerous occasions about the multiple risks caused by sovereign debt growth shamelessly outpacing GDP growth over the past several years. However, attention was focused largely on external obligations of the government, the National Bank and Ukraine’s government agencies, i.e., hard-currency sovereign debt. Authors reached the conclusion, one way or another, that turmoil on the internal market was almost inevitable, considering the parameters of the sovereign and total debt, but did not specify when a “default” might occur. It seemed no one, including foreign lenders, wanted to see volatility in Ukraine on the eve of the Euro 2012 finals.

And then the All-Ukrainian Entrepreneurship Facilitation Center went public with a statement that read: “Starting from Friday, September 23, the State Treasury suspended transactions on all treasury accounts on the national and local level.” The conclusion was that “this situation points to an attempt to accumulate sums needed to redeem two series of internal government bonds worth over UAH 5.3 billion by September 28.” The alarm sounded, it seemed. Entrepreneurs do not need to be told what this news means if taken at face value. Theoretically, consequences may range from panic on the currency market to blocked payments in the real sector. If the government defaults on its obligations, why should others honor theirs?

In actual fact, however, nothing terrible happened. The Finance Ministry released information which was confirmed by Ukrainian banks: the government paid UAH 3.5 billion on internal bonds. It appears that someone succeeded in squeezing money out of the government in late September, particularly by cranking up pressure via the mass media. But the problem of sovereign debt growth remains unresolved and is going from bad to worse.

MACROECONOMIC BACKGROUND

Ukrainians continue to take their money to banks, though less than they did 3-4 years ago. According to the National Bank of Ukraine, in the first half of 2011 the deposit portfolio of natural persons grew by nearly 10% from UAH 275 billion to UAH 302 billion. Ukrainians are not scared by either fears of a second crisis wave or low interest rates – 12% on average, which is 5-6% less than they could claim last year.

One- to two-year deposits are the most popular, and they also have the highest yield. Like in the previous years, banks find it hard to shed liquidity in complicated and uncertain economic conditions – as before, active lending to the real sector remains largely a promise. According to the most recent NBU data, credits issued to non-financial corporations grew from UAH 462 billion to UAH 558 billion in 2009-2011. In 2008, before the devaluation of the hryvnia, this index stood at UAH 443 billion. In other words, with the onset of the crisis banks took everything they could out of the real sector and are now in no hurry to risk their money again. As of August 2011, a mere UAH 80 billion of UAH 558 billion lent accounted for credits that mature in more than five years.

However, deposited money does not lie stagnant. In the first half of 2011, Ukraine’s banking system posted an 87-percent drop in losses. The NBU recently said that 145 of 176 financial institutions were in the black in January-August. Over this period, transaction volumes on the stock market grew by 16.8% to UAH 97 billion compared to the same period in 2010. Financial institutions purchased shares issued by Ukrainian companies, but most of their money was invested in government bonds. They owned bonds worth UAH 54 billion as of January 4, 2011, and nearly UAH 65 billion in early September. The 20% growth is significant but smaller than in 2010 when it multiplied 150%, spiking from UAH 20 billion to UAH 54 billion.

In 2011, the Finance Ministry repeatedly cut interest rates on government bonds, trimming them down to 4.5-5%, but even so transactions on the currency market and investments in securities were, according to the NBU, the most profitable operations for banks. This seems to make sense: money begets money. But, first, this business has a weak correlation with the real economic sector. Second, there is every reason to check whether it is a healthy situation. Abstracting from countless parameters, including some very important ones, a key factor may be singled out – internal government bonds were purchased with, among other things, the money deposited in banks and redeemed with money extracted by the government, in particular from citizens. The term “extracted by the government” can be interpreted to refer to not only deductions that go into the national budget in the forms of taxes and other payments but also the traditional arrears in VAT compensation, the symbolic devaluation of the hryvnia (particularly, of the monetary variety due to excessive emission of money) and many other things.

A statistical paradox is now in plainly clear: Ukrainians continue to take their money to banks, which use some of it to purchase government bonds, which drives up pressure on the real sector to pay off the amount already borrowed. Does a model like this have any future? One question inevitably arises in this context: Are Ukraine’s internal public bonds worth much at all? And, more profoundly, with what does their value correlate, and on what is it based? The latter issue cannot be taken out of the global context, because it is linked to a number of other factors: the stability of hard currencies, the solvency of countries that issue them, global trade turnover, and so on. Some answers can be read between the lines in The Ukrainian Week (Is. 38, 2011), but here I will limit myself to saying that living on credit is unacceptable on both the macroeconomic and microeconomic level. Prime Minister Mykola Azarov seems to sense as much, even if he does not consciously realize it, when he refuses to increase foreign debt and rejects IMF loans. This is the right thing to do. The unfortunate thing however, is that Ukraine does not have any other strategy. Moreover, we will have to continue servicing the loans we have already taken out.

CRITICAL YEAR AHEAD

The above explains why, despite a possible international economic downturn, the Ukrainian government expects — as reflected in the draft 2012 state budget — to obtain even more from the real sector than in 2011:

– individual income tax – UAH 0.63 billion more

– corporate income tax – UAH 6.51 billion more

– excise duty on products made in Ukraine – UAH 5.36 billion more

– excise duty on imported goods – UAH 1.41 billion more

– import duty – UAH 1.35 billion more

– export duty – UAH 1.77 billion less, etc.

These plans are easy to figure out: the much-publicized “monetary dam” will rest on an increased fiscal load that natural and legal persons will be forced to bear. Interestingly, some exporters will be able to breathe more freely than others. This is a perennial problem for Ukraine, but the government’s plan extends even further.

The government proposes setting the maximum sovereign debt at UAH 415.6 billion by the end of 2012 (UAH 375.6 billion by the end of 2011), which means it wants to continue living on credit. Worse still, this principle will be applied to government-owned enterprises. In particular, the Cabinet of Ministers wishes to reserve the right to place internal public bonds in order to purchase additional shares issued by Naftogaz (UAH 12 billion), by Ukrenergo and Ukrhidroenergo (UAH 1 billion), and so on. A curious pattern is taking shape: the government owes money to the banks that buy its bonds, to the IMF and to other foreign lenders (on behalf of citizens); the banks owe money to citizens; and government-owned enterprises (citizens’ property from a purely formal viewpoint) hand over their shares to the government.

It appears that while Ukrainians will be watching soccer games in 2012, privatization will be gaining momentum against the backdrop of a global devaluation of money. Much like in previous years, some receipts from privatization will be used to narrow the budget deficit of UAH 24 billion. It would be interesting to know what the government plans to do in 2013-2015 if it continues to pursue this strategy, which is very likely, considering that it has not changed in the past five years. Many experts point out that 2013 will be a critical year for paying off sovereign debt. Shares issued by government-owned enterprises will not be enough for everyone. What will Ukraine’s internal public bonds be worth in a couple of years?

CURRENT VALUE

When the state of the global economy is uncertain, government bonds interest many potential buyers partly because they are a relatively safe investment. U.S. and EU government bodies are taking advantage of this factor and are issuing bonds to finance budget deficits and solve other problems. Ukraine’s sovereign debt securities are deemed riskier, but this does not prevent the government from using them as it pleases. Filling holes in the budget is just one of its goals. Nationalization of crisis-stricken financial institutions (Ukrgazbannk, Kyiv Bank and Rodovid Bank) in 2009 was another. In 2010, this mechanism helped the government reimburse VAT. However, most exporters were not happy with the novelty. (Some became interested in debt securities, and the government played with the idea of paying VAT with securities for the gas supplied by Naftogaz).

However, in general, this mechanism spelled the complete or partial loss of real money. Those who sold bonds immediately lost 20-25% of the nominal price on the secondary market, while others are waiting until mid-2015 for full payment. (VAT securities depreciate with time, because the government pays off the principal amount in 10-percent semiannual instalments.)

The key cause behind issuing internal public bonds is the need to repay existing debts. About 10 years ago, the Verkhovna Rada deemed this approach unacceptable. Ex-Finance Minister Ihor Mitiukov got an earful from MPs who were against settling the debts of the bankrupt Ukraina bank by issuing internal public bonds. Ukraine had issued no more than UAH 7.5 billion worth of bonds by early 2007 and UAH 9.1 billion by early 2008. In 2009-2011, the process was fast tracked: UAH 30 billion and over UAH 130 billion at the beginning of those respective periods. The issued bonds now form a huge pyramid, and Ukraine is not alone in this situation.

In 2011, the Finance Ministry encountered a problem when the proposed yield on bonds did not generate interest among potential buyers. Of the auctions held in the summer, a mere five brought results. The trend continued almost unchanged in September – bonds simply do not sell like hotcakes these days. In the first 10 days of September, the Finance Ministry held another fruitless auction: it attracted only two bids to purchase one-year bonds worth a total of UAH 31 million with an expected annual yield of 11% or more. “The cutoff rate was at 7.95%,” shares Oleksandr Pecherytsyn, head of the department for financial markets at a bank. “Therefore, the Finance Ministry did not satisfy the applications, even though it had planned to place two short-term bond issues (with six-month and one-year maturation periods) and two mid-term bond issues (set to mature in three and five years, respectively).

Foreigners are not expressing any particular interest in Ukrainian government bonds, either, – they now have UAH 6.5 billion worth of them, down by UAH 4 billion from early 2011. They basically look at how the Ukrainian government is cooperating with the IMF, i.e., possibilities in the global debt game. It is no accident that the Finance Ministry is planning to soon issue bonds nominated in hard currency. According to NBU President Serhiy Arbuzov, the new instrument will be of interest to non-residents and banks with foreign capital.

Evidently Ukraine is failing to cure itself of its addiction to debt. Why not issue bonds secured with land and offer them to Ukrainians?


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