Ukraine And The Markets

by: Desmond Lachman

Looking at the way markets are pricing Ukrainian government bonds, one has to wonder how efficient they are at pricing emerging market economic risk. For despite the many reasons to doubt the Ukrainian government’s ability or willingness to repay its creditors, markets are still pricing Ukrainian foreign denominated government bonds at well over 90 cents on the dollar, which would imply only a limited probability of a Ukrainian default. They seem to be doing so on the mistaken expectation that the IMF and the European Union will quickly bail out Ukraine with little or no strings attached no matter what might happen in that country.

Over the past two years, the IMF has been highly reluctant to conclude negotiations on a loan arrangement for Ukraine for a number of well-grounded reasons. First, the IMF had problems with Ukraine’s poor governance and its rampant degree of government corruption. Second, the IMF considered that Ukraine’s government expenditure level was excessive and that severe public spending cuts were required in order to put Ukraine’s public finances on a more sustainable footing. Third, the IMF had serious problems with Ukraine’s pervasive and untargeted energy subsidies that exerted a heavy toll on its government’s budget.

There is little reason to think that any of those legitimate IMF concerns have been addressed. Indeed, one would think that if the IMF had concerns about Ukraine’s macro-economic outlook before the recent Ukrainian revolution, it would have even greater concerns today. With Ukraine’s currency in virtual freefall, one would think that the IMF would need to have greater assurances than before on the country’s commitment to public spending cuts and to a drastic streamlining of energy subsidies. For absent a serious commitment to budget prudence, one would think that the country could veer off into very high inflation and suffer an even more pronounced bout of capital flight than it is experiencing today.

An even more serious concern for the IMF as it considers providing Ukraine with financial support is the great political uncertainty characterizing that country. With elections now scheduled for May 25, the IMF today can have no idea as to who will be in charge of Ukraine in a few months’ time. At a minimum, one would think that the IMF would need all contenders for the presidency to commit themselves to budget prudence before the IMF committed itself to a large scale lending package for Ukraine. Such a prospect would seem highly unlikely in the context of a heated election particularly considering how politically unpopular IMF-style belt tightening has been.

Perhaps an even greater risk that the markets are overlooking is that of a Russian political reaction to recent Ukrainian events. Pronouncements out of Russia by high level government officials would support the view that Russia is not going to passively allow Ukraine to drift into the arms of the West without a fight. And considering Ukraine’s high dependence on Russian gas supplies, the Russians could once again use the gas lever as they have done before to destabilize the Ukrainian economy.

In short, markets seem to be betting that the West’s commitment to Ukraine is stronger than Russia’s determination to keep Ukraine in its orbit. Perhaps the markets will prove to be right. However, history would not seem to be on the markets' side and one would think that the markets would have needed better odds than they are receiving today to make that bet.