IMF SIGNALS UKRAINE PROGRAM OFF TRACK

C O N F I D E N T I A L SECTION 01 OF 03 KYIV 001519

SENSITIVE
SIPDIS

DEPT FOR EUR, EUR/UMB, EEB/OMA

E.O. 12958: DECL: 09/03/2019
TAGS: EFIN EREL ETRD PGOV PREL UP XH
SUBJECT: IMF SIGNALS UKRAINE PROGRAM OFF TRACK

REF: KYIV 1487

Classified By: Economic Counselor Edward Kaska for Reasons 1.4 (b) and
(d)


1. (C) Summary. The IMF mission team concluded its visit in
Kyiv on September 4 without a major public announcement, but
close observers have acknowledged to us that the Fund's
program may have gone off track. The visit was originally
envisioned as a visit to provide technical assistance and
oversight for the Ministry of Finance's 2010 draft budget, a
source of unease for the IMF in the run-up to Ukraine's
January 2010 presidential elections. Nonetheless, growing
concerns about Ukraine's lack of fiscal discipline, its
non-transparent financial sector activities, and unfulfilled
promises on gas pricing reforms (reftel) caused the IMF to
dispatch mission director Ceyla Pazarbasioglu. Talks with
Ukraine's authorities have been characterized to us as
"difficult" and a way for the Fund to begin "saving face."
End summary.

IMF PULLING BACK?
--------------


2. (SBU) Over the course of this week's negotiations, the
IMF has made no formal statements to the public. However, on
August 31, IMF resident representative Max Alier sharply
criticized Ukraine's authorities for deviating from agreed
upon actions, alluding to the possibility that the Fund would
postpone additional disbursements or pull the plug on its
program altogether. Analysts have speculated that Alier's
statements were an opening salvo, intended to set the stage
for a tougher stance by Pazarbasioglu.


3. (C) IMF banking advisor Jochen Andritzky told Econoff on
September 4 that Pazarbasioglu had come to Ukraine to monitor
the Ministry of Finance's progress on the 2010 budget. When
pressed, however, Andritzky quickly acknowledged that
Pazarbasioglu, in fact, had been concerned about the whole
IMF program and was dispatched to assess progress on broader
conditionalities. The Kyiv-based Andritzky could not say
whether Pazarbasioglu had taken a strong line on the lack of
gas price increases, or how the IMF would deal with the
monetization of the country's fiscal deficit. But he did
agree that there was a "growing consensus" that Prime
Minister Tymoshenko had extracted money from the IMF while
offering very little in return. Recognizing the GOU may have
the ability to weather its financial storms in the months
before the presidential election without another loan
tranche, Andritzky did not discount the possibility that a
lack of action by the GOU would force the Fund to suspend its
lending. He pointed to IMF shareholders as the source of
political pressure to be "soft" on Ukraine, especially those
with significant banking exposure.


4. (C) Other embassy sources close to the IMF negotiations
indicated that Pazarbasioglu had expressed her dismay about
the "lies" of the government. Pazarbasioglu reportedly told
former Finance Minister Viktor Pynzenyk that Prime Minister
Tymoshenko had "misled" the IMF mission in July regarding her
government's willingness to hold down the budget deficit and
enact gas price reforms.


5. (C) EBRD's principal economist (and former IMF senior
economist) Alex Pivovarsky told us on September 4 that
Pazarbasioglu had characterized Ukraine's actions as having
"crossed a boundary." Pazarbasioglu apparently said that she
had "put her trust" in the Prime Minister but had been "taken
advantage of." Pivovarsky further commented that the talks
with the National Bank of Ukraine (NBU) and the GOU had been
described to him as "difficult -- just short of yelling
sessions." According to the EBRD's conversations with
colleagues in Washington, Pazarbasioglu's tougher stance
reflected the belief among senior IMF officials that this
mission trip was a way for the Fund to begin "saving face."


6. (C) London-based Pivovarsky said that the EBRD had
already calculated that the IMF program would go off track.
He said that despite the "significant carrot" of $3.8 billion
(2.5 billion SDR) that had been slated for November
disbursement, there was little chance of a fourth tranche
before the presidential January election. The Fund simply
was "paying the price for the political consequences of its
decisions," he said, alluding to the "flexibility" the Fund
has shown to date with Ukraine. In the EBRD's view, the IMF
had no other choice than to walk away before the elections.

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It would be a "disservice to the country" to refrain from
pushing Ukrainian authorities to adopt policies necessary to
stabilize the country.

NBU ACTIONS PARTICULARLY EGREGIOUS
--------------


7. (C) In two meetings this week with Acting NBU Governor
Shapovalov, Pazarbasioglu apparently raised concerns about
NBU interventions in the forex market, which IMF banking
advisor Andritzky said had been implemented in a "confidence
destroying" manner. The IMF reiterated its call for all
banks to have equal access to NBU refinancing at market
rates. In recent weeks, Shapovalov had publicly acknowledged
that the NBU continued to sell foreign exchange below UAH
8/$1 dollar to undisclosed recipients, who presumably then
would have pocketed the arbitrage. Andritzky told us he had
informally floated the idea of adding a new IMF
conditionality on refinancing disclosures, which he said had
been well-received in the banking community. He also said
that the IMF was toying with the idea of monitoring the
banking system at the "micro" level to better root out
NBU-fostered theft. Equating these two actions to what the
Fund would require of a country like Afghanistan, Andritzky
commented that the level of corruption in Ukraine could
"hardly be worse."


8. (C) Even after receiving entreaties to clean up its forex
interventions, NBU Vice Governor Krotyuk apparently urged
Pazarbasioglu to go public with commentary about the state of
the IMF's Ukraine program. Andritzky told us that the NBU
perceives that it is doing a "splendid" job fighting the
crisis, especially compared to the "botched" handling of the
budget by the Tymoshenko government. Krotyuk had expected
that the IMF would publicly compliment the NBU.
Pazarbasioglu apparently declined to offer comment.

PRESSURES ON BUDGET, CURRENCY EVEN WORSE
--------------


9. (C) On September 3, Pynzenyk told our source, BNP Paribas
head of office Dominique Menu, that the GOU's budget figures
had become more and more unrealistic, and that there had
developed an imperative to cut spending, increase public
debt, and push privatizations. The former Finance Minister
called the GOU's current efforts of monetizing the budget
deficit, estimated to be at least 3% of GDP thus far in 2009,
to be extraordinarily dangerous, particularly in an
environment where GDP declines in the first half of 2009 may
mean that the GOU has over UAH 27 billion (roughly $3.1
billion) less revenue than expected. Analysts project
Ukraine's deficit will grow to between 6-8% of GDP (not
counting bank recapitalizations and Naftohaz debt) by the end
of 2009.


10. (C) Menu said that he and other foreign bankers were
especially concerned about a rapid depreciation of the
hryvnia, which is already the world's worst performing
currency of late. Pivovarsky expected that the hryvnia would
overshoot due to market concerns about the IMF program and
Ukraine's budget and banks, though he expected the currency
would recover in early 2010 if investor confidence rallied.
The overshooting would be painful for banks that had extended
sizable foreign currency-denominated credits. Pivovarsky
predicted balance sheets would worsen and more
recapitalization of banks would be necessary. He questioned
the will of foreign-owned banks to ante up another round of
cash, if the NBU did not demonstrate it would enforce the
same capital adequacy requirements for Ukraine's
domestically-owned banks.


11. (C) The IMF expects the hryvnia exchange rate to hit UAH
9/$1 dollar, which Andritzky characterized as the equilibrium
rate that "we have all been expecting -- though perhaps not
this soon." However, Andritzky did not discount that the
exchange rate would overshoot, in part as a result of the
NBU's non-transparent measures and its inability to rein in
the "lack of trust" in the market. He said some traders had
held off selling dollars all week, but some had begun to come
back into the market on September 4 as the inter-bank rate
approached UAH 9/$1 dollar.

YUSHCHENKO WEIGHS IN
--------------


12. (SBU) President Yushchenko told journalists on September

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3 that Tymoshenko's government had "seriously undermined"
cooperation with the IMF, suggesting that Ukraine had failed
to meet five of six conditionalities that were necessary for
disbursing the Fund's fourth loan tranche. Without
specifically naming any preconditions, he insinuated that
Tymoshenko's government had been unable to "rationalize" its
budget goals. Alluding to Russia, Yushchenko also warned of
"foreign markets" that would offer "non-transparent" loan
conditions, suggesting that Tymoshenko and Putin had come
closer to a finalizing a bilateral financing deal that would
include the GOU "trading" what he called "national assets."
The President said he would attempt to stop any
privatizations of chemical or power generation plants and
would oppose the sale of Odesa Portside Plant, rumored to be
of interest to Russian industrial concerns.

GOU DEFENDS ITS RECORD
--------------


13. (U) On September 3, Deputy Prime Minister Hryhoriy
Nemyria denied reports that the IMF had expressed formal
concerns about the implementation of its lending program. He
commented that the IMF had not sent a letter to Ukraine
expressing dissatisfaction with Ukraine's failure to raise
domestic gas prices. Nemyria told reporters that
Pazarbasioglu had noted to him personally that she did not
wish to give interviews in Ukraine or send official letters
to the authorities. Nemyria said that the IMF mission visit
was related to consultations on the 2010 budget and was not a
program review, which would remain slated for late October or
early November.

G-7 MEETING WITH IMF
--------------


14. (SBU) The IMF's Pazarbasioglu and Alier have scheduled a
brief with G-7 and E.C. ambassadors on September 5 in Kyiv.
Embassy Kyiv will attend and report septel.

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


15. (C) The IMF may have had no other choice than to send a
hard-hitting message to the Ukrainian authorities. The bulk
of the Fund's conditionalities have been left undone, and
Ukrainian officials have given no impression they will take
on any tough decisions before the January 2010 presidential
election. The Fund may have concluded that it would be
better for both Ukraine and the IMF's long-term interests if
the program temporarily goes off track than for more
liabilities to migrate to the public balance sheet without
the necessary, concomitant reforms to spur growth.

PETTIT