Naftogaz, Ukraine’s state-owned oil and gas company, may default on a Eurobond coupon payment on July 19, raising fears that it will also default on a $2.2bn sovereign bond in November, as the Russian invasion cripples the country’s economy.

The possible default puts extra pressure on Western nations to speed up plans to extend emergency budgetary support for Kyiv that appears to be rapidly running out of money to cover expenditure.

Alarm bells began ringing when Naftogaz released a statement saying it is “currently evaluating its liquidity and operating requirements”, placing the blame on Russia’s invasion of Ukraine.

“In light of the prolonged circumstances affecting Ukraine as a result of the ongoing full-scale military invasion by the Russian Federation and its impact on the energy security of Ukraine, the company is currently evaluating its liquidity and operating requirements in line with supporting Ukraine’s strategic priorities, including with a view to preserving available cash,” Naftogaz said in a statement to investors.

Bond traders too that comment on “preserving cash” to mean that the company was contemplating an option where it won’t meet its obligations this month. Naftogaz has a $335mn, 7.375% 2022 Eurobond due on July 19, along with $12mn in interest also due on the same instrument, according to Timothy Ash, senior strategist at Bluebay Asset Management.

Although initially the company signalled it was going to pay and had the FX liquidity offshore to cover the payment, many bondholders now believe Naftogaz will default on the bond. But the company has not yet directly said it will not pay.

Naftogaz is one of the country’s largest and most important state-owned companies, contributing $1.55bn to Ukraine’s state-budget from January to May.

Investors worry that Naftogaz’s logic will be extended to sovereign debt: Ukraine has $2.25bn of sovereign bonds that mature in November.

“It looks like Naftogaz is not paying, so that means the Ukraine 2022s won’t be paid and Ukraine will go into default,” Ash said.

This comes after Russia went into default on a $100mn bond repayment last month, the first time since 1998. However, Russia is disputing the default designation, claiming that the sanctions that prevented it from paying in dollars are a force majeure. The dispute will almost certainly now end up in a protracted legal battle.

Wanting to avoid a similar fate, Ukraine has begun to discuss possible ways to restructure its debt as the war cripples its economy and leaves it short of funds. The relentless blockade of its Black Sea ports by Russia has caused a dramatic fall in exports, whilst damage to infrastructure is estimated at $104bn. Tax receipts have collapsed and government expenditure is largely being covered by the National Bank of Ukraine (NBU), which is printing money to pay the bills.

Despite promises of hundreds of billions of dollars in international aid, Ukraine has only received around $11bn in cash to support government expenditure since the start of the war. As a result, it has had to dip into its international reserves to fund spending, but reserves are shrinking month by month.

Ukraine reported its international reserves have fallen to their lowest level in more than two years. in June The present-day value of the country’s foreign currencies and gold is $22.76bn, dropping by 9% last month. At the start of June, international reserves were at $25.1bn.

Ukraine is running out of money. The government is burning through $8bn a month to finance the war, and short of $5bn a month in revenues, despite international aid. With shrinking exports and growing military spending, the budget deficit is swelling, forcing the central bank to purchase UAH225bn ($7.6bn) of government bonds.

National Bank of Ukraine (NBU) Governor Kyrylo Shevchenko warned in a comment that using monetary means to pay for the war is “unsustainable” and that Ukraine is “running out of time” to deal with this problem.

“The monetary financing of the budget deficit will not stabilise the economy in the long run. We should seek other ways to minimise the fallout from the war,” Shevchenko said. “At the onset of the full-scale war, Ukraine’s only option was to let the NBU conduct the monetary financing of the state budget deficit so that the country’s critical needs could be met. Compared to other ways of meeting budget objectives, the printing of money is a rapid response that makes the burden of the war easier for the people and businesses – in the short run. In the long term, however, taking the monetary financing approach cannot keep the economy afloat. To mitigate the adverse economic and social consequences of the war, the authorities should use methods that optimise the state’s finances.”

The strains on Ukraine’s economy are starting to show. In addition to the falling international reserves and now a possible default on Naftogaz bond, the NBU has also put through a massive 15% rate hike to 25% on June 2 to head off inflation and stabilise the exchange rate.

But inflation is inevitable and last month the World Bank recalculated Ukraine’s inflation at 20% by the end of 2022, a revision from its previous forecast of 15% in April.

One of the options for Ukraine to avoid defaulting is using the $300mn of frozen cash belonging to the Central Bank of Russia (CBR). If Ukraine defaults on its debt then that opens up the possibility of the bond holders taking the case to court, which can legally seize part of the CBR’s money if it can be shown that Russia is to blame for the default.

European Commission President Ursula von der Leyen said on June 7 that the EU is “working on a mechanism” to legally seize this money, following a Ukraine Reconstruction Conference in Switzerland at the weekend, where possibilities on funding a Marshall Plan for Ukraine were discussed.

The legal issue at hand is that property rights protect Russia as technically the CBR’s money is only frozen and still belongs to Russia. Western government can only seize this money if it declares war on Russia – something that Nato members have made explicitly clear they will not do.

Using Russia’s frozen reserves to fund Ukraine’s reconstruction would be a difficult and very lengthy process. Without more bailout money Ukraine runs the danger of going into default, something the government wants to avoid at all costs as that would shut it out of the international capital markets at a time where it will need massive funding to pay for reconstruction.

Despite Western promises to keep coming up with more cash to help Kyiv avoid defaulting, some believe it is unavoidable.

“Realistically, is a German taxpayer, for example, seeing its country’s first trade deficit for 30ish years going to be happy to see their money used to make Ukraine bondholders whole?” a US fund manager told Global Capital. “I doubt it.” But Timothy Ash sees no reason why the West would allow Ukraine to default.

“[I] don't see the logic [of the] US Treasury of forcing Russia into default to bring a PR win, then to allow Ukraine to fall into default giving the PR win back to Russia,” Ash said. “And then Ukraine loses market access just when it will need maximum private sector involvement in the huge rebuild and recovery project. Debt restructuring means no market access for a couple of years… all for $300mn-odd for Naftogaz and the couple of billions bucks external debt service to year end.”