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How to rally support for Ukraine on bond markets

Moritz Kraemer, chief economist at German bank LBBW

Little can increase a government’s financing needs like a war. Unsurprisingly, Ukraine’s public finances are just one of the countless victims of the past 18 months. The government has broadly restored the country’s prewar taxation regime, but revenues remain anaemic.

Spending pressures, including from defence-related items, remain exceptionally high. As a result, S&P Global, a rating agency, estimated this month that the government deficit, including grants, could reach 19 per cent of gross domestic product this year and next. Investors are sympathetic, but wary: two-year bond yields hover around 25 per cent.

But sympathy does not rebuild destroyed infrastructure. The Kyiv government, jointly with its multilateral partners, estimated that in the first year of the war alone the damage exceeded $400bn. Surely that number has since risen substantially. Although nowhere near those estimated damage numbers, Ukraine’s international partners have committed substantial sums that are yet to be disbursed. Most importantly, the EU has set up a €50bn “Ukraine Facility” covering the period 2024 through 2027.

Investment in Ukraine’s recovery and reconstruction cannot wait until the war is over. In fact, the evidence is that reconstruction finance needs to be front-loaded — the need exists now. Commitments must become disbursements, and become so fast. All efforts must be made to front-load the resources available. To do so, the international community can tap into the savings of private investors, whether retail or institutional. In Ukraine itself, more than 180,000 citizens have subscribed domestically to “war bonds”. Canada late last year issued C$500mn in Ukraine Sovereignty Bonds. These are welcome steps but funds need to be mobilised on a much faster clip and a much larger scale.

For Ukraine to directly issue securities to western retail investors, as Israel has done for decades with its successful diaspora bond programme, seems far-fetched. The main reason is that the creditworthiness of Ukraine is yet another victim of the war. S&P Global currently assesses the country’s foreign currency ratings in the “CCC” category. Clearly, the risk of a sovereign restructuring is real. Regulators in Europe and elsewhere will be reluctant to permit marketing such instruments directly to retail investors.

But with enhancements the instruments can still fly. If Ukrainian reconstruction bonds (URBs) are secured by commitments from top-rated entities, such as the EU or the World Bank, they could be marketed to institutional and retail investors alike.

It can be done. URBs can follow the tried and tested and successful blueprints of the Vaccine Bonds issued by the International Facility for Immunization or, indeed, the vast NextGenerationEU (NGEU) pandemic recovery programme. In both cases bonds are backed by future financial commitments of highly rated governments. The rating agencies accordingly assigned the guarantors’ high ratings to the respective bonds.

Where could the URB credit enhancements come from? The most obvious source of highly rated future financial flows could be funds the EU has committed through the Ukraine Facility. Since they are to be disbursed by no later than 2027, this matches nicely with the relatively short-term investment horizon of many retail investors. Conveniently, there would be no need for additional financial commitments by the EU or its member states. The funds are already pledged. Only their deployment is accelerated.

Alternatively, URBs could be partly secured through a windfall tax on the profits of Euroclear, the securities depository where much of the frozen foreign reserves of Russia’s central bank sit. In the first half of 2023 alone, Euroclear earned more than €1.7bn of interest on Russia’s sanctioned assets. A legal consensus in the US and the EU has emerged that the returns of confiscated assets do not accrue to Russia. Thus, the returns can be used to secure debt service payments on the URBs.

URBs are a win-win proposition. First, Ukraine benefits by receiving necessary reconstruction funds more rapidly. Deploying resources quickly reduces the economic and social fallout from the war. EU governments also benefit from propping up what has turned out to be the key frontline ally standing up for our joint values. Today, Europe is defended at the Dnipro river. As the war moves towards its second winter, the time has come to think out of the box.