Despite Ukraine cease-fire, govt default risk still high

Gleb Garanich | Reuters

Members of the Ukrainian armed forces ride on an armored personnel carrier near Debaltseve, Ukraine, February 12, 2015.

A tentative cease-fire and multibillion-dollar IMF aid package buys Ukraine time to stabilize its battered, war-torn economy.

But with high reconstruction costs and a long list of badly needed reforms, the risk of a government bond default remains high.

After more than a year of armed conflict, Ukraine has also seen its currency and economy contract sharply. Inflation is soaring, and business and consumer confidence have plummeted, according to a recent survey by the National Bank of Ukraine.

The collapse in Ukraine's hard currency reserves has left the government with little cash to cover imports, especially critical shipments of Russian natural gas.

To keep the government afloat, the International Monetary Fund on Thursday announced a $17.5 billion aid payment. Kiev needs roughly that much just to pay this year's debt obligations and cover the cost of imported natural gas, according to Bank of America Merrill Lynch estimates.

The deal buys some time, but will do little to repair the war's damage to the Ukrainian economy or the government's longer-term burden of a heavy debt load, which increases as its gross domestic product and its currency shrinks.

"You can't restore growth when there's a war on and you've got an unsustainable debt burden, and precious revenues you've got to use to repay that debt," said Gabriel Sterne, head of global macroeconomic research at Oxford Economics.

Read MorePutin says leaders have agreed on Ukraine cease-fire

To spur growth, the IMF has also been pressing Ukraine on a list of needed reforms. Those include an overhaul of its banking system, a reduction in energy subsidies, reform of state-owned enterprises, cracking down on tax evasion and tougher anti-corruption laws.

But the effort to advance those measures has been hampered by the conflict.

"The Ukrainian government doesn't have any control over most of this," said Stern. "When you're in a war situation there's very little you can do in terms of meaningful structural reforms. What should politicians be focused on—passing tax legislation or the fact that your country's being invaded from the east?"

Ukrainian bonds rallied on Thursday after trading as low as 55 cents on the dollar, a sign that investors are expecting that the country's debt will eventually have to be restructured.

But the prospect of further economic contraction, along with the threat of a deeper slide in the local currency, complicates any possible deal with investors. Those could include a combination of stretched-out repayments, lower interest payments or writing down principal.

Even as the Ukraine government struggles to repay existing debts, it faces the ongoing expense of fighting a war and the longer-term burden of reconstruction. The separatist conflict is costing Kiev some $10 million a day, Volodymyr Sidenko, an analyst at Ukraine's Razumkov political research center, told Reuters.

"Unless the government tackles corruption and implements other promised reforms ... all foreign loans will be wasted," he said.

"It would be like throwing the cash into the stove to burn," Sidenko said.

Ukraine's economic fate depends heavily on whether a new round of talks aimed at stopping the fighting will ultimately succeed where past agreement have failed.

Read MoreCeasefire agreed for eastern Ukraine

Germany, France, Russia and Ukraine agreed to a fragile deal Thursday that left many details unresolved, amid fresh accusations from Kiev of a new, mass influx of Russian military equipment into rebel-held eastern Ukraine. The deal calls for a cease-fire between Ukrainian forces and Russian-backed separatists starting on Sunday, followed by the withdrawal of heavy weapons and a pledge to give eastern Ukraine more autonomy.

But even as the deal was being announced, German Chancellor Angela Merkel characterized it as a "glimmer of hope," saying major big obstacles remained to a lasting peace.

Western leaders are hoping that economic sanctions against Russia have put sufficient pressure on its president, Vladimir Putin, that this round of talks may prove more successful in ending the fighting than past, failed deals.

Combined with a collapse in oil prices, the sanctions have sent Russia's economy into recession and cut the value of the ruble in half, sparking a mass exodus of private capital.

"A lot of people misunderstand how much damage in economic and financial terms has already been done to the Russian economy by a combination of the sanctions and the capital markets themselves turning against Russia," said Roger Altman, executive chairman of Evercore Partners.

But Moscow could play an important role in any potential negotiations over Ukrainian debt. Russia holds $3 billion in Ukrainian bonds issued with terms that give it unusual powers in those negotiations, according to Anna Gelpern, a Georgetown University law professor.

"The bonds give Russia the power to trigger a cascade of defaults under Ukraine's other bonds and a large block of votes in any future bond restructuring," she wrote in a report from the Peterson Institute for International Economics. "If it ever needs debt relief, Ukraine must hope that Russia would not try to use its bonds to block agreement or to get preferential treatment."