Financial Power Europe? The Challenges of EU Financial Assistance to Ukraine

CSDS POLICY BRIEF • 27/2024

By Lukas Spielberger

7.10.2024

Key issues

• Since Russia’s full-scale invasion of Ukraine in 2022, the European Union (EU) has provided about €40 billion in financial support to the Ukrainian government, making it the largest donor to date. Recently, the EU proposed further assistance.
• The EU’s support consists of loans that Ukraine seems unlikely to repay in the future. To reduce the strain that these loans pose on Ukraine’s public finances, the EU has implemented various changes to the way it provides financial assistance.
• Even if some questions regarding the loans to Ukraine remain unresolved, the EU already seems ready to use its new financial powers in its relations with other countries.

Introduction

In the third year of full-scale war, continued international assistance remains critical for Ukraine to withstand Russia’s unprovoked aggression. A lot of attention has recently focused on Ukraine’s need for military assistance, a large part of which had been held up in the United States (US) Congress for months before being passed in June. However, to keep the Ukrainian government operating and allow it to pay civil servants, teachers and nurses, external financial assistance has become existential. According to recent estimates by the International Monetary Fund (IMF), Ukraine will require about $38 billion in external financial assistance to fund its budget in 2025.

In terms of financial assistance, the EU has taken on a leading role and has emerged as the largest provider of financial aidto Ukraine since 2022. As of October 2024, the EU has mobilised over $40 billion in support, compared to $27 billion of US support and just over $10 billion from the IMF. On 20 September 2024, the European Commission proposed another €35 billion loan as part of the Ukraine Loan Cooperation Mechanism (ULCM), secured against the proceeds from seized Russian assets. Indispensable as this support is for Ukraine, the EU’s decision to lend the funds – rather than give grants, as the US has mostly done – means that it has also become the largest creditor to Ukraine.

As this CSDS policy brief explains, the EU’s loans to Ukraine have had various short-term advantages, but they imply long-term fiscal risks that the EU has not yet covered. While the ULCM may signal a change in the EU’s – and the international community’s – approach to supporting Ukraine, dealing with previous loans secured against the EU budget may pose a political challenge in the future. Nevertheless, it is already clear that the EU’s support to Ukraine has not just changed its public finances, but also the Union’s ability to use financial assistance as a tool of its foreign policy agenda in the future.

The EU’s new role as a financial power

The EU’s response to the full-scale invasion of Ukraine has revealed that its ability to respond to external challenges and demonstrate its much-vaunted strategic autonomy as a foreign policy actor differs across policy domains. In the realm of defence, for instance, the EU quickly realised that it lacked both the political and the material foundations to sustain Ukraine’s fight for survival. Both the EU’s military assistance via the European Peace Facility of about €6.1 billion, and EU member states’ more significant bilateral military support of €37.4 billion have been eclipsed by US military assistance of $61.3 billion. On its face, the EU’s budget support to Ukraine has, by contrast, been an impressive display of financial power that seemed all but impossible a few years ago. As of September 2024, the EU has extended about €33 billion in direct budgetary assistance and under the Ukraine Facility, agreed in February 2024, it has committed to supporting Ukraine to the tune of €8 billion annually until 2027. In 2024, the EU’s support made up more than half the external financing of the Ukrainian government budget. The Commission’s recent proposal for the ULCM adds to that another loan of €35 billion, to be disbursed in a single instalment before the end of the year 2024, to respond to Ukraine’s urgent budgetary needs.

The EU’s financial assistance consists of highly concessional loans which are funded through joint borrowing, using the debt management infrastructure set up to fund the recovery facility under NextGenerationEU, and secured against the EU budget. The EU’s choice to lend the money, rather than donate it outright, as the US has done until July 2024, is particularly notable in this context. In the short run, the EU’s loans, unlike those provided by the IMF, pose no direct burden on the Ukrainian government. Repayment of the loans will not begin before 2033 and the EU has exceptionally agreed to cover Ukraine’s interest payments and other loan-related costs. Moreover, repayment is stretched out over 35 years, reducing the amount to be repaid annually. Such attractive terms, not to mention the large volume of financing for a non-EU member state, are unprecedented and reflect significant political efforts to use the EU’s financial capabilities in line with geopolitical considerations.

Nevertheless, the EU’s loans in their current form are a liability for the Ukrainian state – in fact, the EU is Ukraine’s largest sovereign creditor, owning over a third of Ukraine’s external debt. Debt service is already problematic for the Ukrainian government, which just in September 2024 reached a deal with private creditors to restructure over $20 billion of outstanding debt. Even so, the IMF projects that Ukraine’s national debt is on track to equal the country’s Gross Domestic Product (GDP) in 2025 – a level widely deemed unsustainable. Ukraine has ended up in this dire fiscal situation through no fault of its own: until 2021, the country ran a tight fiscal policy under an IMF programme. But Russia’s invasion and continued strikes on civilian infrastructure devastated large parts of the economy. Former industrial centres remain occupied and the Ukrainian government has ramped up military spending to mobilise resources for the war. All this has left Ukraine’s public finances in a precarious state. Not only are further debt restructurings for Ukraine likely, but they would also be in the EU’s interest as they would unburden the government and allow it to invest in post-war reconstruction.

To understand why the EU opted for loans as a form of support in spite of these drawbacks, one needs, as so often, to look at a combination of institutional legacies and intergovernmental disagreements. On the one hand, the Ukraine Facility is built upon the institutional foundations of the EU’s macro-financial assistance (MFA). MFA is a well-established policy instrument, rooted in the EU Treaty and governed by the co-decision procedure. Until 2022, MFA used to be a fairly technical instrument through which the EU extended small loans to supplement over 80 IMF-funded programmes in neighbouring countries, of which several were in Ukraine. Thus, the policy option of funding emergency loans to Ukraine was in a sense the EU’s default response – a budgetary instrument through which it could fund large grants, such as the US Exchange Stabilisation Fund, did not exist.

What is more, politically, mobilising sufficient financial resources for the benefit of Ukraine was difficult enough even in the form of EU loans. At first, several countries had advocated for support to take the form of grants, funded out of the EU budget. In the summer of 2022, Germany refused, for instance, to disburse only emergency loans without a grant component. Similarly, the Netherlands had advocated for grants, but, according to its then-finance minister Sigrid Kaag, it ‘couldn’t find support for this’. According to an official involved in these discussions, the idea of offering grants to Ukraine was dropped quietly when the EU’s first large support package of €18 billion, called MFA+, was negotiated in late 2022. Hungary’s Russia-friendly prime minister Viktor Orbán may have been most outspoken in resisting grants in the MFA+, but several other member states must quietly have favoured EU borrowing over sending taxpayer money via Brussels to Kyiv. A borrowing-and-lending operation got around financial constraints and allowed the EU to disburse far greater amounts than would have been available from national treasuries. The EU’s newfound international financial power revolved around its own ability to borrow on capital markets, which had just been boosted to fund the recovery facility.

Beware the contingent liabilities

From the perspective of the EU’s public finances, the question of how much of a problem a loan can pose depends how it is guaranteed in the budget. Traditional MFA loans were guaranteed by paid-up funds from the EU’s budget, equivalent to 9% of the loan amount, that were set aside in the so-called External Action Guarantee. However, this approach soon proved infeasible to backstop EU loans to Ukraine in 2022. After Russia’s full-scale invasion, Ukraine was considered a much riskier borrower and the EU, in July 2022, decided to increase its provisioning rate from 9% to 70%, all but turning future loans into grants. As larger loans were extended in the second half of 2022, it became clear that the External Action Guarantee would no longer suffice as a backstop.

To guarantee the €18 billion MFA+, and the €33 billion of loans planned under the Ukraine Facility, EU member states agreed to mortgage the EU’s “budget headroom” as they did for loans to member states. This meant that the loans were no longer guaranteed by funds that the Commission invested in a guarantee account, but merely by member states’ promises to reimburse the EU in case of non-repayment, up to a certain amount. Compared with the External Action Guarantee, this approach had a clear advantage: it did not require member states to cough up any funds when the loans were made. But were Ukraine to default on its loan, the member states would have to transfer the necessary funds to compensate the Commission, in addition to their regular payments into the EU budget. Short-term expediency trumped long-term fiscal prudence.

Given the widespread political consensus in favour of supporting Ukraine, this technical change to the guarantee structure was waived through with fairly little controversy, at the time, according to several officials involved. The Swedish government, not known for its keenness to take fiscal risks, stated that while ‘the government is generally critical of borrowing above the expenditure ceiling […it] considers that the urgent and extraordinary situation in Ukraine justifies exceptional solutions to help the country’. An official from another usually frugal member state told this author in early 2023 that to their government, the guarantee structure made little difference – they would have to pay either way. Several financial technocrats interviewed on this topic see the financial and political risks buried deep in the EU budget and, for the most part, admit that some degree of debt forgiveness for Ukraine will be part of the ultimate settlement. However, at the political level there is omertà concerning these risks. After all, the problem will not materialise until 2033, when future governments will have to handle it.

And yet, already in 2024 it is clear that mobilising member state funds on top of the regular EU budget for debt service is an unpopular proposition. Recent rumours that the EU is exploring ways of delaying the repayment of its debts under the recovery facility, which is mandated to begin in 2028, illustrate that borrowing and spending are more popular than repaying. It is not difficult to imagine how fraught the discussion can get when it comes to sending more money to Brussels to patch up for Ukraine’s unwillingness or inability to pay. Absent its own fiscal backstop, the EU’s financial power remains precarious. However, there are several policy options available for the EU to prevent such a cliff-edge.

The way forward

Although calls for the EU to write off Ukraine’s debt upfront are understandable from an economic policy perspective, it is all but impossible that EU leaders would take that decision. The economic advantages in terms of directly improving Ukraine’s debt sustainability are likely to be outweighed by the political cost of having to admit that recent loans will not be paid back in a time when national budgets are already strained. This is not to say that the economic imperative for debt relief is not recognised. But rather than write off outstanding debts directly, expect a combination of financial obfuscation, political dealmaking and innovative financial instruments that will all turn the EU into a more purposive financial power in the future.

Financial obfuscation has been part of the EU’s toolkit for keeping over-indebted states afloat ever since its ‘extend and pretend’ strategy for Greece. In essence, this approach involves granting highly concessional loans that put no immediate pressure on the recipient government’s budget to allow a government to meet its short-term financing needs and, above all, keep servicing its debts. In this respect the EU’s loans, which cost Ukraine nothing until 2033, are already much more attractive than the loans that Ukraine is receiving from the IMF, which the country is already paying back. To allow Ukraine’s government to stay afloat, the EU might extend the maturities of loans under the MFA+ and the Ukraine Facility further when they come due, or even grant a new loan on similarly generous terms to repay these old loans. The EU could, in short, bury the debt relief in its balance sheet and keep kicking the can down the road.

Political dealmaking is likely also going to play a role, not least since the EU’s momentous decision to grant Ukraine candidate status and the remote prospect of becoming a member state one day. Usually, candidate countries would qualify for various financial assistance instruments from the EU; however, for Ukraine, this assistance has been subsumed under the technical support that the EU provides under the Ukraine Facility. Going forward, one can imagine that Ukraine’s debt service to the EU might similarly – and most likely informally – be offset against support that the country would otherwise receive as either a candidate country or a member state. EU grants that Ukraine would be entitled to might have to be channeled into debt repayments to the EU.

Lastly, the proposed Ukraine Loan Cooperation Mechanism can be seen as an innovative approach to continuing financial support to Ukraine via joint borrowing without adding further to Ukraine’s debt. The Mechanism is the EU’s response to a June 2024 G7 agreement to use frozen Russian foreign exchange reserves – which are largely held in Belgian security depositories – to finance Ukraine’s war effort. While the EU’s planned €35 billion loan will be funded through further EU debt, and secured against the EU budget, these borrowings are supposed to be repaid from the interest earned on the frozen Russian assets and not the Ukrainian government. Exceptional as this operation may be, it reflects the EU’s leading role in coordinating international support and its willingness to look for ways to keep financial support flowing without overburdening Ukraine’s government with debt.

Conclusion

Without a doubt, the EU’s support to Ukraine since 2022 has been momentous. Though the EU has failed to agree on large budgetary grants, it has used its new borrowing powers to fund the lion’s share of international financial assistance in Ukraine. It has offered uniquely attractive loan conditions and come up with a new budgetary guarantee structure to underpin support to a third country at an unprecedented scale. At first glance, the EU’s approach of providing loans bears risks for the EU budget and political economy incentives make it unlikely that member states will want to write-off the resulting Ukrainian debts upfront. Nevertheless, the EU has various options short of outright debt forgiveness, both technical and political, that can blunt the impact of its loans on Ukraine’s public finances. The recent Commission proposal to earmark proceeds from sanctioned Russian assets to fund another emergency loan to Ukraine demonstrates the EU’s central role in securing international support. Within a few years, the EU has established itself as an international financial power.

Furthermore, for all the uniqueness of Ukraine’s situation and the overwhelming political and moral imperative to make loan assistance as light on its government as possible, there are the first indications that the EU’s assistance to Ukraine has transformed its ability to assist third countries financially more generally. Recently, the EU has shown a greater willingness to use macro-financial assistance for more political ends, as reflected in its mooted loan to Tunisia and a recent loan to Egypt. Some elements of the loans to Ukraine, not least ultra-long maturities, have been replicated in other loans, such as the Western Balkans Facility. If the EU’s financial capabilities were ramped up to support Ukraine at scale, by now, they are being used for other purposes, too.

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