The Global Financial System Is Dying in a London Courthouse

In the four years that Russia and Ukraine have been at war, the front line has hardly shifted—and when it has, it has generally been in Russia’s favor, as when the town of Debaltseve was seized in February 2015. Last month, however, Ukraine finally notched a major victory. It wasn’t the result of fighting in the Donbass but rather a ruling by the Court of Appeal in London.

The fact that a London courthouse has become one of the key battlefields of the war underscores that there’s far more at stake in the Russia-Ukraine war than territory in eastern Ukraine—the fate of the international financial system, at least in its current shape, also hangs in the balance. The only thing that is certain is that, as a result of the war in Ukraine and the ongoing court case it has produced in London, the global financial system will never be the same.

The international financial system as it exists today was designed to sever questions of global economic policy from parochial political disputes—or, if necessary, to reconcile them—by establishing and empowering technocratic international institutions. The system was established in the aftermath of World War II, as the Bretton Woods Agreement effectively made the U.S. dollar the world’s reserve currency, and also led to the establishment of the World Bank (the world’s leading development bank) and the International Monetary Fund (IMF), which came to serve as the lender of last resort to sovereign states. A series of other institutions sprang up around these to serve the same technocratic ends, such as the Paris Club, which has come to oversee most restructurings of sovereign-to-sovereign loans.

Russia has supported the global financial order when it serves its own political interests, as demonstrated by a recent effort to use some of its own sovereign bond issuances as a tool to repatriate capital. But the Kremlin has simultaneously always complained that the allegedly nonpolitical system was designed by the United States and Europe to structurally advantage their own interests over those of other countries—complaints that have only grown more vocal in recent years amid the imposition of international sanctions against Moscow.

Russia and Ukraine’s battle over a bond in Britain represents Moscow’s latest challenge to the international financial system, and its ostensible separation of economic disputes from political ones, by brazenly seeking to entangle the two, and tempting Kiev to respond in kind.

The dispute began when Ukraine’s then-president, Viktor Yanukovych, flew to Moscow in December 2013 to meet his Russian counterpart, Vladimir Putin, as protests against his decision to abandon an association agreement with the European Union raged in central Kiev. Yanukovych and Putin announced a bilateral action plan that included $15 billion in loans from Russia to Ukraine. One week later, the first loan was issued as Ukraine sold a dollar-denominated bond issued under English law directly to Russia’s National Wealth Fund.

On the face of it, this was not unusual. Emerging markets often issue dollar bonds under English or New York law. Ukraine had used almost the exact same structure to sell debt to private investors many times before.

It is unprecedented in modern history, however, for one country to loan to another directly through such a bond, which is typically an instrument of private-to-sovereign loans. Structuring the loan in this way had several advantages for Russia. First, it allowed Moscow to weaken the international financial system by highlighting its limited reach; the Paris Club has traditionally been the venue for sovereign-to-sovereign debt restructurings, but Russia simply chose not to file its Ukrainian bond there. This approach also allowed Russia to intervene in Ukraine’s private debt market. The latter effort was telegraphed by the fact that the legal wording in the bond was nearly, but not entirely, the same as in Ukraine’s previous bond issuances. These terms granted the bond’s holder, the Kremlin, significant leverage over Kiev by effectively allowing it to trigger default any time it saw fit—again, not unusual in the case of a private bond holder, but certainly so when borrowing from a sovereign government.

The only reason Ukraine would have considered such a loan was the fact that it was relatively cheap—Yanukovych’s teetering government needed money urgently, and the cost of servicing Russia’s bond was well below the market rate from private investors at the time. Putin nevertheless claimed the bond sale was “commercial” and said $12 billion in further loans, using the same structure, was in the offing.

Those loans never arrived. Although Yanukovych’s government filed plans to sell an additional $1.98 billion in debt on Feb. 17, 2014, Yanukovych fled Kiev for Russia five days later. The Euromaidan revolution brought his political opponents into government, who vowed they would sign the EU-Ukraine Association Agreement and reject Putin and Yanukovych’s bilateral plans. Moscow then moved to annex Crimea and fomented a separatist insurgency in eastern Ukraine.

Ukraine’s economy subsequently collapsed. Its currency, the hryvnia, hit a 10-year low only days after Yanukovych’s ouster and would continue to weaken throughout 2014 while investment fell more than 18 percent in each of the first two quarters. The yield on Ukraine’s debt spiked, as did the cost of its credit default swaps, a financial instrument used to insure against default.

As Russia’s aggression ravaged the Ukrainian economy, it became clear that Ukraine needed to restructure its debts. Ukraine came to an agreement with its private creditors in August 2015, including with the investment firm Franklin Templeton, which held the lion’s share of Ukraine’s bonds—an agreement that guaranteed those involved would receive better restructuring terms than any holdouts, including Russia. No private creditors joined the Kremlin in holding out.

Once Ukraine agreed to restructure its other private debts and received a tranche of its IMF bailout in late 2015, it then defaulted on the Russian loan.

The Kremlin moved to sue, seeking to exploit the full force of the global legal financial system to pursue its claims—and to weaken Ukraine. It quickly discarded Putin’s assertion that the bond was a commercial loan, insisting it be treated as official intergovernmental debt. Claiming a private bond as such sovereign debt was an unprecedented situation and one that posed an immediate challenge to the IMF. At the time, the fund’s rules prohibited it from loaning to countries that were in default on their official debts, defined as loans from multilateral institutions and other sovereigns.

In December 2015, just before the bond came due and Ukraine was meant to repay the $3 billion principal, the IMF agreed with Russia’s position: It ruled that the bond was official debt. Nearly concurrently, however, the IMF changed its rules, enabling it to grant loans to countries in default to official creditors. The Kremlin was outraged, alleging this was evidence that the international financial order was biased against it.

Ukraine persisted in its default on the Russian bond, confident that the Kremlin’s ability to frustrate its IMF bailout was barred by the rule change. However, Moscow had another avenue to pursue: British courts, which had legal jurisdiction over the bonds. It quickly sued to demand full repayment.

Ukraine quickly mounted a defense for why it need not repay the debt. First, it argued that the bond was “odious debt,” a legal argument that sovereign creditors have often attempted to make against repaying the debts of previous governments, albeit with little success; Kiev hoped to bolster its case by claiming the Yanukovych regime was despotic, as evidenced by the unbelievably ostentatious displays of wealth at his residence. Another of Ukraine’s later legal arguments was that Russian actions in Ukraine in late 2013—imposing a partial trade blockade and threatening a gas war, among other actions—were part of an intentional effort to put Yanukovych’s government under duress to force it to agree to the debts.

In March 2015, London’s High Court of Justice issued a summary judgment in Russia’s favor, holding that the various defenses submitted by Ukraine were not justifiable. But the Court of Appeal’s ruling this September held that the abovementioned duress argument was one that the court should hear and ordered a full trial. Russia immediately appealed, sending the case to the U.K. Supreme Court for final judgment.

No matter what the Supreme Court decides, the international financial system will change. A Ukrainian victory would lead to a trial on the merits of Ukraine’s duress argument and potentially set a new precedent that could reverberate through sovereign debt markets. Upholding the duress argument would mean that, in the future, the political conditions under which sovereign bonds are issued could become a way to dispute repayment.

Russia, for its part, would be highly averse to a full trial given disclosure requirements that could require it to reveal details about exactly how it convinced the Yanukovych regime to sign a loan so disadvantageous to Ukraine. This might be reason enough for Russia to abandon the $3 billion in principal it is still owed, though the Kremlin would be all but certain to cloak this retreat in an argument against the bias of the international financial order.

A ruling in Russia’s favor would risk immediately pushing Ukraine into default—and lead to an extremely complicated process of negotiating with Moscow, in contravention of Ukraine’s pledge to creditors in its 2015 restructuring. It would also give legal legitimacy to Russia’s strategy of using private debt markets in combination with aggressive foreign policy to assert its power. That could potentially inspire similar such moves by other hostile powers.

Indeed, it is unlikely this will be the Kremlin’s last foray into blending private debt markets and politics. The latest evidence is the lien secured by the Russian state oil company Rosneft over a 49.9 percent stake in the American refiner Citgo resulting from a loan from Rosneft to Citgo’s Venezuelan parent company, PDVSA.

The Kremlin has been warning of the implications of the IMF’s rule change, with Prime Minister Dmitry Medvedev labeling it akin to opening Pandora’s box in terms of maintaining confidence in international financial institutions. The bond was an opening salvo in Russia’s war with Ukraine. It may prove to be the same for Russia’s attempts to challenge the international financial order.