Debt negotiations with Ukraine could decide the war

As Ukraine fights the Russian invasion, it faces a battle on two fronts: military and financial. Global attention is understandably focused on developments on the battlefield, where Russian troops are advancing toward Ukraine’s second-largest city, Kharkov. But at the same time, Ukraine is also grappling with financial problems.

With its economy damaged by the war and defense costs estimated at $54.4 billion, Ukraine is on the verge of defaulting on $22.8 billion in debt. For Ukraine, debt is not an accounting matter—it represents the ability to defend its sovereignty and secure its future.

At the beginning of the war, private investors led by JP Morgan agreed to freeze Ukraine’s debt repayments. This agreement expires in August. Both Ukraine and its creditors are scrambling to reach a last-minute debt agreement to avoid default.

Such debt restructuring talks are common between states and investors, but they usually take years and rarely take place in the context of war. At present, the negotiations between the two sides are far apart. Ukraine is demanding a 40 percent reduction in its debt, and investors are only willing to accept a 20 percent loss – known in financial circles as a “haircut.”

Ukraine faces a compromise in its debt negotiations. On the one hand, securing a major debt cut or even an outright default could free up significant budgetary resources in the short term. This would allow Ukraine to redirect funds from debt repayment to immediate war-related needs.

However, the long-term consequences of such a decision could be severe, leading to higher borrowing costs and longer exclusions from capital markets. The outcome of these negotiations will affect not only Ukraine’s immediate defense capabilities, but also its long-term economic resilience.

A country’s ability to access credit markets plays an important role in determining the outcome of a war. In an earlier study published in 2013, I found that countries with lower borrowing costs are significantly more likely to win their wars.

Debt allows countries to mobilize more resources more quickly than they would otherwise be able to. The cheaper the debt and the easier it is to access, the more resources the country can mobilize for its war effort.

Because debt plays such a large role in war, defaults by states involved in war are rare. The risk of losing access to credit markets is usually too high. However, there are some notable exceptions.

Russia technically defaulted on its debt obligations shortly after invading Ukraine in 2022 because sanctions made it impossible to pay off the debt. And Saddam Hussein’s Iraq defaulted during the Iran-Iraq war in the 1980s. Yet both countries had significant natural resources to draw on – a luxury Ukraine does not have.

The exceptions of Russia and Iraq highlight another crucial factor in war financing: the nature of a country’s political system. As autocracies, Putin’s Russia and Saddam’s Iraq were able to impose restrictive economic measures in the event of war.

For example, the Russian government has introduced controls that make it difficult for exporters and foreign companies operating in the country to take money out of Russia.

In contrast, the Ukrainian government must take into account the domestic political pressures created by war financing. Measures such as those taken in Russia would likely lead to political discontent in Ukraine.

Debt allows democratic politicians to mobilise resources without resorting to unpopular fiscal strategies. However, faced with the prospect of reduced access to debt, Ukraine has returned to divisive tax policies that increase the tax burden on individuals while cutting social spending.

Taxes are important to the war effort, but they risk jeopardizing the domestic support needed to continue the fighting. And journalists and international watchdog groups accuse the Ukrainian government of being too restrictive in its response to domestic discontent.

The Ukrainian domestic secret service is said to have monitored an investigative media team in their hotel rooms.

The financial future of Ukraine

However, there is also good news for the Ukrainian leadership. After a long delay, the US Congress passed a military aid package worth $60 billion in the spring. At the same time, Great Britain provided Ukraine with its largest aid package worth more than $3.8 billion for 2024.

Recently, the G7 (consisting of Canada, France, Germany, Italy, Japan, the UK and the US) agreed to use Russia’s frozen assets to finance a new $50 billion loan to Ukraine.

This additional funding is needed for Ukraine’s war effort. But it does not solve its immediate debt problems. The aid packages from the UK and the US are only for military equipment and cannot be used for budgetary support. The G7 loan will be more flexible, but that money is not expected to be disbursed until later this year.

Ukraine must balance the immediate needs of war funding with long-term economic considerations and domestic political pressures. The stakes could not be higher. The terms Ukraine achieves in debt negotiations will affect not only its ability to finance the current war effort, but also its ability to rebuild after the conflict ends.

Patrick E. Shea is a lecturer in International Relations and Global Governance at the University of Glasgow.

This article is republished from The Conversation under a Creative Commons license. Read the original article.