Ukraine’s unexpected spike in economic growth to 4.6% in the second quarter means the warrants that were offered bond holders in 2015 in exchange for delaying coupons will almost certainly be triggered at the end of this year.
Ukraine's former finance minister persuaded holders of the country's sovereign bonds to accept delayed and reduced coupon payments in exchange for the warrants that have a face value of $3.6bn and pay out if certain triggers are reached: if the economy grows by more than 3% and if the size of the economy exceeds $125bn.
Economists were caught off guard when Ukrstat reported growth surging to 4.6% in the second quarter of this year, up from 2.5% and far in excess of the 2.7% Reuters consensus expectation. That prompted some analysts to ask if the economy was finally about to boom after some twenty years of stagnation.
“Time for the Ukrainian economy to take off as inflation has stabilized with minimal budget deficit & strict monetary policy. The hryvnia exchange rate has risen as desired to keep labour in Ukraine. Finally, we see reasonable growth, but property rights must be secured,” Anders Aslund, economist and a senior fellow at the Atlantic Council, said in a tweet.
The surge in growth will change the perception of the warrants. In July they were trading at 85 cents on the dollar as investors clearly didn't believe the economy was going to grow and if it did they still worry whether the government will make good on its obligations.
The growth in first half of this year means that even if growth is flat for the rest of the year then the bond payments will be triggered.
“Ukraine's 2019Q2 GDP growth came in at 4.6% y/y, a large upside surprise considering that consensus forecast was around 2.7%. This means that even if growth were zero for the rest of the year (q/q), full-year growth would reach around 3%,” tweeted Benjamin Hilgenstock, an economist with the Institute of International Finance (IIF).
However, the first payments won’t be expensive. If the real growth is 3.1% for all of 2019 then the first payout will amount to a mere $24mn at current exchange rates, calculates Ivan Tkachev, the economics editor at RBC.
The warrants mean their owners are entitled to 15% of GDP growth over 3% and an even more generous 40% of growth over 4%. However, the total payment is capped at 1% of GDP for the first four years and the money owed is paid one year after the calculation is made.
Tkachev goes on to calculate that if the economy continues to grow in the second half of the year and expands by 3.5% then the payments will rise to c.$117mn.
“Note that payments for 2019 depend on nominal Ukraine’s 2018 GDP (already-known), GDP deflator 2019/2018 and difference between real 2019 growth and 3%,” Tkachev tweeted. The GDP deflator has already been adjusted down from 122% in 2017 to 109% for this year.
And the warrant payments are not due for a while, giving the government plenty of time to get the money together. The warrant payments for 2019 will be calculated only in April 2021 based on the World Economic Outlook figures calculated by the International Monetary Fund (IMF), which ultimately rely on the Ukrainian statistical agency, Ukrstat, numbers.
But there is a second condition for the warrants to kick in: the value of the economy must be above $125bn in dollar terms based on the average UAH/USD exchange rate year to date. Currently that is UAH26 to the dollar which means the worth of the economy will breach this threshold this year as well. The Ukrainian economy was worth about $100bn last year, but will top $125bn this year.
The warrant payments are calculated on a formula based on the GDP growth that runs through to 2040 so that if Ukraine booms it could get very expensive.
Tim Ash, senior sovereign strategist at BlueBay Asset Management, commented recently that a better deal would have been to put some sort of upper cap on the payout, but at the time when the deal was cut in 2015 the government was desperate as the economy was in full collapse, contracting by 17% at its worst that year. Any reprieve was desperately needed. At the time the government saved itself from circa, $1.3bn of bond coupon payments that it simply didn't have.
However, there is a clause in the warrant deal that allows the government to buy investors out and if economic growth does start to gather momentum then it would make sense for the Ministry of Finance to take advantage of this option. And those investors brave enough to take the deal cut in 2014 – Russia which holds $3bn of Ukrainian Eurobonds notably refused and those bonds are now in default – will be handsomely rewarded for their courage. If the government pays…
The default on the Russian held Eurobonds, that were part of a deal cut with former president Viktor Yanukovych, highlights the danger that if under pressure the government might renege on its obligations, or at least force a harsh restructuring deal on investors, as it did with the bonds of state-owned national gas company Naftogaz in 2009.
But the government will have to be careful how it handles any restructuring attempt. While investors have sympathy with the decision to default on the Russian held debt, which can be argued is “odious debt” and therefore doesn't have to be repaid, if it defaults on the warrants then that could trigger a cross default on the bonds that were restructured in 2015 worth $14.4bn.
Even if Ukraine’s economy grows strongly in the near future, it cannot afford to make itself a pariah on the international capital markets by reneging on these obligations.