UNSTEADY UKRAINE RESPONSE WORRIES IMF TEAM

C O N F I D E N T I A L KYIV 002434

SIPDIS

DEPT FOR EUR, EUR/UMB, EEB/OMA
TREASURY PASS TO TTORGERSON

E.O. 12958: DECL: 12/11/2018
TAGS: EFIN EREL ETRD PGOV PREL XH UP
SUBJECT: UNSTEADY UKRAINE RESPONSE WORRIES IMF TEAM

REF: A. KYIV 2412

B. KYIV 2413

C. KYIV 2207

Classified By: ECONOMIC COUNSELOR EDWARD KASKA, REASONS 1.4(B) AND (D)


1. (C) Summary. An IMF team led by Ceyla Pazarbasioglu, in
Kyiv to assess Ukrainian implementation of the Fund's $16.4
billion Stand-By Arrangement (SBA),offered mixed reviews of
GOU anti-crisis efforts during her December 10 meeting with
the Ambassador. Pazarbasioglu complimented Minister of
Finance Viktor Pynzenyk and National Bank of Ukraine (NBU)
Governor Stelmakh for "trying to do the right thing" but
lamented political weakness and conflicts of interest in
their respective institutions. Her insights on Ukraine's
2009 budget, bank recapitalization program, and external
financing gap were mostly dour, as was her assessment of the
potential for GOU bungling of Prominvestbank's
nationalization. Pazarbasioglu called for greater EU
engagement in the eastern European financial crisis, perhaps
through a Brady Bond-type solution to the region's debt and
liquidity problems. She asked for the U.S. government to
weigh in with EU counterparts on the Brady Bond idea, as well
as consider providing a qualified banking advisor to serve as
an impartial member of the Prominvestbank board. End summary.

IMF Back in Ukraine
--------------


2. (SBU) Pazarbasioglu and her crew of policy and technical
advisors traveled to Kyiv on December 1-11 for an interim
look at Ukraine's adherence to the SBA's conditionalities.
Pazarbasioglu arrived just over a month after the SBA was
finalized, seeking to contain apparent problems with GOU
coordination and program implementation. During her stay,
Pazarbasioglu met with senior government officials, private
businessmen (including those she called "billionaires"),and
a group of foreign ambassadors. She requested a separate
private conversation on December 10 with the U.S. Ambassador
to provide a candid readout of her trip and request U.S.
backing for IMF supported programs.

Unsteady Hands at Finance, NBU
--------------


3. (C) Assessing two of Ukraine's primary decision makers in
the financial crisis, Pazarbasioglu mixed praise with
stinging criticisms, repeated often to us by senior IMF
officials. On the Minister of Finance: Pynzenyk "cares and
is trying to do the right thing," said Pazarbasioglu. "I
don't think he has the Prime Minister's backing, but I hope
he stays." Pazarbasioglu's erstwhile lieutenant (see comment
in paragraph 11),resident IMF representative Balazs Horvath,
observed that Pynzenyk lacks political clout. Isolated from
PM Yulia Tymoshenko, he operates as if a "Damocles sword is
hanging over him." On the NBU Governor, Pazarbasioglu and
Horvath both spoke of their admiration for Stelmakh's
personal integrity. In general, "Pynzenyk and Stelmakh talk
to each other," said Horvath, though there is a lack of
policy coordination between the Minister of Finance and the
NBU Governor, reflected at all levels. The IMF has taken the
unusual role of "hand holding" between the two institutions
in an effort to coordinate strategy and create safeguards for
the SBA.


4. (C) Pazarbasioglu said the top NBU management "doesn't
understand or have expertise to deal with a flexible exchange
rate." "This is doubly difficult," she said, "when the
banking system is fragile and there is an environment of
political uncertainty." The NBU's clumsy management of the
hryvnia depreciation in November caused reserves to fall by
over $2 billion. Pazarbasioglu said that the IMF was forced
to demand a halt on NBU interventions after the NBU
repeatedly sold dollars in a non-transparent manner, often
below market rates. Only after the IMF provided a technical
advisor to the NBU did the central bank begin to conduct more
transparent currency auctions that priced foreign exchange
near the market rate. Pazarbasioglu expects the hryvnia to
stabilize in the short term. She did say, however, that the
hryvnia could depreciate further due to the inflation
differential to the dollar, perhaps to a rate of "8 UAH/$1 or
even 10 UAH/$1."


5. (C) As an institution, the NBU has a "Soviet mentality"
toward its core economic functions, and it thinks "very
differently" from other central banks. Pazarbasioglu
recalled an example of the NBU's explanation of its monetary
policy controls. Stelmakh equated any potential interest
rate increase with higher rates of inflation, even as Ukraine
struggles with falling GDP and a large current account
deficit. Pazarbasioglu and Horvath reiterated accusations of
conflicts of interest at the NBU's council, where business
and political influences seep into the central bank's policy
making. NBU council head Petro Poroshenko was singled out as
a particular epitome of the council's deleterious role.

Financing Gap
--------------


6. (SBU) Pazarbasioglu confirmed that a supposed $27 billion
financing gap, cited in PM Tymoshenko's November 4 letter to
Treasury Secretary Paulson and again during the Ambassador's
December 4 conversation with Minister Pynzenyk (Ref A),is
not an IMF projection. The IMF has not changed its
projection of the financing gap for 2008-2010, which remains
at roughly $16.4 billion for 2008-2010, and is meant to be
covered by the SBA. Pazarbasioglu emphasized, however, that
the IMF program made certain assumptions, particularly that
i) the GOU would implement SBA conditionalities, ii) most
bank debt due in 2009 would be rolled over, and iii) the
world economy would rebound in the second half of 2009.
Although she had not seen the $27 billion projection cited by
the GOU, she understood how the GOU arrived at the figure.
If less bank debt were rolled over, if outstanding sovereign
debt faced cross-triggers, or if the IMF's assumptions about
the global economy did not hold, then the financing gap could
be much larger than what the IMF has projected.

Ukraine's 2009 Budget
--------------


7. (SBU) Having previewed the Ministry of Finance's draft
2009 budget in tandem with the World Bank (Ref B),the IMF
agrees with the World Bank's assessment that the budget is
not yet close to being balanced. The biggest culprits are a
huge drop in revenues, combined with a large deficit in the
pension fund, according to the IMF. Pazarbasioglu expressed
satisfaction that the Ministry had based its austere fiscal
policy on conservative revenue assumptions. However, even as
the draft plan would cut public wages and eliminate nearly
all capital spending, pensions would continue to push the
government's overall costs. The IMF has recommended serious
pension reform to the GOU, as Ukraine faces a rare
convergence of short and long-term adjustment needs. (Note:
The SBA conditionality of a 2009 balanced budget is driving
immediate cutting measures, while projections of the
country's rapidly aging population may force the GOU to take
a broader approach to a reform package. End note.)

Banking Diagnostics
--------------


8. (SBU) The IMF gave a "thumbs-up" to the ongoing
diagnostic audits of Ukraine's 17 largest banks. The audit
process is due to finish by December 15, when examiners will
present their initial findings to the GOU and IMF.
Originally, the IMF had asked external auditors to
investigate 30 percent of the banks' loans. Because the
sector has recently experienced deteriorating loan
performance, however, the IMF team revised its request and is
now asking auditors to include reports on 50 percent of all
bank loans. Pazarbasioglu expects the auditors to file for
extensions and submit final reports around the end of the
year.

USG Assistance Request
--------------


9. (SBU) Pazarbasioglu considered Prominvestbank's impending
nationalization to be a mixed blessing. A high-profile
casualty of Ukraine's recent financial crisis, Prominvestbank
could serve as a "critical precedent" for future GOU
interventions in Ukraine's wobbly banking sector. On the
other hand, the IMF estimates that there is currently little
NBU capacity to administer problem pwQ MQZBn the
boards of Ukraine's failed banks, with Prominvestbank serving
as a significant test case. According to Pazarbasioglu, this
effort to add impartiality and bridge the roles of the
Ministry of Finance and the NBU has been endorsed by Minister

of Finance Pynzenyk and Deputy Prime Minister Nemyria.
(Note: The GOU announced plans on December 10 to take over
Prominvestbank -- the sixth largest bank in Ukraine and
subject of much rumor and speculation in the country's
financial circles (Ref C) -- after a bid by the Klyuyev
brothers collapsed due to a lack of external financing. End
note.) The IMF had been concerned that "strategic investors"
secured their bid through political connections in parliament
and close ties to the NBU's council, and Pazarbasioglu
stressed the need to prevent a similar event from happening
in the future.


10. (SBU) Pazarbasioglu also asked that the USG weigh in
with EU counterparts to encourage them to implement a
solution to the financial crisis that has spread throughout
eastern Europe. She suggested the model of U.S. Brady Bonds
that helped Latin American countries restructure debt in the
late 1980s and early 1990s. The IMF said that Europe should
play a special role in the region, because its banks had
pushed expansions of capital lending and reaped huge profits
as a result. (Note: Embassy Kyiv conveyed these requests to
Treasury on December 10. End note.)

Comment
--------------


11. (C) Pazarbasioglu and Horvath were aligned in their
thinking on every topic discussed, despite apparent personal
tensions between them. Horvath took the opportunity of
Pazarbasioglu's late arrival to inform the Ambassador of his
immediate departure from Kyiv. He said his exodus from IMF
had been in the works for some time, due to an internal IMF
dispute earlier in 2008 over the planned closure of the
Ukraine mission (to which he had been opposed). For her
part, Pazarbasioglu expressed no regret that Horvath was
leaving, even though Post has considered him a valuable
contact and first-rate analyst of Ukraine's economic
problems. There are plans to replace Horvath, but
Pazarbasioglu speculated that a new resident IMF
representative would not arrive until late January 2009.


12. (C) Pazarbasioglu and Horvath's impressions of NBU
Governor Stelmakh and Minister of Finance Pynzenyk were
notably more charitable that their general appraisal of the
GOU's crisis response. That they separated the Minister and
the Governor from their institutions sheds light on the fact
that the IMF views each man as lacking control or power more
broadly in the government.
PETTIT