TYMOSHENKO'S CONTROVERSIAL 2010 BUDGET

UNCLAS SECTION 01 OF 03 KYIV 001602

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STATE FOR EUR/UMB, EEB/OMA

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TAGS: EFIN EREL ELAB ECON ETRD PGOV PREL XH UP
SUBJECT: TYMOSHENKO'S CONTROVERSIAL 2010 BUDGET

SENSITIVE BUT UNCLASSIFIED, NOT FOR INTERNET DISTRIBUTION


1. (SBU) Summary: Ukrainian Prime Minister Yulia Tymoshenko's draft
2010 budget projects a deficit equivalent to 4% of GDP (exclusive of
funds for bank recapitalization) and contains moderate increases in
social spending, as well as provisions for transfers to economic
sectors hit by the country's current crisis. The most profound
change is a technical mechanism that would allow transfers of funds
directly from central authorities to local, city-level governments,
bypassing oblast-level governors, who are subordinate to the
President. President Yushchenko is unlikely to approve this
provision. The current political standoff in the Rada (Ukraine's
parliament) may preclude final passage of the draft budget before
the January 1 due date. Even if it mustered enough support in the
Rada, the budget likely would be amended after the January 2010
presidential elections. End summary.

BUDGETARY PARAMETERS
--------------


2. (SBU) The draft budget provides for revenues of UAH 284.8
billion and expenditures of UAH 324.3 billion, equaling annual
increases of 19% and 20.6%, respectively. The upper limit for the
deficit is projected by the GOU to be UAH 46.7 billion (roughly $5.6
billion) or 3.97% of GDP, a figure within the IMF's required target.
Nonetheless, this amount could become a source of controversy, as
President Yushchenko had called on the government to limit the 2010
budget deficit to 3% of GDP.


3. (SBU) The proposed budget would transfer UAH 17.9 billion to
cover the Pension Fund's 2010 deficit, an increase over the UAH 13
billion allocated for this purpose in 2009. It also foresees that
Ukraine would repay UAH 31.7 billion in external debt.


4. (SBU) The budget's proposed subsidy for Naftohaz, covering the
differential between the cost of Russian gas and the price afforded
to Ukrainian residential consumers, is UAH 6.52 billion. This
amount is lower than the UAH 7.7 billion that was ultimately
approved for Naftohaz in 2009 through a March 11 Cabinet of
Ministers' resolution, but higher than original 2009 budget figures
of UAH 1.6 billion.


5. (SBU) In addition to core spending, the GOU has also accounted
for expected increases in financing needs for bank recapitalization,
equal to UAH 50.5 billion. This amount is expected to cover
recapitalizations for an undisclosed number of top Ukrainian
domestic banks, as well as provide "top-off" money for previously
nationalized banks that have suffered further deterioration of their
loan portfolios. (Note: As in 2009, when UAH 18.6 billion was
transferred from bank recapitalization funds to Naftohaz via
treasury bills, the GOU considers money set aside for bank
recapitalization to be fungible. The IMF did not include bank
recapitalization funds in its estimate of the GOU's 2009 core budget
deficit, a position it will likely adopt in 2010. End note.)

PLUGGING THE GAP
--------------


6. (SBU) In order to finance the 2010 budget deficit, the GOU would
rely on record levels of domestic borrowing -- up to UAH 104 billion
($12.4 billion),a figure that may prove unrealistic, given the slow
revival of the domestic bond market. There are also concerns that
National Bank of Ukraine (NBU) purchases of domestic treasury bills
would become the primary source of debt financing, a move that would
increase inflationary pressures. The government plans foreign
borrowings at the comparatively low amount of UAH 15 billion ($1.8
billion),yet even this may turn out to be wishful thinking, given
Ukraine's current inability to access external financing. The GOU's
revenue target for privatizations is an ambitious UAH 10 billion
($1.2 billion). However, the GOU's active efforts to privatize
Odessa Portside Plant, several regional power distribution companies
(the so-called "oblenergos"),and Ukrtelecom, may mean these
revenues could materialize.

OPTIMISTIC MACRO ASSUMPTIONS
--------------


7. (SBU) The draft budget foresees 2010 GDP growth at 3.76% and
inflation at 9.7%. Rada budget committee and Our Ukraine faction
member Pavlo Zhebrivskiy commented that a 3% growth figure would be
more realistic, with prospects dim for an uptick in the critical
chemical production sector. Zhebrivskiy also said that inflation
would likely reach 12-13%, as the GOU plans to impose higher
residential gas rates, per the IMF agreement.


8. (SBU) Local analystQhave focused on the GOU's "overly
optimistic" exchange rate assumptions of UAH 7.5/$1. The hryvnia

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has faced nothing but downward pressure of late and currently is
being traded at around UAH/USD 8.4-8.5. Furthermore, most corporate
foreign debt due in 2009 was rolled over to 2010, suggesting that
demand for dollars will remain high and depreciation pressures for
the hryvnia will continue. Using a more realistic exchange rate
translates into increased government expenditures, especially for
gas and foreign debt payments, perhaps pushing the 2010 budget
deficit well above 4%. The average price for imported Russian gas
projected in the budget is $260 per thousand cubic meters (tcm).
(Comment: Oil prices would need to fall in 2010 for this figure to
be a realistic forecast. The 2009 average price will be
approximately $230/tcm, though Ukraine received 20% off the base gas
price in 2009, per the January 2009 gas contracts. Without that
discount, the average price in 2009 would have been roughly
$288/tcm. End comment.)

SOCIAL SPENDING
--------------


9. (SBU) The draft budget contains a 16% increase in the minimum
wage and a 7% increase in the minimum pension, both of which would
be implemented gradually during the course of the year. It also
provides 20% wage increases for education and public healthcare
workers. Still, these increases have been criticized by Viktor
Yanukovich-led Party of Regions (PoR) as too little. PoR has been
pushing its plan to significantly increase social spending (between
UAH 8-40 billion),a move blocked by Tymoshenko's BYuT and others.


ECONOMIC DEVELOPMENT
--------------


10. (SBU) The draft budget would expand Ukraine's economic
development fund, known as the stabilization fund, raising it from
UAH 19.9 billion in 2009 to UAH 27 billion for 2010, though this
line item has long been criticized as non-transparent and a tool for
"manual management" of budgetary resources. Analysts tell us that
revenue sources for the stabilization fund are also questionable, as
UAH 19.6 billion or 1.7% of GDP would be transferred via borrowing
and privatization.


11. (SBU) Stabilization fund expenditures would be allocated to
Euro 2012 infrastructure projects (UAH 6.69 billion),public housing
(UAH 1.15 billion),agriculture support (UAH 3.38 billion),and
military equipment purchases (UAH 3.38 billion). In addition to
funding economic development programs via the stabilization fund,
the GOU would also use budget resources to support the coal industry
to the tune of UAH 21.6 billion ($2.6 billion),a figure that is
nearly twice the value of the annual output of all state-owned
mines. This proposal has been roundly criticized for heightening
structural imbalances in Ukraine's coal sector.

LOCALITIES AFFECTED
--------------


12. (SBU) The proposed budget would alter the way in which the
central government would transfer funds to local budgets. According
to the draft budget, the central government and localities would
bypass the 26 oblast-level governors, who are subordinated to the
President, in favor of direct communication between localities and
the Cabinet of Ministers, who would be the ultimate arbiters of all
budgetary transfers. This proposal has raised eyebrows in Kyiv,
particularly regarding the technical capacity of over 12,000 cities,
towns, and villages to manage increased accounting responsibilities.
Moreover, President Yushchenko will likely be adamantly opposed to
the change, as it would strip his appointed governors' ability to
allocate and distribute resources. Reportedly, the IMF also views
this proposed reform with skepticism, considering that it has been
hastily and improperly prepared by the government.

RADA (AND BUDGET) BLOCKED
--------------


13. (SBU) Yanukovich has announced that the PoR will continue to
block the Rada from voting on the 2010 budget until the 2009 budget
is amended to increase social spending. Taking the PoR's indefinite
blockage together with controversial elements of the proposed 2010
budget, most observers believe Tymoshenko's fiscal program has
little chance of approval. Deputy Head of the Presidential
Secretariat Oleksandr Shlapak described the budget as being full of
"pseudo reforms" and consisting of "election promises, trickery, and
cowardice." Furthermore, analysts project that even if the proposed
budget were adopted, Ukraine's new president would likely be forced
by fiscal imbalances to initiate significant amendments.


14. (SBU) If the 2010 budget is not adopted by December 31, monthly
budget allocations will be funded at one-twelfth of 2009

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allocations. This would provide the GOU significant discretion to
manage expenditures, since the monthly allocations would be
distributed to the state treasury in bulk. Nonetheless, Tymoshenko
has announced that the Cabinet of Ministers will draft a separate
resolution on the implementation of an interim 2010 budget if the
proposed budget is not passed. Observers have expressed concern
that Tymoshenko would use a Cabinet resolution to ram through the
new rules on direct transfers to localities, even if President
Yushchenko ultimately vetoed the 2010 budget based on his opposition
to that provision.

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


15. (SBU) The IMF appears to have been supportive of Tymoshenko's
draft 2010 budget, perhaps because the GOU continues to promise an
increase in gas prices for residential customers, which the IMF has
said could provide an extra 1% of GDP in revenue in 2010. Whether
Tymoshenko will fulfill her pledge to the IMF to raise household gas
prices just prior to the formal launch of her presidential campaign
and at the beginning of winter heating season is yet to be seen.


16. (SBU) Possible increases in domestic gas prices
notwithstanding, the IMF will still need to push for pension and
other social spending reform, given the limited availability of
domestic and external financing and the possibility that
privatization revenue may not be forthcoming. Yet, with the
election season fast approaching and little success to date on these
goals, we are not optimistic about the prospects for serious pension
reform this year, even with IMF insistence.

PETTIT