London or Paris: which is the club for Russia’s Ukraine debt?

(Reuters) — A legal conundrum is threatening plans to ease Ukraine’s debt burden and possibly its entire $40 billion IMF-led bailout: should a $3 billion Eurobond held by Russia be classed as commercial paper, or as bilateral sovereign debt?
Kiev is trying to persuade holders of its commercial bonds to swap their bonds for new ones with a lower face value, a reduced interest rate and a longer repayment period.
The aim is for Ukraine to save $15.3 billion from its debt bill, which would be investors’ contribution towards bailing out the country. But classification of the Eurobonds held by Moscow falls into a grey area.
Moscow bought the bonds from Kiev before a pro-Russian president was forced from power early last year, opening a rift which widened with the annexation of Crimea and a separatist rebellion in eastern Ukraine.
If these bonds are classified as official government debt, Russia could escape the restructuring which Kiev wants to impose on private bondholders, making it harder to plug the $15.3 billion hole in its finances by a deadline at the end of May.
Even leaving aside the two bickering governments, consensus is absent among legal and financial experts who call it a situation without a recognisable precedent.
Russia lent Ukraine the $3 billion in December 2013 out of its «rainy day» sovereign wealth fund, structuring the debt as a two-year Eurobond governed by London law.
That, experts agree, was a canny move, firstly because of the complexity of restructuring Eurobond debt, and secondly, because of an unusual clause allowing Russia to demand repayment early if Ukraine’s debt exceeded 60 percent of annual economic output.
So far Moscow has not demanded the money even though it is probably entitled to do so. Instead it seems intent on tightening the screws in another way — by declaring the bond to be bilateral sovereign debt and therefore not subject to the private creditor «bail-in».
Russian government officials have said they won’t restructure the debt, indicating that discussions must be bilateral and not as part of a wider package.
Moscow seems to believe its bonds are subject to discussion by the Paris Club of official creditors, rather than the London Club, which encompasses debt owed to the private sector.
Ukraine disagrees. «They are a Eurobond but they are saying they are not London club. I am not going to do the work for them,» said Finance Minister Natalia Yaresko.
A source close to the talks said Ukraine was confident of its position. «Never before has any Eurobond been classified as Paris Club. There is no precedent,» the person said.
But the Paris Club itself states that it deals with «claims granted by official bilateral creditors i.e. states» or international financial institutions such as the IMF.
The money was lent at a concessional 5 percent interest rate at a time when markets were demanding that Ukraine should pay double that.
«The Russians clearly configured this debt to be able to have it both ways; it’s private in form and official in substance. They are in a beautiful position where they have the choice of being an official or a private creditor,» said Anna Gelpern, a law professor at Georgetown University in the United States.
Gelpern, who specialises in sovereign debt restructurings, says that despite the unusual features, she would be «comfortable» classing it as Paris Club debt.
That would gel with Paris Club norms. What matters is a member country’s debt claim on another country, without mention of whether it is a loan or a bond. In theory, that would mean Russia could declare its Eurobonds as a claim at the Paris Club if it chose to.
The IMF appears to agree. «If I’m not mistaken, the $3 billion Eurobond comes from the Russian sovereign wealth fund, so it’s official debt,» its spokesman said on Thursday.
Private bond holders, already fuming that official lenders are not being asked to write off debt, will be up in arms.
Crucially, any impasse leading to a default on the Russian-held bonds risks derailing the IMF’s own $17.5 billion loan to Ukraine. This is because the Fund is not allowed to lend to a member state that is in default to another.
«Private external arrears are tolerated but arrears to official bilateral lenders are not,» the IMF said in a 2013 paper on sovereign debt restructuring.
Still, there are caveats here too. Greek bonds held by the official sector via the European Central Bank escaped a restructuring of the country’s debt in 2012. But other central banks and state-owned entities such as pension funds and bailed -out Dutch bank ABN Amro took a hit.
Gabriel Sterne, head of global macro at Oxford Economics, expects the IMF to take an indulgent view, noting it has a loan deal with Iraq even though Baghdad is behind on war reparations to Kuwait. A useful IMF get-out clause is that the debtor is negotiating «in good faith» to settle arrears, he says.
Finally, who decides whether the Russian bonds are subject to private sector bail-in or not? For now, Moscow seems in a position to use it as a bargaining chip, either to gain control over disputed eastern Ukraine or gas supplies to Ukraine.
Whatever the outcome, the saga will further confuse already murky debt workout mechanisms.
«There was a mechanism where a country gets in trouble, agrees IMF funding, goes to the Paris Club for relief, then to private creditors, every step is conditioned on the next,» Gelpern said. «But when the categories are so jumbled, it doesn’t work.»
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