Just months before the toppling of its government, Russia cut a loan deal with Ukraine that would make even an ace structured finance dealmaker envious. One expert on sovereign debt has called the transaction "clever." And the deal could come back to haunt Ukraine's economy.
Back in December, Russia lent Ukraine $3 billion as part of an assistance package that was supposed to reach $15 billion. But Russia didn't just hand over money directly to Ukraine. Instead, Russian had the Ukrainian government issue $3 billion in bonds. The bonds were denominated in euros. And then Russia bought all of the bonds.
That may have seemed like a straightforward way to do the deal. Ukraine already had billions of eurobonds outstanding. So issuing more may have appeared easier than writing up a new loan agreement. Plus, the deal would give a lift to the prices of Ukraine's other eurobonds, which were already suffering from the growing political turmoil in the country.
But the roundabout loan deal had more advantages for Russia than it first appeared. Here's where things get interesting.
It turns out that Russia didn't just have Ukraine do a straight debt offering like the ones it had done before. Instead, Russia wrote into the new bond offering a provision. As part of the bond deal, Ukraine had to promise that it would keep its debt-to-GDP level below 60%. If it rose above that level, Russia had the right to demand the bonds be repaid immediately in full.
That kind of qualification in government bond deals is unusual. Mitu Gulati, a sovereign bond expert, says he has never seen a government bond with a similar debt-to-GDP provision. Most sovereign debt is "covenant-lite."
It would be hard to prove this was premeditated, but including that provision gives Russia a lot of economic leverage. At the time, Ukraine's debt-to-GDP was near 40%. But with Russian looking likely to hive off Crimea, and taking that portion of the Ukraine's economic activity with it, along with the slowdown the political unrest has caused, it's likely that by the next reading or two Ukraine's debt will be in the 60% range or beyond it.
That means Russia can ask for its money back, and at the same time add more economic hardship to Ukraine as it struggles to rebuild.
If this was a straight loan, Ukraine could just say to Vladimir Putin, "Hey you just invaded us. Debt's off. We're not paying." But since it's a bond deal, it won't be that easy. To invalidate the eurobond debt, Ukraine has to argue that Russia knew that part of the money it agreed to give to Ukraine's past government was at least in part going to line the pockets of a corrupt ruler. The Ukrainians certainly believe that, but that might be hard to prove to an international court.
There are a lot of other Ukrainian eurobonds out there that look similar to the ones Russia is holding, so not paying the ones Russia is holding will have larger implications for all of Ukraine's debt, causing prices to fall and interest rates to rise. What's more, Russia could sell its bonds to the market, likely at a premium because of the special provision. That may make a court less likely to invalidate the debt, and Ukraine less willing to do so, if it is held by a private investor, especially a non-Russian one.
That being said, the United States and Europe will likely offer generous loan guarantees and have already pledged aid to Ukraine. That should help it with its near-term debt problems should Russia call its debt. And it probably won't, given that the debt offers Russia another piece of leverage, and another reason for Ukraine to negotiate.
Of course, there is still a chance that Ukraine would just say it's not paying the debt, and for it all to work out okay. The unusual debt deal probably works opposite from what you would expect on Wall Street. Most bond holders don't want to swap their debt for equity. Neighboring nations looking to rebuild old empires may be more willing to make that trade.