SCENESETTER FOR CODEL BOEHNER'S VISIT TO UKRAINE

UNCLAS SECTION 01 OF 04 KYIV 001264 CODEL SENSITIVE SIPDIS E.O. 12958: N/A TAGS: ECON PGOV PREL RS UP SUBJECT: SCENESETTER FOR CODEL BOEHNER'S VISIT TO UKRAINE (U) Sensitive but unclassified. Please handle accordingly. Not for Internet. Summary -------------- ¶1. (SBU) Your August 6-8 visit to Kyiv follows by two weeks that of the Vice President, who reassured Ukrainians that the "reset" of U.S. relations with Russia would not come at Ukraine's expense. The Vice President also called on Ukraine's leaders to put their antagonisms aside and move forward on the economic and energy security reforms needed to obtain financial support from the IMF and other international financial institutions. Such support is critical to putting Ukraine's economy -- which may see a 15 percent decline in GDP this year -- on a path to recovery. ¶2. (SBU) The pace of economic and energy reform that is needed has been slowed by the political rivalry between former Orange Revolution allies President Yushchenko and PM Tymoshenko. The two remain bitterly at odds and will compete, as will their 2004 antagonist, Party of Regions leader Yanukovych, in the January 17, 2010 presidential election. Yanukovych currently has a lead in pre-election opinion surveys. Tymoshenko's popularity has suffered as a result of the poor economy and Yushchenko barely registers in the low single digits. A "second wave" of economic crisis this year could help bring Yanukovych to power. Conversely, if the economy were to begin to recover, Tymoshenko, a strong campaigner, could turn the tables on Yanukovych. End Summary. Vice President Calms Nerves -------------- ¶3. (SBU) The "reset" of relations between Washington and Moscow had left some Ukrainians uneasy about Ukraine's standing with the Obama Administration. The Vice President, during his July 20-22 visit, made clear -- in meetings with leaders and in a major speech -- that the reset of relations with Russia would not occur at Ukraine's expense and that it would not in any way alter Ukraine's right to pursue membership in alliances of its choice. He underlined that the Administration rejected the notion of a Russian "sphere of influence" over the former Soviet states. 4 (SBU) The Vice President reiterated U.S. support for Ukraine's economic development. He called on Ukraine's fractious leadership to look to the national interest and address economic reforms and energy security. He underlined U.S. support for Ukraine within the IMF and other international financial institutions and urged Ukrainian leaders to meet the conditions that would allow the release of future tranches of the IMF's current $16.4 billion program. The Vice President also called attention to the need to work on transparency, anti-corruption measures and good governance to attract foreign investment, especially in the energy sector. ¶5. (SBU) The Vice President commended Ukrainian civil society -- a success of the Orange Revolution. NGOs in Ukraine operate freely and there is a vibrant media. The politics, albeit chaotic, are competitive. If Ukraine were to succeed in consolidating a functioning, free, prosperous state, it has the potential to inspire democracy advocates in its less free neighbors. Economic Crisis Continues -------------- ¶6. (SBU) Your visit comes at a time when Ukraine is experiencing its worst economic crisis in a decade. After several years of buoyant growth following the Orange Revolution, GDP grew by only 2.8 percent last year and is expected to contract by some 15 percent this year. The national currency, the hryvnia, has lost 60 percent of its value since last October, and net foreign reserves have fallen from a high of $38 billion in September 2008 to about $20 billion at present. The country's banking system is teetering after Ukrainians withdrew large sums of money from their banks and foreign lenders turned their backs on the country. Despite budget cuts, the GOU is still facing a significant budget gap this year, which the IMF now estimates at 6 percent of GDP. Unemployment is now nearly 10 percent. Hopes Hang on IMF -------------- KYIV 00001264 002 OF 004 ¶7. (SBU) The GOU and central bank's initial policy response to the economic crisis was hapless, but the IMF provided some short-term stabilization after it agreed to support Ukraine with a $16.4 billion loan last October. Two tranches totaling $7.4 billion have already been disbursed, and the IMF Board on July 28 approved disbursement of the next, $3.2 billion tranche. In return for its support, the IMF has required Ukraine to move towards a more flexible exchange rate policy, establish a mechanism to recapitalize and, if necessary, liquidate banks, and reform the pension system and the heavily subsidized domestic energy sector, both of which have created an unsustainable drain on public finances. ¶8. (SBU) The IMF loan was originally meant to help Ukraine meet its external debt obligations, but the IMF has already agreed to allow the GOU to use part of the loan to cover the glaring budget deficit. The World Bank may provide some budgetary support in return for GOU delivery on long-promised economic reforms, but otherwise it is improbable that budget help from outside sources will be forthcoming. The GOU likely will close any remaining budget gap through a mixture of central bank borrowing and further cuts in spending. Energy -------------- ¶9. (SBU) Ukraine's economy is one of the most energy intensive in the world, and it remains heavily dependent on energy imports from Russia, purchasing about 70 percent of its natural gas, 60 percent of its crude oil, and 100 percent of its nuclear fuel from its northern neighbor. There is a general consensus that Ukraine needs to diversify its sources of energy and greatly increase energy efficiency, but little has been done since independence to encourage energy efficiency or attract the foreign investment that could help the country to modernize its Soviet-era energy infrastructure and further develop domestic sources of oil and gas. ¶10. (SBU) About 80 percent of the natural gas that other European countries purchase from Russia passes through Ukraine's strategically sensitive gas transit system (GTS). The January 2009 gas conflict between Ukraine and Russia that led to a two-week cutoff of Russian gas supplies to central and western Europe demonstrated to Europe that transit security still cannot be separated from the bilateral Russian/Ukrainian gas relationship. In March, the EU and international financial institutions offered $3 billion in loans for technical upgrades to ensure the reliability of Ukraine's GTS and increase it efficiency. In return, they expect Ukraine to improve both transparency and accountability in the gas sector, and to create a viable commercial basis for the gas transit network. To date, little progress has been made in adopting the reforms expected by the donors in return for their support ¶11. (SBU) Instead, the GOU has focused on the challenge of meeting its monthly gas payments to Russia. The gas supply and transit contracts signed by the Ukrainian para-statal Naftohaz and the Russian firm Gazprom in January did increase transparency in the bilateral gas relationship. The hastily concluded agreements have created new problems for Ukraine, however. Ukraine's prices for Russian gas are now moving towards European levels far faster than the fees Russia pays to ship gas through Ukraine's GTS. Ukraine committed to purchasing minimum amounts that are now higher than what the country needs in the wake of the economic downturn. While Russia thus far has not penalized Ukraine for taking less than the contracts stipulate, the provision does give Russia significant leverage over Ukraine. In addition, Ukraine now needs to pay for gas it pumps into its vast underground storage facilities during the summer months as it is delivered, and not, as earlier, as it was withdrawn and consumed in the winter. Naftohaz's Financial Problems -------------- ¶12. (SBU) This last provision has created the need for significant bridge financing, as Ukraine's state-owned and cash-strapped energy company, Naftohaz, is short on liquidity during the summer months, when consumption is low. Naftohaz,s financial problems are growing more severe by the month, as GOU regulations force it to sell natural gas to households at prices far below cost. The need to pre-finance gas deliveries is now exacerbating Naftohaz,s financial problems. The GOU subsidizes Naftohaz,s losses, and despite a recent GOU statement (made at the insistence of the IMF) that gas prices for households and industry will be increased KYIV 00001264 003 OF 004 by 20 percent in the autumn, the subsidies remain an unsustainable burden on the GOU budget. ¶13. (SBU) Each month a guessing game ensues as to whether Naftohaz can pay its monthly gas bill to Gazprom, with various Russian voices warning Ukraine of sanctions foreseen in the January contracts if Naftohaz fails to pay. To date, the GOU and central bank have enabled Naftohaz to make its monthly payments on time by drawing down precious foreign reserves and eroding the strength of state-owned banks, but the strategy is not sustainable over the longer run. The GOU recently announced plans to significantly increase Naftohaz,s capital, a move that will give the company some breathing room, but the move further increases the GOU's budget deficit and does nothing to address Naftohaz,s underlying problems and those of the gas sector as a whole. ¶14. (SBU) The GOU has now asked both Russian and the EU/international financial institutions for up to $5 billion in bridge loans to secure gas purchases from Gazprom until the winter. The European Bank for Reconstruction and Development and the World Bank are now considering providing a substantially smaller amount to assist with gas purchases, but have indicated they would expect viable and convincing reforms in the gas sector, and it remains to be seen whether the GOU will agree to the broad array of reforms that would be required. Nuclear Power and U.S. Firms -------------- ¶15. (SBU) Ukraine's nuclear sector generates approximately half of the country's electricity, while Russia provides 100 percent of Ukraine's nuclear fuel and stores all of its spent fuel. U.S. Department of Energy assistance has helped Ukraine boost the operational capacity of its reactors and significantly reduce reportable events. American firms Westinghouse and Holtec have proposed projects that would diversify Ukraine's nuclear fuel supply and allow spent fuel to be stored domestically. The USG is the largest single country donor to the Chernobyl Shelter Fund and a significant contributor to the Nuclear Safety Account. The new safe confinement structure to cover the destroyed Chernobyl reactor is estimated to be completed in late 2012 or early ¶2013. Presidential Elections: January 2010 -------------- ¶16. (SBU) Amid the ongoing economic and energy crisis, Ukraine has scheduled presidential elections for January 17, ¶2010. PM Tymoshenko, President Yushchenko, and former PM and Party of Regions head Yanukovych have all announced that they will participate. Arseniy Yatsenyuk, a young centrist former Rada speaker and foreign minister, is considered a credible challenger to Yanukovych and Tymoshenko, and has polled in third place. Yanukovych currently enjoys a comfortable lead in the polls and is expected to win the first round of voting, but remains vulnerable in the second round. Polls also show that voters are disillusioned with the political process, which could lead to low voter turnout, or an increase in protest voters. Analysts speculate that the presidential campaign will be hard-fought, with a high probability for vote buying and dirty tricks. That said, the last two parliamentary elections (2006 and 2007) were generally free and fair -- a major improvement from the first rounds of the 2004 presidential election, which were marred by fraud. Yushchenko's Priorities -------------- ¶17. (SBU) President Yushchenko, wary of Russian influence, remains a strong advocate for Ukraine's entry into NATO as the best way to guarantee Ukraine's security and territorial integrity. However, he has been unable to significantly expand support for NATO accession in Ukraine. The NATO Information office in Kyiv estimates that only 20-30 percent of Ukrainians support NATO membership. A recent Rada vote provides an indicator: the Rada -- including MPs ostensibly allied with Yushchenko -- failed to approve a bill that would have allowed foreign military forces to conduct exercises in Ukraine this year. This resulted in the cancellation of key exercises with the U.S. and other NATO partners for 2009. ¶18. (SBU) Yushchenko is also focused on the issue of energy security. He is an advocate for U.S. and EU investment in KYIV 00001264 004 OF 004 the Ukrainian pipeline network, which he describes as "an integral part of the European gas market." He strongly favors the departure of the Russian Black Sea Fleet from its base is Sevastopol (Crimea) when its lease runs out in 2017. Tymoshenko's Priorities -------------- ¶19. (SBU) The Prime Minister's portfolio is centered on economic issues. As such, she is the target of blame -- some justified, some not -- for the impact of the economic crisis. Tymoshenko has unsuccessfully sought bilateral budget support from the U.S., but would appreciate any additional advocacy for Ukraine from the U.S. with international financial institutions. She has said that she is committed to the IMF assistance program and her government complied recently with the program's conditions to receive a third tranche of funds. The Prime Minister also believes that the issue of energy independence is an important one for Ukraine. However, her negotiation on a gas deal earlier this year with Putin remains a point of contention with Yushchenko. Yushchenko regards it as a bad deal for Ukraine, with Ukraine paying market or near-market prices for gas, while Russia pays below-market transit fees. ¶20. (SBU) Tymoshenko has populist impulses. As such, it has been and will continue to be difficult for her to enact painful economic reforms in an election year. Unlike Yushchenko, she avoids the topic of NATO membership because of its lack of resonance with voters. She has sought a pragmatic relationship with the Kremlin, but maintains her independence. Yushchenko warns, however, that she (and Yanukovych) would be overly deferential to Russia if elected President. ¶21. (SBU) Tymoshenko has emphasized enhancing Ukraine's relations with the EU, which is popular with the Ukrainian public. Ukraine is in negotiations with the EU on an Association Agreement, which includes a Free Trade Agreement. If concluded -- perhaps as early as 2010 -- it would mark a significant step forward and boost reform efforts. Enhancing relations with the EU, including the pursuit of membership, is something on which all major political forces in Ukraine agree. PETTIT