Why Ukraine Matters More Than You Think (Or "Only Wimps Pay Their Debts")

Ukraine, we are told, is infamous for its colorful proverbs and as the title suggests Citi’s Matt King warns that emerging market (EM) bond investors may yet become familiar with more of them in coming weeks. Unfortunately Ukraine’s importance is greater than its economic or even geopolitical significance would suggest. Risk premia everywhere have been compressed by the prolonged force-feeding of central bank liquidity. EM in particular has benefited from enormous inflows. However, for developed market (DM), King believes even a serious deterioration in Ukraine still feels unlikely to really derail the serene march tighter we see in spreads – but even so, he warns there are some broader implications of the EM woes which investors would do well to be aware of as “drunkards know no danger”.

Via Citi’s Matt King,
“Drunkards know no danger”

In some ways, the lack of market reaction to the Ukrainian revolution is entirely understandable. Sovereign debt is small (40% of GDP, and only 20% external) – so if there is a crisis, it ought to be one of liquidity, not solvency. EM investors have long thought of the Ukraine as a potential trouble-spot, typically categorizing it with Argentina and Venezuela – so their individual exposures ought to be quite manageable. Besides, it only amounts to around 3% of EM bond indices. And spreads are already high, and the curve inverted, meaning shorts are expensive and at first sight a lot is priced in already.

Dig deeper, though, and we are not nearly so sure – both on the Ukraine itself, and on the broader implications.

The markets seem to be making two main attempts to justify bond prices still trading in the low 90s. The first is that ‘surely the EU and US would not remove their support and leave the country to its fate: one way or another, an IMF bailout has to be forthcoming’. The second is that even in a disaster scenario, long-term average EM recovery rates are around 60%. To us, both lines of reasoning seem flawed.

For an example of a country where an uprising that initially looked set to bring democratic and state reforms has been followed by that country being abandoned to its fate, with disastrous humanitarian consequences, you only need to look as far as Syria. Perhaps in the Ukraine it might be slightly clearer to the EU/US which side ‘merits’ their support, but it is not at all difficult to imagine a scenario in which they fail to win power, or – worse – there is no clear government with whom to negotiate.

At a minimum, the country’s first large bond maturity in June makes the timing of the planned elections in late May extremely awkward. On balance, our economist Ivan Tchakarov thinks that provided there is a government in place, the IMF will end up disbursing. Probably this would come in the form of one small ($2bn?) tranche prior to the elections with the promise of a much larger sum afterwards.

But the probability he attaches to this happening is only slightly better than 50% (around 60:40). And it is in the alternative scenario that we come to the second flaw in consensus reasoning.

“Only when you eat a lemon do you appreciate what sugar is”

EM historical recovery rates do average around 60% – but with an extremely wide range (Figure 2). Indeed, as the IMF note in a recent paper,3 they tend to be divided in an almost binary fashion. On the one hand are prompt, pre-emptive, restructurings and maturity extensions, with recoveries little below par. On the other come outright (and frequently protracted) defaults and repudiations.

While there is some chance the IMF might insist on private sector involvement as a precondition for disbursement, to our minds the overwhelming risk is that any default would fall into the second category, most likely as part of some form of sovereign break-up. In this case, recovery would likely be far below 60% – as was the case in Iraq and Serbia.

As such, we are more inclined to attribute continuing high bond prices to overoptimism – or, at best, illiquidity, given that nearly one-third of the outstandings are known to be held by one account. While the recent statement from the newly appointed head of the central bank is encouraging, unless there is decisive progress made in coming days, we think bonds will come under downward pressure. Frankly we are staggered that the invasion of the Crimean parliament by around fifty armed men – which would seem to significantly increase the chance of break-up – has only led to bonds selling off by another point.

“One malicious cow disturbs the entire herd”

And yet it is the broader backdrop which we find most interesting and important here.

The scope for immediate economic contagion from any default in the Ukraine is relatively limited (though the relatively large exposures of some Austrian and Italian banks, mostly through subsidiaries, may raise a few eyebrows – Figure 3).

The geopolitical significance is obviously much larger, but here too we struggle to see as likely a scenario in which increasingly acrimonious relations between the West and Russia lead to serious repercussions for the world economy, beyond, say, higher gas prices for western Europe.

But these events are occurring against a backdrop of a steady stream of negative stories in EM – from Turkey’s alleged corruption tapes, to the protests in Thailand, to China’s constant struggle to rein in credit without destroying growth. And despite growing tactical underweights by many investors, EM – along with all other high yielding assets – in strategic terms has been the darling of asset allocators over the past decade, and has seen huge institutional inflows which have yet to fully reverse (Figure 4).

As we see it, each additional headline, and each downward revision to EM growth prospects, takes us closer to the point where investors undertake a wholesale reevaluation of the risk-reward of EM assets for their portfolios – just as has already happened with gold, and is happening with commodities more broadly. At best, this would result in drastically reduced inflows, rendering problematic the refinancing of the large volume of (mostly corporate) EM debt which has built up in recent years; at worst, it could lead to a rush of outflows.

In the long term, we think even DM is vulnerable to a similar re-evaluation. Indeed, in a world in which the run-up in asset prices owes more to central bank largesse than it does to fundamentals, 6 it feels almost inevitable. And yet the price action in DM credit remains so strong, the shortage of paper so acute, that we think it would take a major intensification of the crisis for that to become likely. Until then, we expect EM assets to underperform, but DM credit to grind tighter. We have to give the last word to the Ukrainians, though: “He who licks knives will soon cut his tongue.”

Furthermore, UBS’ Kathleen Middlemiss warns specifically on Ukraine:

Ukraine’s bond term structure remains massively invered

The situation in Crimea drags on. For corporate bondholders we feel the risk has moved to focus on those issuers with upcoming coupon payments and debt maturities in Ukraine along with the threat of economic sanctions against Russia’s issuers. The scarcity of obtaining US Dollars domestically coupled with the devaluation of the Hryvnia is also a concern for upcoming US Dollar payments. Any significant further devaluation would certainly put financial strain on issuers.

Ukraine Financials have upcoming USD payments due

The liquid non-financials paper is not trading at distressed levels, yet. The crisis looks far from over and should Ukrainian corporate issuers restructure debt, we believe the Eurobond holders would not escape financial pain.

Best case scenario for Ukraine sovereign credit: already in the price?

While the government’s recent discussions with the IMF delegation do give us some assurance that Ukraine would be able to strike a funding deal and roll over its short term FX debt, we do not see terrific value in being long at these levels; we find that the bonds are hardly priced for distress, with the implied probability of default on the CDS less than other high yielding names like Argentina and Venezuela. The upcoming Crimea referendum also has the potential to further inflame political tensions, and we prefer to stay side-lined until we get more signs of the situation normalizing.


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