SCENESETTER FOR CODEL BOEHNER'S VISIT TO UKRAINE

UNCLAS SECTION 01 OF 04 KYIV 001264

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TAGS: ECON PGOV PREL RS UP
SUBJECT: SCENESETTER FOR CODEL BOEHNER'S VISIT TO UKRAINE

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Summary
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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
--------------


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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

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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

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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