LONDON, Sept 4 (IFR) - Ukraine is expected to breach a key covenant on a bond it sold to Russia that allows Moscow to insist on early repayment, sparking the possibility of a default on its debts.
The breach follows a significant deterioration in Ukraine's public finances, especially its debt ratios, as the conflict with Russia wreaks havoc on its economy.
The IMF said in a review of a stand-by arrangement with Kiev published this week that Ukraine's debt-to-GDP ratio will reach between 67.6% and 68.9% by the end of the year.
That will put the ratio beyond the level agreed as one of the conditions of a US$3bn two-year bond that Ukraine sold to Russia in December 2013.
A clause in the prospectus says that "so long as the notes remain outstanding, the issuer shall ensure that the volume of the total state debt and state guaranteed debt should not at any time exceed an amount equal to 60% of the annual nominal gross domestic product of Ukraine."
Analysts said if Russia demands its money back, Ukraine could face the prospect of default if it doesn't meet the claims.
"If Russia did demand acceleration, Ukraine would have to make that payment as it is a Euroclearable bond issued under international law with a pari passu clause. Otherwise they would be effectively in default on their outstanding debt," said David Spegel, global head of emerging markets sovereign and credit strategy research at BNP Paribas.
However, given that the seizure of Crimea and pro-separatist rebel attacks in the industrial heartlands of Donetsk and Luhansk have ravaged Ukraine's economy with the IMF forecasting GDP to shrink by 6.5% this year, Spegel added the Kiev government could argue the debt-to-GDP ratio is not a fair measure.
"In reality, now the GDP excludes Crimea and certain parts of Eastern Ukraine. Ukraine could argue it is not above 60% by not excluding Crimea and the east, but ultimately, it's all down to Russia's decision. For sure it's going to be used as a bargaining tool," he said.
Other analysts reckon Ukraine has moral, as well as possible legal suasion, on its side. "I am assuming that the Ukrainian authorities have taken legal advice on the enforceability of these covenants or that they use the odious debt argument to nullify the risk of being called into default," said Tim Ash, head of EM research ex-Africa at Standard Bank.
Ukraine's worsening public finances have increased its external borrowing needs. In its assessment last week, the IMF warned Ukraine may need an additional US$19bn of financing from donors if the fighting continued into next year. That's on top of the existing US$17bn loan programme.
The IMF also suggested the Ukraine government plans to a cover a US$1.1bn shortfall with a sovereign debt issue later this year.
Sources say that Ukraine is in early-stage discussions with banks about potentially re-entering the market, though many are sceptical about whether the sovereign has access, with its bonds yielding double digits across the curve.
"The IMF is living in cloud cuckoo land, talking about market access for Ukraine this year," said Ash. "The main question being asked by investors is when, not if, Ukraine will be forced to restructure/reprofile its debt ratios."
"You can't put a bond out in September or October and then do a restructuring in December," agreed a banker. "A private debt bail-in has still not been ruled out."
With the headlines volatile hour-by-hour - as Wednesday proved with Ukraine's president proclaiming a permanent ceasefire had been agreed only for Russia to say that wasn't the case as it's not party to any crisis in the first place - any deal would be impossible until there is a significant de-escalation in tensions.
The next test of Ukraine's financial health will be at the end of this month when state-owned Naftogas has a US$1.595bn bond due. The money Ukraine has received from the IMF this year should mean the government has enough funds to cover the repayment, though with the bond trading at a cash bid price of 97.80 less than a month before it's due suggests some investors are less confident.
The IMF says that Naftogas "will need more financial assistance from the government to cover its increased deficit and repay external liabilities." The Fund estimates that Naftogas's total financing bill will reach 7.6% of GDP this year, with support in 2015 unchanged at 1.9%. (Reporting by Sudip Roy; additional reporting by Michael Turner, editing by Julian Baker)