Macro and Markets

The IMF announced today that it has reached an agreement in principle on a two-year program (stand-by arrangement) with Ukraine. The headline numbers are $14-18 billion of IMF money and overall financing of $27 billion, which is lower than some had hoped, but don’t be fooled. This is a three-to-six month program, designed to meet Ukraine’s critical near-term financing needs and to get reforms going. Both are essential tasks, and rightfully the focus. The program will be revised (and likely boosted) after elections. It will be at that point that thorny issues like debt restructuring will be addressed. The program lays out a roadmap for how the official community would like to see Ukraine reform, and how it expects the economy to respond. That’s a useful anchor for expectations, and an important signal of support for Ukraine, but given the extraordinary political and economic uncertainty it is a wish more than forecast. Still, the program shows IMF leadership at a critical time, and in that sense, is essential as a complement to sanctions and as a Western response to Russian aggression in Ukraine. A few points about the program: 1. Tough up front actions Prior actions—those things Ukraine must do before the IMF Board approves the program in April and makes the first disbursement, reportedly includes: (i) a commitment to maintain a flexible exchange rate system, (ii) increases in energy prices by 50 percent, (iii) passage of a budget for 2014, and (iv) a commitment to anti-corruption legislation and improving the business climate. Fixing the banking system is a fifth pillar of the program but it’s too early to know how bad the hole will be. I would have preferred less austerity now, but a full program apparently was the only way to get enough money to Ukraine in the near term. The question now will be the domestic reaction to these measures (which will no doubt be blamed on the former government). The IMF has asked for as much austerity as is reasonable to expect, and perhaps more. 2. Keeps the lights on The IMF first disbursements aim to trigger the release of $6 billion to $8 billion over the next several months from the EU, the European Bank for Reconstruction and Development (EBRD) and the World Bank. Passage also looks to be imminent for the $1 billion U.S. loan guarantee, along with a small amount of bilateral assistance. That should be just enough to provide critical government services (including safety net payments), service its foreign-currency denominated debt, and purchase gas till the summer. Press reports suggest those payments total $6.2 billion in the second quarter. What is unusual here is that the IMF has agreed to a set financing gap and allowed its stated financing to vary between $14-18 billion depending on other support.  That makes sense given the uncertainty, but it’s troubling that at the same time the IMF is stepping into the breech, other creditors seem to be stepping back.  This morning, there are reports that European aid other than "emergency" assistance may be delayed until after elections.  The IMF should not be alone in the financial vanguard. 3. Optimism on the economy The program reportedly assumes a decline in GDP of 3 percent this year (many private economists expect a decline or 5 percent or more) despite substantial fiscal measures and a deepening crisis. The central government deficit will decline, but the overall deficit (including the gas company) should continue to be in the range of the 9 ½ percent of GDP figure from last year (it would have been over 10 percent without new measures). 4. No PSI, for now It appears that there is no debt restructuring (private sector involvement, or PSI) planned at this time. That means holders of June 2014 eurobonds should be happy. But if I’m right that there will need to be a rethink of the program in the summer, the reprieve may be short lived. Even ahead of that, we shouldn’t underestimate the domestic political desire for burden sharing, if not through a restructuring then through a rollover of bank lines (Vienna Initiative) or new loans from wealthy Ukrainians (e.g., a friends of Ukraine donors conference or patriot bond). So watch the reaction domestically to the sharp rise in energy prices to consumers. One more point:  the IMF announcement notes that "With no market access at present, large foreign debt repayments loom in 2014-15."  We are warned. Markets should respond well to the news. Over the past few weeks, markets have rallied on signals that the IMF program was near and drew support from hopes that Russia would make no further moves against Ukraine. In that sense, I see a substantial disconnect between the markets and many on the political side, who seem far more worried that we could be at an early stage of an escalating confrontation between Russia and the West. That suggests that, at a minimum, markets remain vulnerable to adverse news from Ukraine in coming weeks.  

Sunday’s referendum in Crimea looks set to lead to escalating tensions and an intensification of sanctions. To date, U.S. and EU sanctions proposed or introduced have been modest and targeted, focused on individuals (presumably mostly Ukrainian) regarded as responsible for “infringements on Ukrainian sovereignty,” and do not include measures on Russian corporations, financial transactions or cross-border trade. That could change next week. The U.S. government has taken the lead, with sanctions on those directly involved in destabilizing Ukraine, or who have misappropriated funds. For all the focus on congressional legislation, for the most part the president has the authority to extend financial sanctions through a flexible executive order. The EU has been more tentative in implementing sanctions, no doubt concerned about possible Russian retaliation and the potential economic disruptions that would result. Nonetheless, there appears to be a growing consensus in Europe on the need for a tougher response to Russian actions in Crimea. The 28 EU nations have agreed to a three-step collective response to Russian aggression in Crimea. The first stage has involved suspending visa, trade, and investment negotiations with Russia, and freezing the accounts of 18 associates of Ukraine’s former regime--including ousted President Yanukovych. The EU’s second stage of sanctions--which could be rolled out as early as Monday--could include asset freezes and travel bans on those “responsible for actions which undermine or threaten the territorial integrity, sovereignty and independence of Ukraine”, as well as the cancellation of all EU-Russia summits. According to Reuters, the list of people subject to sanctions would include people “close to Putin in the security services and military establishment as well as on prominent members of the Russian parliament”. In the third stage, if Russian aggression continues, EU sanctions would include trade restrictions, an arms embargo, and broader economic sanctions for Russia’s elite. It could also mean applying existing financial rules more rigorously. Would sanctions work? It’s hard for sanctions to be effective. The record is spotty, and many of the cases where they have been perceived as successful in achieving political or economic agenda—including most recently Iran—were counties whose economies were small, less developed or less integrated in international markets. To be effective, these sanctions need to cast a broad net—if they are not comprehensive and multilateral, they may be easily evaded. Consequently, the new measures are being coordinated between the EU, the United States, Switzerland, Turkey, Japan, and Canada in an effort to ensure the sanctions net is as tight and effective as possible. What will make sanctions effective in this case is also a risk. Russia’s business elites have strong ties with the West, and it is reasonable to believe that sanctions against them and their interests can have a meaningful effect on their welfare. That in turn should create conditions for a compromise with Russia. But that greater degree of financial integration also makes retaliation potentially more disruptive. EU market is customer to 45% of Russia’s exports, and Russia is also dependent on Europe to supply the majority of its machinery and transportation equipment. 75% of foreign direct investment (FDI) funding Russia’s economy is in the hands of investors from Europe. Presumably, though, retaliation would accelerate Europe’s efforts to diversify away from Russian energy. One can hope that the threat of sanctions could lead to a de-escalation and negotiation, but it looks increasingly likely at this point that we will head to stage two. Sanctions look set to intensify should Russia annex Crimea after this weekend’s referendum. Given Russia’s apparent intent in maintaining control over Crimea, they may have to remain in place for a while. Other measures outside sanctions to punish Russia may also be floated.  In this scenario, the creation of “off-ramps” becomes all the more important.