UKRAINE: YANUKOVYCH ECONOMIC POLICY RECORD MIXED

C O N F I D E N T I A L KIEV 003906

SIPDIS

SIPDIS

STATE PLEASE PASS USTR FOR LMOLNAR, CKLEIN, SDONNELLY
TREASURY FOR MGAERTNER
COMMERCE FOR ITA/CLUCYK

E.O. 12958: DECL: 10/10/2016
TAGS: ECON ETRD EFIN EINV POL PREL UP
SUBJECT: UKRAINE: YANUKOVYCH ECONOMIC POLICY RECORD MIXED

REF: A. KIEV 3755

B. KIEV 3670

C. KIEV 3783

D. KIEV 3905

Classified By: Ambassador for reasons 1.4 (b) and (d)


1. (C) Summary: After eight weeks in power, the Yanukovych
government's record on economic policy in a number of areas
has not been as bad as some expected, nor as good as others
hoped. The conventional wisdom among the foreign business
community has swung from "let's give them a chance" to "deja
vu all over again." Apparently forgetting their frustration
with the Tymoshenko and Yanukovych government's failure to
enact their reformist agendas, many businessmen point out
that the Yanukovych agenda seems to lack economic reform
altogether. Separating alarmism from real GOU policy moves
presents a more nuanced picture. Some of the moves taken to
date have been negative: the freezing of VAT refunds, the
GOU's embrace of RosUkrEnergo, and the imposition of
restrictions on grain exports. At least one move seems
clearly positive: maintaining the policy that Ukraine would
not sacrifice EU aspirations for integration with the Single
Economic Space. In most other areas -- including WTO
accession, the reactivation of special economic zones, and
the budget -- the GOU's rhetoric and policy steps have so far
been ambiguous and its intentions are still indecipherable.
The record to date is therefore mixed, but trending negative.
We will be watching policy moves in key areas to see if that
trend continues. End Summary.

GRAY EXPECTATIONS
--------------


2. (C) The return of Viktor Yanukovych as Prime Minister was
bemoaned by some as a betrayal of the Orange Revolution, and
welcomed by others as a chance for effective government after
a period of disappointing inaction. Although the Party of
Regions has prominent members who represent powerful
industrial interests associated with Kuchmaism, many
observers hoped the oligarchs would steer the party toward
enlightened pro-market and pro-Western policies rather than
reverting to the cronyism and kleptocracy of the past. The
USG has adopted a pragmatic approach, judging the government
on the actions it takes.


3. (C) Hopes that the new Yanukovych government marked a
significant break with the past were dampened by Mykola
Azarov's appointment as First Deputy Prime Minister and
Minister of Finance, the dual role he had occupied under
Yanukovych and President Kuchma. Certainly Azarov is
widely-acknowledged to be decisive, intelligent, and to have
real managerial talent. If this energy is harnessed to serve
reformist goals, then it would be a welcome change from the
policy paralysis of the previous two governments. Azarov,
however, was also renowned for his willingness to use
administrative power against the regime's enemies or to
enrich the well-connected. As Head of the State Tax
Administration (STA) from 1997 to 2002, his tax police were
much feared and the system of authorizing VAT refunds
notoriously corrupt. As a recent article in "Delovaya
Stolitsa" put it, Azarov represents the old Donetsk clan of
veteran Soviet nomenclatura, rather than the new Donetsk clan
of rich businessmen.

VANISHING VAT REFUNDS
--------------
Scorecard: Negative


4. (C) At the top of the "negative" column is the freezing
of VAT refunds to exports. As one of Azarov's first moves,
this seemed to confirm that he was bringing back the old
system of extensive administrative control. In his second
week in office, he instructed the STA to suspend the
repayment of VAT refunds to exporting businesses. Press
reports in early September claimed that the only VAT refunds
the STA had paid in August went to Donetsk firms. Rumors
held that the Donetsk firms in question all belonged to Party
of Regions sponsor Rinat Akhmetov. In response to these
reports, President Yushchenko ordered the Prosecutor General
to investigate August VAT repayments. Discussions with U.S.
investors, including non-agricultural firms, confirmed VAT
arrears have soared. However, some non-Donetsk firms (e.g.,
Mittal Steel Kryvyi Rih) say they have had no problem with
VAT refunds. (Note: Azarov has on three occasions -- most
recently on September 26 -- promised Ambassador or Deputy
Chief of Mission that he would make sure U.S. agricultural
processing and trading companies received their refunds,
which now approach $100 million. Azarov's office called the
Embassy this week and requested additional information on
these businesses. One of the business received a small
partial refund on October 3. End Note.)


5. (C) State Tax Administration officials attribute any
delays in VAT refunds to the necessity of carrying out
crosschecks of the entire supply chain of exporters before
authorizing a refund. Since even local tax offices
themselves have admitted to businesses that they are unable
to carry out such crosschecks, the policy amounts to a de
facto freeze on most refunds.


BUDGET POLICY
--------------
Scorecard: Ambiguous


6. (C) Azarov's proposed 2007 budget falls into the "too
early to tell" category. While engaging in the typical
politician's ploy of blaming his predecessors for the mess
they left him, Yanukovych in actuality has been fortunate in
inheriting a rather healthy economy and fiscal situation.
Some of Finance Minister Azarov's budget proposals, e.g.
curbing the growth of social spending and addressing pension
reform, seem sensible. Critics point out, however, that the
cuts in some forms of social spending are more than offset by
proposed rises in others. They also criticize the proposed
creation of a three billion hryvnia stabilization fund to be
used at the discretion of the Cabinet of Ministers, and the
emphasis on state-directed investment. While the draft 2007
budget's deficit (now planned for 2.55% of GDP) is not
excessive, there are worrisome signs. The GOU has embarked
on renewed borrowing. Promises of tax reduction for
business, combined with privatization receipts that are
likely to be even smaller than planned in the budget, point
to a danger of a growing budget deficit. Keeping the fiscal
deficit low and adequately financed was one of the successes
of the post-Orange Revolution governments - the new
government seems to have abandoned this hard line.

BETTER SPECIAL ECONOMIC ZONES?
--------------
Scorecard: Ambiguous


7. (C) It is also premature to judge Azarov's efforts to
reactivate the special economic zones (SEZs). The GOU's
current proposal appears to be an improvement over the system
that was in place prior to April 1, 2005, when Tymoshenko's
budget ended the regime of tax and customs privileges offered
businesses in the SEZs. Although some companies operated
legitimately within them, the SEZs had been notoriously
corrupt. Shell firms could reap huge profits by channeling
flows of funds through the zones to avoiding taxes; importers
used the zones as a customs-free channel for goods to enter
the Ukrainian market, making the zones WTO inconsistent.
Tymoshenko's cancellation of these privileges, although
criticized for being abrupt and for penalizing legitimate
investment within the zones, was generally welcomed as a
blow against corruption and for sound fiscal policy.


8. (SBU) The GOU's draft legislation, released on
September 22, seems designed to avoid some problems of the
past. Consideration of the draft legislation is reportedly
far off, and the text, in any case, is subject to possible
changes in the Rada. As it stands, the draft vests authority
in the Ministry of Economy, rather than with local officials,
for approving projects for privileged tax treatment. By
centralizing the power to decide who gets the tax and customs
privileges, Azarov may be reducing opportunities for local
level corruption, but is gathering still more power into a
Cabinet of Ministers that he dominates.


9. (SBU) To aid new investment projects it provides customs
duties exemptions for goods used to construct investment
projects, and a three-year corporate income tax holiday for
new investment projects. For export processors, it provides
facilitation of VAT and customs payments on non-agricultural
goods temporarily imported and sets out general rules for
applying customs and VAT to goods leaving the zones and
entering Ukraine's Customs territory. (Note: Without more
details on these rules and, perhaps, a track record of
implementation, it is difficult to say whether the proposed
SEZ regime would be WTO consistent.)


10. (C). Although designed to address Ukraine's real need
to compete with neighboring countries for FDI dollars, and to
facilitate export processing, the reactivation of the SEZs,
even if they function ideally, remains a controversial
approach. Many observers suggest that Ukraine would be
better off concentrating on creating favorable conditions for
investment and easing customs processing procedures for
businesses throughout the country, rather than granting
privileges to firms in special zones. (Comment: Given their
checkered record in Ukraine, post remains skeptical that SEZs
will be implemented in a transparent and corruption-free
manner.)

MIXED SIGNALS ON WTO
--------------
Scorecard: Ambiguous


11. (SBU) Though WTO accession is nominally at the top of its
priority list, the GOU has sent conflicting signals about its
actual intentions. Rhetorically, the GOU has backed the
potentially incompatible goals of protecting domestic
producers and acceding to the WTO in 2006 (Ref B). Both
Yanukovych and Azarov have flirted with the idea of seeking a
rollback in some of Ukraine's commitments made to date in WTO
negotiations in order to protect domestic producers. Azarov
has suggested that many of the tariffs that the Tymoshenko
government lowered should be restored to higher rates. He
advocates import substitution and export promotion to spur
growth, policies that are difficult to achieve without
WTO-inconsistent measures.


12. (SBU) In actual practice, the GOU has taken two worrisome
steps: it has delayed consideration of WTO legislation and,
in a September 28 Cabinet of Ministers' decree, instituted
export licensing on wheat in an effort to keep prices low for
millers. The delay has come from Yanukovych's insistence on
giving businesses and Rada members a chance to review the
benefits of WTO membership in general, and the accession
terms specifically. The grain trade restrictions seem likely
to seriously complicate WTO accession.

STANDING FIRM ON SINGLE ECONOMIC SPACE
--------------
Scorecard: Positive


13. (SBU) Yanukovych's position on economic integration
within the Single Economic Space (with Belarus, Kazakhstan,
and Russia) has so far not differed from that expressed by
previous governments dating back to Kuchma. He has held to
the line that Ukraine is interested primarily in the SES
becoming a free trade area, but not a customs union. Joining
an SES customs union would complicate WTO accession and be
inconsistent with aspirations for a free trade agreement with
the EU. Yanukovych backs close economic ties with Russia
more vociferously than his predecessors, but he has not yet
closed any doors to Ukraine's increasing its economic
integration with the EU.
CONCLUION: POSITIVE

WHAT'S THE REAL PRICE OF CHEAP RUSSIAN GAS?
--------------
Scorecard: Worrisome


14. (C) Perhaps the most important question about GOU policy
that still remains unanswered is how far Ukraine will go to
get favorable energy terms from Russia. With the appointment
of former NaftoHaz CEO Yuriy Boyko, a figure who was involved
in the founding of RosUkrEnergo (RUE),as Minister of Fuels
and Energy, the new GOU rejected decisively the efforts of
some previous government officials to undermine or revise the
basic arrangements of the January 4 gas agreement. Instead,
the GOU has cemented the central role of shady middleman RUE,
half of which is owned by Gazprom. It has also benignly
encouraged the expansion of the activities of UkrHazEnergo, a
joint venture between NaftoHaz and RUE created by the January
4 deal to handle the sale of imported gas within Ukraine.
Despite efforts in early 2006 by the GOU to limit
UkrHazEnergo's role in the market, the joint venture has
succeeded in taking over much of NaftoHaz's business of
selling gas to industrial consumers, and has begun efforts to
expand into other aspects of energy distribution. While this
process began under the previous government, the new GOU has
given UkrHazEnergo a freer rein in roaming into new areas
(such as production and distribution). This is distressing
to those who see the joint venture as a Trojan horse for
GazProm.


15. (C) In order to obtain adequate natural gas supplies and
an optimal price from Russia, Ukraine has been discussing
broad "strategic cooperation" with Russia. So far the
contours of Ukraine-Russia "strategic cooperation" are not
clear, pending the results of the November Yushchenko-Putin
Interstate Commission and 2007 gas price negotiations. Both
GOU and Russian officials have hinted at linkages to
electricity exports, nuclear power station construction, as
well as openness to joint ventures in the energy sector
itself. For example, Ukraine may indirectly participate in
joint oil and gas production projects on Russian territory.


16. (C) A central concern is whether strategic cooperation
will result in some ceding of control over key assets of
Ukraine's economy to Russian entities including Gazprom.
Encouragingly, the new GOU has said Ukraine's gas pipeline
system remains off-limits to Russian control via a vehicle
like the International Gas Consortium, but Minister Boyko has
shown willingness to allow Russian firms to acquire Ukrainian
regional gas distribution companies. Talks are currently
underway for sale of as many as eight of these companies
either to RUE or to UkrHazEnergo. Russian oligarch Viktor
Vekselberg reportedly bought four other regional distribution
companies in July.

STATE INVOLVEMENT IN GAS AND OIL DEVELOPMENT
--------------
Scorecard: Worrisome


17. (C) The new GOU's approach to natural gas and oil
exploration and development in the Black Sea as well as
onshore suggests hostility to foreign productive investment.
In contrast to the previous GOU's efforts to attract foreign
investment and technological expertise, Minister Boyko
announced that future exploration and development task should
be left to Ukrainian state-owned firms, perhaps with foreign
financing. (Comment: NaftoHaz's abysmal reputation as a
borrower and their lack of know-how makes this strategy
dubious, to say the least.)


18. (C) Boyko's statement seemed to threaten the production
sharing concession that Houston firm Vanco had already won in
April 2006 for a block in the Black Sea off Crimea. When
Minister of Environment Dzharty then announced that Vanco was
in procedural violation of its terms and could lose the
contract, it reflected what was rumored to be a widespread
GOU view that the deal should be scuttled. While in meetings
with GOU officials Vanco officials said they made some
progress in September, it appears that some GOU officials'
opposition to Vanco came from a combination of ignorance of
the terms of the deal and grumbling by losing bidders. Boyko
told the Ambassador October 4 the GOU is committed to finish
the negotiations with Vanco (Ref C). Prime Minister
Yanukovych the same day reiterated that view to Deputy
Assistant Secretary David Kramer (Ref D). (Comment:
However, neither Vanco nor post believes they are out of the
woods yet.)

PRIVATIZATION: NOT A PRIORITY
--------------
Scorecard: Negative


19. (SBU) Serious privatization of state enterprises seems to
be at a standstill, and there apparently is an indefinite
suspension of plans to sell Ukrtelecom, local energy
companies, or port facilities. The Tymoshenko government
took the first tentative steps on these privatizations, but
never moved to completion. Azarov's government has not yet
turned to them. Methods of privatization are becoming less
transparent, with open tenders replaced by insider awards.
For example, a planned tender for a Luhansk locomotive plant
was cancelled and instead the government plans to sell to a
hand-picked buyer.

WHAT'S MISSING: LIBERAL ECONOMIC REFORMS
--------------
Scorecard: Ambiguous


20. (C) In recent meetings with members of the American
Chamber of Commerce, foreigners doing business in Ukraine
expressed their suspicions of Azarov. All agreed he was now
the undisputed tsar of economic policy, especially as
non-political diplomat Volodomyr Makukha appears to have
little policy clout as Minister of Economy. To many
businessmen's ears, Azarov is sounding like an old-school
dirigiste manager, announcing a five-year plan for Ukraine's
re-industrialization that is dependent on state selection of
priority sectors and budget-supported investment. His moves
on VAT refunds and the SEZs are seen as consolidating his
power, which, businessmen tell us, they expect he will use to
favor those politically connected to the regime.


21. (SBU) Many businessmen complain that the GOU's impact on
the business climate will come as much from what it does as
from what it has no apparent intention of doing. Missing
from the Yanukovych/Azarov set of economic policy priorities
is the agenda of reforms businessmen and international
observers have been advocating to no avail for several years,
including under the Tymoshenko and Yekhanurov governments.
These include judicial reform, deregulation, passage of a
joint stock company law, abolition of the commercial code,
and ending the moratorium on sale of agricultural land.

COMMENT
--------------


22. (C) There is no question that many of the policies
pursued by the Yanukovych government are not what western
businessmen and economists consistently prescribe.
Nonetheless, it is important to remember that the record of
the Tymoshenko and Yekhanurov governments on economic reform
was thin, despite their greater rhetorical support for the
reformist agenda. The record so far of the Yanukovych GOU's
actual policy steps is mixed, but trending negative. We will
be watching developments in all the key areas cited above to
see if the GOU can polish its rapidly tarnishing image on
economic policy.
Taylor