UKRAINE’ S decision last week to stop foreign debt payments marks a distinct shift in tone for the war-torn and recession-battered country.

As negotiations between Kiev and its creditors stall and bankruptcy nears, the rhetoric of government communiques is shifting.

In March a presentation to investors noted that “a collaborative process is paramount . . . Ukraine is committed to undertake consultations with its creditors”. By May the government declared it had “the right . . . not to return loans borrowed by [a] kleptocratic regime”.

In sovereign debt circles the tack Ukraine appears to be taking is known as the ‘odious debt’ argument, which rejects the notion that governments are liable for the debts of their predecessor.

It is a strange approach given that legal enforcement of sovereign debt is already a mirage. Private lenders have few recourses if a country opts not to repay bonds. Unlike a company, a nation cannot be stripped of parts and sold, and without military action payments cannot be forced. This is why Argentina is in a battle with creditors for more than a decade after defaulting.

However, by questioning the legitimacy of debt it does not intend to pay, a country can hope to ward off the informal sanctions that usually accompany default, such as denial of future loans.

It is a risky strategy. If talks break down countries can harm their chances of arranging a restructuring deal, and may be locked out of credit markets.

For Ukraine time is running out. Kiev is trying to restructure about $23bn of debt. Without a deal by next month it risks losing its next tranche of IMF funding. Default may be the only option left

So far Greece has not officially employed the odious debt argument, although it has created a ‘Debt Truth Committee’ to investigate its debts.

It can be a successful negotiation tool. In 2008 Ecuador declared two bonds issued in 2000 to be unlawful debt taken out by a previous corrupt regime. The next year the country completed a restructure of its debt, buying back bonds at just 35 cents on the dollar.

However, Adam Feibelman at Tulane university says it could be a pyrrhic victory. Ecuador’s definition of odious debt did not match the definition coined in the 1920s by Alexander Nahun Sack, a Russian legal theorist, as debt contracted and spent against the interests of the population without its consent.

For Ukraine the case rests on the fact that the money owed was taken out during the rule of Viktor Yanukovich, who fled last year after the collapse of his pro-Russian regime. It includes a $3bn bond owed to Russia and due for repayment at the end of this year.

Kiev says the money was not used for the good of the Ukrainian people. “To the public these funds have not reached. They were wasted in vain for the country . . . Government has the right to direct the funds paid by taxpayers in Ukraine to the needs of its citizens and not to return loans of the kleptocratic regime of Yanukovych.”

Not every government inherits the debts of its predecessor. A 2007 paper for the UN outlined incidents of payments being denied on the basis of odious debt. It began with the US refusing to take on the debt of Cuba when Spain ceded sovereignty in 1898, arguing that the money had been used in part to suppress popular uprisings. The debt was never paid.

Later the Soviets repudiated the outstanding debt of Russia’s Tsarist government after the 1917 revolution.

When Iran was arguing against debts to the US taken out before the revolution, Washington said that even when a government was removed the state was unchanged.

Advocates of the odious debt argument tried to persuade Nelson Mandela to reject South Africa’s apartheid-era debts and asked the US to write off Iraq’s debt in 2003. Neither piece of advice was followed, although Iraq was granted debt relief.

Anna Gelpern, a fellow in law at Georgetown, says the problem is choosing an objective judge and then enforcing a decision, particularly now that sovereign debt is owned by so disparate a group of investors.

For Ukraine time is running out. Kiev is trying to restructure about $23bn of debt. Without a deal by next month it risks losing its next tranche of International Monetary Fund funding. Default may be the only option left.

Published in Dawn, Economic & Business, June 1st, 2015

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