A selloff on Ukraine's dollar debt is focusing attention on a controversial $3 billion bond held by Russia, raising investor concerns that President Vladimir Putin could use the issue to trigger a cascade of defaults across Kiev's sovereign Eurobonds.
The so-called bail-bond, taken out late last year by former Ukrainian President Viktor Yanukovich, carries a clause which - given Kiev's steadily worsening finances - may enable the Kremlin to demand immediate repayment.
At best, that could force Western lenders to stump up more cash for Kiev. In the worst - albeit less likely - scenario, so-called cross-default provisions carried by most Eurobonds would force payment on all Ukraine's remaining dollar bonds at once if Moscow is not paid on time.
Putin, who has annexed Crimea and is widely accused of stoking a separatist revolt in eastern Ukraine, is seeking to maximize economic leverage to prevent pro-Western President Petro Poroshenko fulfilling a far reaching free trade agreement with the European Union.
Under Russian pressure, the EU and Ukraine agreed this month to postpone implementation of the accord until the end of 2015 after Kiev accepted a ceasefire with the pro-Russian rebels in a conflict that has killed more than 3,000 people.
At the heart of the bond issue is an unusual clause in the covenant which stipulates "total state debt and state-guaranteed debt should not at any time exceed an amount equal to 60 percent of the annual nominal gross domestic product (GDP) of Ukraine".
As Ukraine's economy has shrunk and its currency has fallen, that level may already have been breached - Commerzbank analysts reckon the current hryvnia exchange rate around 13 per dollar UAH= is the trigger point. If not, debt-to-GDP will top 67 percent by end-2014, the International Monetary Fund predicts.
"There is little doubt the ratio will be crossed," says Standard Bank analyst Tim Ash. "Russia will likely use this issue to make life very difficult for Ukraine."
The issue is preying on Ukrainian officials' minds, Ash says, noting that Finance Minister Oleksander Shlapak told a recent conference he expects Moscow to demand early repayment. In that event, Kiev would dip into IMF money and the central bank's $16 billion reserves, Shlapak said.
But even if Russia does not call the bonds, there are other ways it can use them to strengthen its position against Ukraine.
RUSSIAN CLOUT
Moscow was canny enough to structure the debt as Eurobonds governed by UK law and enforceable in British courts. So even without demanding repayment, the Kremlin as holder of almost a fifth of the outstanding bonds will wield huge clout if Ukraine is forced down the debt restructuring path.
Because the other bonds are in relatively few hands - U.S. giant Franklin Templeton alone is believed to hold 40 percent - a debt workout without Russia could be relatively simple.
Thus it would make sense for Ukraine to delay restructuring until the bail-bond expires in December 2015 - just to avoid facing Russia across the restructuring table. But it now looks unlikely Kiev can hang on that long.
"I don't think Russia wants to accelerate the bond because Ukraine does have the reserves to pay this debt. They want to be sitting at the restructuring table and have a say in the final outcome," said David Spegel, head of emerging debt strategy at BNP Paribas.
"That's the reason the (IMF and EU) have been unwilling to push the restructuring issue, it's one of the biggest impediments."
Putin's leverage over Kiev is not without risk for Moscow. Russian banks, some already weakened by Western sanctions over the Ukraine crisis, would take a hit of Ukraine defaults.
Three big Russian institutions - Sberbank, VTB and Alfa - are among Ukraine's top banks by assets. Moody's estimated last year that Gazprombank, Vnesheconombank (VEB), Sberbank and VTB had a combined exposure to Ukrainian risk of up to $30 billion.
Analysts say Russian banks also have large holdings of Ukrainian bonds though this has proved difficult to quantify. A Ukrainian default would almost certainly force losses on them.
"ODIOUS DEBT"
As Ukraine's finances worsen, bond markets have started to price in a debt restructuring. Many note it makes no sense for the IMF, after its Greece experience, to keep handing cash to a country without making bondholders share the pain.
Gabriel Sterne, head of global macro at Oxford Economics, notes that Greece defaulted when confronted with a too-big-to-pay 12-billion euro maturity in 2012. For Ukraine, the Russian bond is the biggest payment on the horizon, not counting $5 billion or so in gas bills.
"Ukraine have to admit at some point their debt is not sustainable and for me, the $3 billion payment is that point," Sterne said. "I would put odds on them not paying that bond in full."
So far, there is no sign that Ukraine plans to repudiate the debt, though some have urged it to do exactly that.
Georgetown University law professor Anna Gelpern has been prominent among those recommending that Ukraine refuse to honor the bond as "odious debt". (here)
The term refers to money borrowed by a previous regime that was either misappropriated or not used to citizens' benefit.
Gelpern has also said the British parliament and courts should refuse to enforce the contracts on that Eurobond.
That seems unlikely. Aside from the reputational damage caused by defaulting, courts rarely endorse the "odious debt" argument, says Spegel of BNP Paribas.
Hardly any government has used it recently, not even Iraq after the overthrow of Saddam Hussein or post-apartheid South Africa, which might have had a case for doing so.
"Although it was a liability taken on by Yanukovich and there are claims he may not have acted in the public interest... the fact remains that he was a democratically elected president, so the argument is unlikely to sit well with a court," Spegel said.
Others point out that legal action around an odious debt appeal will take a long time and cross-defaults could be triggered in the meantime on other Eurobonds.
"The easiest option for Ukraine might just be to repay early," said Ash of Standard Bank.
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