Ukraine has a growing debt problem that the government under President Volodymyr Zelensky is only making worse. The International Monetary Fund’s financial support for Ukraine is conditioned on the country making various reforms that will reduce its dependence on international assistance in the future. Kyiv, however, appears to be looking for ways to circumvent the IMF’s conditions while still tapping into the market for government debt. That’s a dangerous strategy for a country whose relationships with the United States and the countries of Western Europe—which together constitute the main source of IMF funds—remain indispensable as it fights off Russia on its eastern border.
The government’s avoidance of reforms should worry the Biden administration in the United States: A Ukraine sliding away from democratic reforms will be more vulnerable, while a sluggish economy could reverse its trade reliance from the European Union back to Russia. A more prosperous, democratic Ukraine, on the other hand, means a less powerful Kremlin. But by aggressively tapping into capital markets, where Ukraine pays very high interest rates, and by dragging its heels on reforms expected by the IMF, Ukraine’s current administration is only putting the country at more risk, while facing a worrisome level of debt.
The IMF’s $5 billion financial package for Ukraine, agreed on in mid-2020, has stalled, with the most recent review mission ending in February without a deal on the next tranche of funding. The IMF is waiting until Ukraine’s leadership decides to recommit to the agreed priorities, which include bank independence and judicial reform, as well as anti-corruption measures. This is not the first time Ukraine’s cooperation with the IMF has been delayed due to the pace of Kyiv’s corruption reforms. Back in 2016, Christine Lagarde, then the managing director of the IMF, gave a harsh warning to Ukraine that it would stop a $40 billion bailout program for the country unless it was serious about fighting corruption.
At the same time, the debt problem is only becoming more urgent. Ukraine’s public and publicly guaranteed debt increased from 50.4 percent of GDP in 2019 to a projected 65.4 percent in 2020, according to the IMF. In December alone, Ukraine’s Finance Ministry raised roughly $4 billion in government bonds, with the majority of the securities at interest rates between 10-12 percent. Among other debt, Ukraine also announced a $350 million short-term loan from Deutsche Bank that month. According to Ukraine’s finance ministry, the country will have to repay roughly $11 billion during the first half of 2021, or about 7 percent of the country’s GDP. It will then have to repay roughly an additional $10 billion during the rest of 2021.
The picture becomes even gloomier when you count in Ukraine’s sales of GDP-linked warrants. These securities have been criticized by economists and financial experts. With a payout that rises as Ukraine’s growth improves, these warrants can provide a potentially hefty win for investors but put a struggling economy like Ukraine’s at even more risk and dampen its potential to grow.
In 2015, Ukraine’s creditors agreed to write off 20 percent of their original holdings as part of a sovereign debt restructuring. In exchange, the bondholders received these GDP-linked warrants, which will have to be paid as soon as GDP growth exceeds 3 percent and nominal GDP exceeds $125.4 billion. The payouts become especially lucrative for bondholders once real GDP growth exceeds 4 percent, when Ukraine must pay 40 percent on wealth created above the $125.4 billion GDP threshold. With Ukraine’s economy forecast to grow at 4.2 percent in 2021, that’s very likely to happen. Substantial payments can take place in 2021, but the warrants extend through 2040—potentially resulting in huge payouts for the next 19 years.
Easy access to expensive debt is also slowing down Ukraine’s reform agenda, as the country’s current administration has other options for finding cash without the need to reform. Despite the coronavirus pandemic, global debt markets have reached historic volumes, allowing developing countries such as Ukraine to more easily fish for cash.
Due to the failure to act on corruption, further disbursements to Ukraine by the IMF could be in jeopardy. The Zelensky administration has hesitated to take decisive action against systemic corruption, which is among several priorities on which the IMF has conditioned its support. So far, Zelensky has been trying to juggle between three major hubs of influence in Ukraine: oligarch-backed lobbyists, promoters of the Kremlin’s agenda, and politicians committed to a Western-allied trajectory. All the while, his administration has been sending contradictory messages to potential allies and the IMF.
At home, Zelensky’s ratings have plummeted: He has been criticized as serving a corrupt system that he had pledged to fight against during his campaign. According to a poll published on Dec. 16, 2020, 42 percent of Ukrainians considered Zelensky the worst disappointment of the year among political figures. The same poll also indicated that his party, Servant of the People, had lost half of its electoral support. This could make it even more difficult for him to pursue reforms.
Some members of the Ukrainian business community have emphasized that cooperation with the IMF is key to Ukraine’s economic success. Its support, they say, has symbolic weight and acts as a litmus test for the international community to assess Ukraine’s level of anti-corruption commitment. Andy Hunder, the head of the American Chamber of Commerce in Ukraine, said in an October 2020 interview that he considered the IMF program a “seal of approval” for international investors. Ukraine’s largest business association, the European Business Association, found in a recent survey that investors would react negatively if Ukraine failed to reach an agreement with the IMF on its next loan tranche.
For Ukraine to break its vicious cycle, it needs to send a strong message that it is moving forward with its anti-corruption reform agenda. This means establishing a just judicial system while also reforming and removing state-owned enterprises that breed corruption.
To decrease its debt vulnerability and save its economy in the long run, the government should buy back or restructure the GDP warrants while Ukraine’s international reserves, at roughly $30 billion, are at an eight-year high. The Ministry of Finance already repurchased around 10 percent of the notes last year. This will reduce the loan burden going forward, helping to free the country from a progressive warrant system that charges more the more successful the economy becomes. Ukraine should also limit its current selling of securities, at least as long as it has to pay sky-high interest rates because of political risk. If Ukraine does decide to tap the capital markets again, it should be with more thought of lowering the long-term financial burden.
It’s unlikely, however, that this will happen. Zelensky’s staff has had too much turnover to carry out systematic reforms—during his presidency, Ukraine has had three finance ministers alone. What’s more, it will be easy to leave the debt issue for future administrations to deal with.
But that doesn’t make the situation any less urgent. Although still distant, a debt default is a possible consequence if Ukraine keeps loading up on expensive credit. A default is ruinous for a country’s investment climate. Investors worrying about such an outcome may continue pulling out their money from Ukraine, as many have already been doing. Increasing debt will also escalate Ukraine’s political vulnerability, both at home and abroad. If Ukraine’s government decides to continue piling up debt without much-needed reforms, it is only setting itself up for a perfect storm.
