What Will Happen if We Default?

Will Ukraine be able to settle accounts with its creditors or not? Will the government declare default or not? What will happen if it does default? All these questions have gone lately outside the limits of narrow professional debates and captured the minds of the masses of people.

Trying to grasp the essence of these issues and to be in sync with the readers' interests, The Day regularly publishes various views on whether or not there will be default. An businessman, who unwisely bought Ukrainian debentures, strongly advised on September 28 in an open letter to President Kuchma to never announce default. The same issue, but a different article, studied Ukraine's ability (rather questionable, it appears) to follow this advice.

It might seem that under the conditions of a constant threat cash-flow shortfall of an annual $2-4 billion to cover the balance of payments deficit (i.e. when hard-currency flows from the country are not compensated for by flows into the country) default becomes an obvious prospect. Or, in other words, it becomes a matter of simple arithmetic. However, it appears that the procedure of assessing a “sovereign” default also has other techniques. What else does the solvency of an insolvent state depend upon? This is the subject of an article by Oleksiy SIEKARIOV who decided to share with The Day's readers his views on the problem of default Ukrainian style.

WHAT IS DEFAULT?

Default is a purely technical term. It only means the statement of a debtor of his insolvency, i.e., inability to settle his debts completely and on time. A default emerges in particular when the borrower: does not make payments (to redeem the main part of debt, the interest, commissions, etc.) in due time, introduces in the agreement misleading information about guarantees of payment, utilizes the borrowed funds in an inappropriate way, suffers an abrupt deterioration of his financial position, or fails to meet his obligations toward a third creditor party (cross- default).

Contemporary civil law provides as a rule for two possible consequences of such a situation: a compromise between the creditor and the debtor or the latter's bankruptcy. In the former case, the two sides can either strike an amicable deal or refer the case to court. The debtor will insist during litigation that the court pass a decision whereby he can pay the debt in installments and avoid bankruptcy. The court can make a compromise decision if the claimant, i.e., the debtor, is able to meet a number of rather strict conditions, the chief of them being immediate satisfaction of a certain minimal creditors' claim. This minimum level, or quota, is set by law and can amount to 35%, as is the case in Germany. Moreover, one of the main reasons why the debtor may be denied a court action (in addition to failure to comply with the quota) is “negligence that caused insolvency.” Such a denial is in fact tantamount to a verdict on bankruptcy, i.e., on a forcible liquidation of the debtor as a juridical person. Similar procedures are also laid down in Ukraine's new bankruptcy law made public on September 15.

HOW A COUNTRY SHOULD MAKE USE OF LOANS TO AVOID BANKRUPTCY

As Jeffrey Sachs writes, it is inadequate governments that most often develop the problem of excessive debt burden. The main indicator of inadequacy is pandering to various group interests, be it specially protected enterprises or old age pensioners (potential voters). This is usually done to assert oneself politically and is most often not accompanied with a sufficient proclivity to enact necessary reforms, for example, to reinforce budget revenues or cut expenditures. This policy is economically unsound: enterprises, sure of getting an early sop, will not strive for profit, let alone pay taxes on it. This policy always leads to a financial crisis, for the budget fails to withstand its own pie- in-the-sky promises (concessions) and debt service (real payments) at the same time. Moreover, if in this case the government does not resist the temptation to “finance” the treasury deficit by monetary emission, the country will inevitably plunge into the abyss of hyperinflation.

The involvement of foreign and domestic credit resources is, conversely, a good way to avert this danger. Creditors often furnish funds to governments without any basic guarantees, for they expect gains from capturing the domestic market and in addition pin their hopes on timely payments, for their client, after all, is a sovereign state, and states never vanish into thin air as easily as fly-by-night firms are known to do.

Experience teaches, however, that a state might well have an inadequate government. Such a state will be unable to avoid special privileges and subsidies it cannot afford even under the burden of debt. Its sovereign debt is bound to grow to the critical point if the desire to retain power prevails over economic rationality. In addition to throwing the country into inevitable crisis, such a position will very soon shake creditors' confidence in the good faith of their sovereign borrower.

WHAT CAN HAPPEN TO SOVEREIGN BANKRUPTS

Sovereign debts are most often subject to rescheduling. In 1997, Peru finished the issue of $8 billion Brady bonds against the default announced back in 1984. These bonds, named after a former US Treasury Secretary, were floated in 1989 to restructure the bad public debts of the emerging market economy countries. At face value, they are usually guaranteed by US Treasury Bills and are considered the most reliable means of servicing a sovereign debt (but the latest experience of Ecuador has greatly compromised this).

In 1992, Poland and Egypt had half their sovereign debts, against which they had earlier announced default, written off. Unlike paying in installments, writing off is an exceptional case. In the case of these two countries, this was dictated by purely economic considerations: Poland was to become a showpiece postcommunist state, while Egypt was to be rewarded for its peace settlement with Israel.

Of all debt-management patterns actively utilized by governments, we should single out buyouts of ones own debts (those same Brady bonds), conversion of the latter into new liabilities (the so-called securitization), the exchange of a sovereign debt for the shares of state-owned companies), and the sale of real estate. Such patterns can be used preventively, i.e., without announcing default, which, incidentally, is being convincingly demonstrated by the Ukrainian Ministry of Finance.

When payment was effected in installments and especially when default debts were written off, the bankrupt states always lost a certain part of their political self-sufficiency due to the weakness and unfairness of their governments, i.e., they in fact lost sovereignty. Moreover, they lost access to international capital markets for a long time and thereby lost a source for the modernization and increasing of their own economic potential.

IS IT WORTH IT FOR UKRAINE TO ANNOUNCE DEFAULT?

I do not think any of the presidential candidates seriously wish Ukraine such a fate. But it is no accident that the default issue is now discussed openly: it is clear the economy will not be able in 2000 to work so effectively as to pay its debt obligations with an increase of real output.

There will be no formal reasons for announcing default until Ukraine fails to make another debt or interest payment without coordinating this with the creditor. The recent ING Barings affair is important in two ways. First, the creditors agreed to make concessions, albeit reluctantly, for fear of losing all the money they had loaned. In any case, they will fail to declare this country bankrupt and secure immediate material compensation from the government. The Ministry of Finance learned this all too well and managed (helped by the National Bank) to reschedule an overdue debt with technical brilliance. The British Regent Company, having bought a solid block of Ukrainian securities from ING, trumpeted for the whole world to hear: “Ukraine's gone bankrupt!” but still failed to cash in on it.

Secondly, the very fact of the Ukrainian government offering ING an installment payment plan just a few weeks before the due date is tantamount to de facto default. It is at the moment of noncompliance with contractual obligations or even the slightest suspicion of such a probability that international credit markets begin to close to a country. The all-time high interest at which Ukraine must now borrow is the result of precisely this de facto default.

Ukraine has been clearly branded as a deadbeat, essentially because it breached the sound logic of credit utilization: creating market institutions, revitalizing competitive industries, increasing output and exports, and, as a result, paying off the loans on time. Instead, Ukraine opts for budgetary pie in the sky, trying to rescue the nonviable industries, also at the expense of loans.

It would be wrong to say the situation is hopeless. The government is aware of the inadmissibility of excessive budgetary expenditures (although it so far economizes on the most flexible things like research and keeps inefficient industry afloat by means of hidden subsidies), so a consolidated budget may soon become a reality. In spite of a disastrous fall in foreign trade, exports did exceed imports by $602 million in the first six months, which strengthens Ukraine's position concerning debt service. The debt itself is not the three billion, as President Kuchma inadvertently said (see Den 's comment on September 23), but two billion and change. The Finance Ministry has already launched an offensive on the restructuring front in order to ease the burden. Finally, Ukraine favorably accepts the IMF intention to involve private creditors in risk sharing and support countries that try to pay the debt in installments. Simultaneously, the IMF clearly expresses the idea of true structural reforms in its demands to government debtors. So Ukraine will now hardly be able to pull the wool over the IMF eyes, saying: “We made an administrative-reform decision only yesterday.”

Ukraine does have a chance. Should default be announced, this country will be a dead duck. But if Ukraine makes it through, it can soon return to the international community as a full-fledged partner.