Guest contribution from

In December 2013, Moscow signed off on a US$3bln loan to Ukraine. The loan, in the form of a two year Eurobond, was intended to be the first of US$15bln in such loans, which Russian President Vladimir Putin hailed as a lifeline to Ukraine. The bonds paid an annual interest rate of 5%, far below the market rate at the time. Yet this maneuver threatens to cost Russia dearly in the future, even as the final status of the Eurobond continues to be litigated in UK courts. While useful as geopolitical leverage, Moscow’s actions in its debt disputes with Ukraine puts it at risk of losing billions of dollars in debt owed by Venezuela, currently teetering on the edge of default.

The US$3bln bond included a number of unique provisions, rare in the largely boilerplate world of sovereign bond contract wording. One of the provisions even explicitly acknowledges that relations with Moscow will impact Ukraine’s ability to refinance or repay the debt. Another controversial clause would have allowed Moscow to force repayment if Ukraine’s debt-to-GDP ratio spiked, although it ultimately chose not to trigger the provision when that occurred in late 2015. Two other measures, known as cross-default and acceleration clauses, would have forced Ukraine to immediately make payment on other outstanding obligations, likely harming Ukraine’s relations with other creditors. Arguably the most notable aspect of the loan was the structure of the bond, designed so it could be sold on in private markets by Russia’s National Welfare Fund. When Ukraine’s default occurred, however, the Kremlin insisted the bond be treated as official debt, although there is no precedent for treating tradable Eurobond in this manner. Simultaneously, Russia refused to take part in Paris Club negotiations — the traditional venue for settling official debts – on restructuring the note.

This argument proved particularly troubling for the IMF, which wanted to avoid being seen as a party to the dispute. However, concerns were also widespread that Russia could block Ukraine from receiving funds under a US$17bln IMF bailout agreement in May 2014. Backed into a corner, in December 2015 the Fund changed its regulations and ruled that while the debt was official, it would now lend to countries with outstanding debts to official creditors. The IMF previously would only lend to countries that did not have outstanding obligations to other states, a policy in part intended to avoid politicizing the Fund’s actions. Others have argued the decision could benefit Ukraine, although views on the decision remain mixed. Its classification as official debt meant that a final restructuring agreement struck with Kyiv’s private creditors did not apply, and weakened Ukraine’s argument before London courts that the debt should be treated as private. Meanwhile, the designation of the debt as official freed Moscow from the need to participate in Paris Club negotiations.

Russia’s attempts to mix public and private debt have played a role in the sole UK court ruling on the dispute to date. The tradeable nature of the bond allowed the court to rule against Kyiv claims the bond should be dismissed as ‘odious debt’. A relatively-rarely invoked legal defense, odious debts are those unwittingly or forcibly incurred that run counter to the interest of the debtor. Questions have been raised about this ruling and it is undoubtedly a key point in Ukraine’s appeals. It should be noted even the most favorable judgement for Russia may be complicated by Britain’s ‘clean hands doctrine’ that requires the claimant (Russia, in this case) demonstrate it is not acting in bad faith to the debtor. Nevertheless, Russia may well escape the 20% haircut that by Kyiv’s private debtholders agreed to.

Ambiguity around Ukraine’s finances and the threat of Russian claims against Kyiv remain a crucial component in Russia’s ongoing attempts to destabilize the Ukrainian state. The bond dispute is as much a part of this as Gazprom’s lawsuits, ongoing military activity in the Donbass, or cyberattacks on Ukraine’s financial infrastructure and banking networks.

Russia’s bond battle with Kyiv could expose it to another fight with Venezuela. The December 2015 IMF rule change allows the Fund to ‘provide financing to a country even when it has outstanding arrears to official bilateral creditors’. As a result, should Venezuela default, including before official creditors, it could still receive an IMF bailout. Given the geopolitical nature of Venezuela’s debt, Western interests in the country, and the Venezuelan opposition’s recent warnings it may not honor some debt mean the current rules pose a significant concern for Moscow.

As a result, should Venezuela default, including before official creditors, it could still receive an IMF bailout.

Venezuela has an estimated US$139bln in external debt, and as of May, only US$10bln in foreign currency reserves. Russia and Russian state-owned companies are amongst Caracas’ largest creditors. The exact size of these loans, mired in the murky relationships between state oil firms Rosneft and PDVSA, is difficult to estimate. The main complicating factors are Venezuela’s offers to swap debt for stakes in oil assets, complex agreements between Rosneft and PDVSA, VTB’s purported holdings of Venezuelan debt, and perhaps most intriguingly the joint Russian-Venezuelan ownership of Evrofinance Monsarbank, which underwrote a number of Venezuelan debt issuances.

However, Russia’s status as one of Venezuela’s leading, and most politically exposed, creditors is indisputable. As of January 2013, Rosneft had invested at least US$10bln in Venezuela, although CEO Igor Sechin’s words should be taken with a grain of salt given his previous claim investment in the Carabobo-2 field would top US$16bln. Rosneft has since agreed several other loans and investments, most prominently the US$1.5bln loan for which it received 49 per cent of PDVSA’s US subsidiary Citgo as collateral in December 2016. Russia also offered Venezuela up to US4$bln in credit for arms purchases, of which Venezuela reportedly used at least US$3.6bln. In total, the Russian government’s loans to Venezuela likely exceed US$10bln and may rise to US$13bln, excluding interest.

Even with Maduro government still in power, payment issues on its debt to Russia have already emerged. Russia’s Audit Chamber announced in June that it expected not to receive some 53.9bln rubles (US$900m) of the US$2.84bln owed to Moscow under a 2011 loan agreement, which has already been restructured twice. In April, Sovcomflot seized a PDVSA oil shipment over late payments to the Russian state-owned shipping firm. Meanwhile, credit rating agency Fitch warns a default by PDVSA this year is probable, and credit default swap rates imply a 90% chance of a sovereign default over the next five years.

Ukraine’s debts to Russia before the 2015 default included US$605m in bilateral loans and nearly US$1bln in state-guaranteed sub-sovereign debt on top of the US$3bln Eurobond. While Russia improbably claimed nearly US$30bln in debts to Gazprom at the time, the Arbitration Institute of Stockholm Chamber of Commerce ruled against this claim in May. In total, Ukrainian debt owed to Russia in 2015 totaled roughly half of what Venezuela owes Russia today. Venezuela is set to sink further into crisis, and its opposition has warned it would consider much of its recently-issued debt as ‘odious’ should it come to power. The IMF’s rule change means Russia risks major losses should the Maduro government collapse. Russia’s financial fight against Ukraine may well prove penny wise and pound foolish should Caracas default.

---

Max Hess is a Senior Political Risk Analyst with AKE International. He is a graduate of the School of Oriental and African Studies at the University of London and Franklin & Marshall College. Max has written for The Intersection Project, The Moscow Times and The Telegraph and been featured on the BBC, Radio Live, Rossiya 24, Deutsche Welle amongst others. His focuses on trade networks, sovereign debt, political economy and regional relations in Eurasia.