Ukraine shifts gear with debt deals as war takes toll on finances

More tough choices beckon for Ukraine after last week’s debt restructuring highlighted the lack of urgency from Kyiv’s military backers to step in and provide the funding needed to cover a monthly $5bn budget shortfall.

Kyiv last week secured preliminary agreements with bondholders and a group of western governments to push back debt repayments for two years from August 1 after calls to allies to meet the shortfall went largely unheeded.

The agreements, which if signed would free up about $6bn, and were coupled with a 25 per cent devaluation of the hryvnia, ease the immediate pressure on Ukraine to honour its obligations to foreign creditors. In the view of some, they also better reflect the financial circumstances in which the war-ravaged country finds itself. “There was bewilderment among some investors as to why Ukraine had not done this already,” one foreign banker said after last week’s announcement.

The sharp drop in the pegged exchange rate was designed to slow the rapid depletion of Ukraine’s foreign currency reserves. Citizens who have fled abroad have been using hryvnia bank cards to withdraw $1.5bn a month from the country at an artificially cheap rate, said Maria Repko of the Centre for Economic Strategy, a think-tank in Kyiv.

But, with the restructuring providing cover for little more than a month of government spending, economists caution that Ukraine remains under severe financial strain. The war has forced Kyiv to up its monthly military spending from $250mn February to $3.3bn in May.

The government, which has already imposed severe spending cuts on everyday services to cover its military bill, could be forced to take even more drastic action.

“Something has to happen on the domestic side — either raising taxes or cutting spending that’s not critical,” said Yuriy Gorodnichenko, economics professor at University of California, Berkeley. “Everybody thought the war was going to end quickly . . . but it’s going to last months, if not years.”

Kyiv’s room for manoeuvre is extremely tight. With all but the most essential spending cut to the bone, and VAT and customs duties on imports — suspended after Russia’s invasion — now reinstated, there are no easy options. Any further taxes on businesses would — according to Repko — risk tipping them into bankruptcy, deepening the humanitarian crisis.

If sustained at its current levels, the massive rise in military spending would mean the government ran out of funds again in the autumn, she warned.

Credit rating agency Moody’s has forecast a budget deficit equal to 22 per cent of GDP, leaving Ukraine’s government with a financing gap of about $50bn for 2022. Most of this $50bn gap consists of the government’s budget deficit, running at $5bn a month.

Without foreign financial support, Repko said Ukraine would “go into a spiral and the military effort will be impossible to maintain”.

About $38bn in budgetary support has been pledged by foreign governments and multilateral agencies since Russia’s invasion in February, but only $12.7bn had been delivered by early July, according to Ukraine’s finance ministry. A further €1bn in EU funding is due by the end of the month. “The commitments are very large but the disbursements are lacking and slow,” said a foreign banker working with Kyiv.

Ukraine has been burning through its foreign reserves to help finance its war effort. The central bank has also bought government bonds worth $7.7bn since the invasion, including $3.6bn last month alone — a de facto money printing exercise.

Finance minister Sergii Marchenko told the Financial Times last week that it would be “very risky” to rely on money printing for much longer because it would stoke inflation, which has already doubled since the invasion to 20 per cent and is likely to climb further following the currency’s devaluation, which will raise the price of imports.

Net reserves are now just $12.9bn, down from $19bn in February — enough to pay for only about two and a half months of vital imports from agricultural inputs to vehicle parts and fuel.

A deal reached with Russia last week to safeguard exports of Ukrainian grains would bring in about $800mn of export earnings a month, if it holds, according to Dragon Capital in Kyiv. But the deal was in jeopardy after Russia fired missiles on the port of Odesa a day later.

Viktor Szabó, an investment director at UK asset manager Abrdn, said the government’s options were very restricted.

“If they burn up their reserves, they’ll have to decide whether to pay soldiers or nurses. They’ll have problems running schools and hospitals,” he said. “It’s a catastrophe.”

Additional reporting by Mark Raczkiewycz in Kyiv