Thu 05/04/2023 12:02 PM
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Relevant Document:
April 24 Action Plan 2.0 Paper

A group of U.S. and European sanctions experts is calling on Western governments to escalate pressure on Russia’s public finances through a number of measures spearheaded by lowering the price cap for Russian crude oil.

The International Working Group on Russian Sanctions, which is coordinated by Stanford professor and former U.S. ambassador to Russia Michael McFaul, issued a new paper, titled Action Plan 2.0, on April 24, outlining next possible steps for Western governments to erode Russia’s financial capacity to continue its invasion of Ukraine.

On a call this afternoon, Craig Kennedy, Center Associate at Harvard University and former Vice Chairman of Bank of America Merrill Lynch, said enforcement of the oil price cap needs to be tightened significantly and the price cap itself lowered to $45/bbl with a target of $30/bbl from the current level of $60/bbl.

Kennedy said $30 is the estimated price point where Russia would still export, so global supply disruption would be avoided, but the income to the Russian government would decline sharply. He pointed out that approximately two thirds of oil cargo ships are owned, financed or insured by Western entities, giving them leverage to tighten the screw on the important oil revenue flowing into Moscow’s coffers.

The group urges governments to impose secondary sanctions on those assisting Russia to dodge measures and suggests terminating the direct supply of Russian gas to the EU, except for the volumes traveling through Ukraine’s transmission system. The experts argue in favor of imposing full sanctions on Russia’s oil flagship companies including Gazprom, Gazpromneft, Rosneft, Surgutneftegaz, Lukoil, Tatneft, Transneft, Sibur, Zarubezhneft, and Novatek with some limitations to allow price cap compliant transactions.

Outside energy, the International Working Group recommends a full embargo on all iron and steel products without exemptions and banning the production of steel products in third countries if the steel originates from Russia. It also argues to sanction metal companies because they generate significant tax payments to the Russian government, these include Alrosa, Evraz, Mechel, Metalloinvest, MMK, Norilsk Nickel, NLMK, Polymetal, Polyus, Rusal, Severstal, TMK, Uralsteel, and VSMPO-Avisma. The group notes that Ukraine’s metallurgical companies can supply metals to European countries instead.

In the financial sector, the experts call on the full package of sanctions on Russia’s 10 largest lenders by assets, many of which have already been targeted. These include Sberbank, VTB Bank, Gazprombank, Alfa-Bank, Rosselkhozbank, Credit Bank of Moscow, Bank Otkritie, VEB, Promsvyazbank, and Sovcombank. The group underlines that governments should also refrain from granting new banking licenses to Russian banks, noting that these new international subsidiaries could be used to circumvent international sanctions. Regulators should also, the group says, set a timeline for Western banks to completely exit Russia, including Raiffeisenbank, UniCredit, and Hungary’s OTP.

The group also calls on the EU to enforce a U.S.-style ban on investments into Russia or subsidiaries that generate a material portion of their revenue in Russia. Finally, the group fully backs the work to pass laws to confiscate Russian state assets and transfer them to an escrow account and then on to Ukraine. They note that a Reconstruction Fund should be set up to compensate Ukrainian war victims and support the reconstruction of Ukraine in coordination with the Kyiv government and the State Agency for Restoration and Infrastructure Development and the National Bank of Ukraine.

New Debt Restructuring Ideas

While ideas are being exchanged on how to hurt Russia’s finances, Ukraine is preparing to restructure its sovereign debt in early 2024. Kyiv has told creditors it will seek a solution to restore debt sustainability, close the government’s financing gap and create the “necessary conditions for commercial sector participation” in Ukraine’s reconstruction after the war.

A group of Ukraine’s bilateral creditors has already announced their willingness to extend the current debt standstill over the period of the new IMF Extended Fund Facility, which runs until March 2027.

As for Ukraine’s $20 billion of sovereign eurobonds, quoted around 20 cents on Solve Advisors, many analysts believe the government will pursue more comprehensive debt relief than the current debt service deferral deal which is set to lapse in August 2024.

Bluebay Asset Management’s Tim Ash suggested requisition bonds in an April 30 blog post, whereby Western government would invest frozen Russian funds in liquid global securities and the return would be sent to Ukraine. He noted that Kyiv could even issue Ukrainian requisition bonds and the West could invest frozen Russian funds into these instruments to support Ukraine’s public finances and reconstruction. Such a Ukrainian bond issuance could also allow Kyiv to impose a haircut if Russia fails to pay Ukraine war reparations. Alternatively, Russian assets could be used as collateral in future Ukrainian government borrowing programs, Ash suggests.

In late 2022, Tim Ash and his colleague, Senior Portfolio Manager Polina Kurdyavko, proposed a structure where unallocated IMF Special Drawing Rights, or SDRs, are used as collateral in new bonds issued by Ukraine and other struggling emerging market countries.

That structure, akin to Brady Bonds in Latin America in the 1980s, would allow the borrower to issue higher-quality bonds backed by SDRs and thereby help a stressed or distressed issuer, which would otherwise be excluded from international capital markets, raise new capital or secure larger-than-otherwise-possible haircuts in a restructuring.

Ukraine could leverage its SDRs to secure steeper-than-otherwise-possible haircuts on its existing eurobond debt based on the logic that investors would be willing to swap their existing distressed non-SDR-supported notes for SDR-collateralized bonds. This mechanism could in turn help Ukraine re-enter the international bond market at a critical time for the war-torn nation to help fund its gaping budget deficit and raise some of the money needed for reconstruction.

Ukraine’s GDP declined by a third in 2022 and the IMF forecasts Ukraine’s real GDP to contract by 3% in 2023, according to the World Economic Outlook. Kyiv’s GDP warrants are quoted at 25/27 on Solve Advisors. Western governments, led by the U.S. and EU, have been plugging Ukraine’s budget deficit since the full-scale invasion began 14 months ago. An overview of the external budget financing support for 2023 is shown below:

Many analysts believe Ukraine will launch a counter-offensive against the Russian invaders in the coming weeks to recapture positions. Last week, Ukraine’s defense minister Oleksii Reznikov said preparations were about to conclude and his forces had received Leopard 2 combat tanks and challenger tanks. At a press conference, he said Ukraine is aiming to restore its 1991 borders.

Earlier this week, the White House said it estimates that Russia has suffered more than 100,000 casualties since December of which 20,000 are believed to have died. The World War 1-style trench fighting in Donetsk is believed to have killed thousands on each side.

Meanwhile in Kyiv, President Zelensky yesterday denied any involvement in a drone colliding with the Kremlin, which the Russian authorities categorized as an attempt to assassinate President Putin. Russia is reportedly scaling back its May 9 Victory Day celebrations this year due to security concerns.

This morning in The Hague, Zelensky underlined the importance of holding Russia accountable before an international war crimes tribunal, similar to the Nuremberg trials in 1945/1946. Ukraine has registered more than 85,000 Russian war crimes since the war began. Zelensky also said Russia must compensate Ukraine in full for the damages caused.
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