WAKING UP TO UKRAINE'S FISCAL NIGHTMARE

C O N F I D E N T I A L SECTION 01 OF 02 KYIV 001984

SENSITIVE
SIPDIS

DEPT FOR EUR, EUR/UMB, EEB/OMA

E.O. 12958: DECL: 11/12/2019
TAGS: EFIN EREL ETRD PGOV PINR UP XH
SUBJECT: WAKING UP TO UKRAINE'S FISCAL NIGHTMARE

REF: A. KYIV 1982

B. KYIV 1981

C. KYIV 1916

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


1. (C) Summary. Payment delays have begun in Ukraine's
regions and will get much worse in December 2009. January
and February 2010 will be even darker, with no near-term
causes for optimism in sight. Analysts from the IMF, World
Bank, and EBRD ominously predict that, while social payments
will continue (albeit unevenly) and the December 7 gas bill
will likely be met, Ukraine's voting populace will be in for
a rude awakening when the state treasury is drained. Public
enmity will be concentrated at Prime Minister Tymoshenko, who
has few apparent options left to avoid fallout from the
budget crisis. End summary.

UKRAINE IN SURVIVAL MODE, SAYS IMF
--------------


2. (C) The IMF's Kyiv-based budget expert Igor Shpak
confirmed that Ukraine was essentially broke. Ministry of
Finance plans to covert IMF Special Drawing Rights (SDRs) on
November 13 were a last ditch effort to "survive" through
November 2009 and make the December 7 gas payment. Shpak
indicated that every Cabinet of Ministers meeting now began
with a visit from the chairwoman of the state treasury, who
deliberated with Tymoshenko and her ministers on how to
"manually" distribute the few remaining state resources for

2009.


3. (C) December would be even more difficult, according to
Shpak. Absent an unforeseen event, the state treasury will
be unable to make a portion of its payments. In the IMF's
view, there were three ways to avoid barren coffers in
December: 1) find additional resources from the IMF; 2) beg
or twist the arm of NBU governor Stelmakh to monetize; or 3)
run arrears. The first option was "very unfeasible", while
the second was unlikely, given the acrimonious relationship
between the NBU and the GOU.


4. (C) Shpak acknowledged that cutting outstanding 2009
expenditures would be nearly impossible, since 90% of
projected December payments were to so-called protected
articles, such as transfers to localities, pensions, and
entitlements. Arrears to regional budgets were "imminent",
Shpak said. The IMF had already heard evidence of delayed
payments of teachers' wages in Kyiv. There were anecdotes of
widespread, general arrears throughout Ukraine's regions.


5. (C) Increased VAT refund arrears were also likely. The
IMF official indicated that the GOU had been manipulating VAT
statistics, and that proper accounting for arrears was now
intentionally non-existent. Shpak could not say whether the
GOU figure of UAH 18 billion ($2.2 billion) reflected overdue
or total VAT refund claims. Either way, it was a figure that
was likely to grow in the coming weeks.


6. (C) The IMF foresees a "nightmare" scenario in January
and February 2010, when the GOU will encounter even worse
payment problems. Revenues are due to "collapse" in January,
Shpak said. Electoral politics surrounding the budget would
get "very messy," he projected.


7. (C) In such an environment, it was unlikely the
"incapacitated" Rada budget committee would pass the 2010
budget. The IMF has not ruled out the possibility that a
last minute deal would be made among Ukraine's authorities,
similar to the "disastrous" pact made on December 26, 2008,
that set in motion the unsustainable 2009 fiscal deficit.
Since target dates for the draft 2010 budget already had been
breached, Shpak predicted the GOU continue to try to gain
control over early 2010 expenditures with the so-called
provisional transition budget, the Ukrainian version of a
continuing resolution (Ref A).

WORLD BANK: ARREARS INEVITABLE
--------------


8. (C) Admitting it was difficult to know exactly how
Tymoshenko would spend the IMF SDRs, World Bank senior
economist Ruslan Piotkivskiy surmised that Naftohaz would
likely use up to the equivalent of $600 million in SDRs for
the December 7 payment to Gazprom. This would leave the

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equivalent of $1 billion in SDRs for outstanding budget
allocations and/or the January 7 payment (Ref B).
Piotkivskiy opined that, if pressed, Tymoshenko would choose
to fund social payments over gas, while working hard to free
up money from other sources to prevent a shut-off.


9. (C) The World Bank's Piotkivksiy argued that the NBU had
some room to monetize without violating its IMF-backed net
reserve floor or significantly adversely affecting inflation.
Acknowledging political realities, however, Piotkivksiy said
the NBU was unlikely to purchase government debt before the
presidential election. In the World Bank's view, it was
certain a future NBU governor (appointed by the newly elected
president) would face significant pressure to monetize the
deficit in 2010.


10. (C) Piotkivskiy said Tymoshenko would try to gain
revenues from the issuance of short-term domestic securities,
such as those auctioned in October at a punitive interest
rate of around 30%. He cautioned that the domestic market
would remain small and that yields would be driven sky high.
Ultimately, such an auction could not be a viable substitute
for other revenue sources.


11. (C) Piotkivskiy concluded that the GOU would be stuck
with an outstanding (roughly $2 billion) deficit in December,
after it burned through IMF SDRs and issued small amounts of
short-term government debt. Across-the-board arrears would
inevitably result, likely for subsidies, transfers to local
budgets, VAT refunds, and government goods and services.

EERIE RESEMBLANCE TO 1998, SAYS EBRD
--------------


12. (C) EBRD's London-based senior economist Alexander
Pivovarskiy suggested that short-term borrowings at
exorbitant rates could help Ukraine get through fiscal
difficulties during the election period. But they would put
Ukraine in an extremely tight bind in April-June 2010,
particularly if the IMF program remains off track or if
international financial markets continued to be closed,
preventing Ukraine from rolling over short-term debt. EBRD
director of policy studies Jeromin Zettelmeyer concurred,
commenting that such a scenario bore an eerie resemblance to
Ukraine's 1998 default.


13. (C) If there were a silver lining amidst the country's
fiscal mess, Zettelmeyer said it was in the NBU's refusal to
monetize government debt (Ref C). Done for "perverse"
reasons of political competition between Yushchenko and
Tymoshenko, Zettelmeyer noted that blocking deployment of
NBU's reserves had given Ukraine a heightened chance of
escaping a devastating currency crisis.

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


14. (C) Separate conversations with the IMF, World Bank, and
EBRD -- institutions whose lending programs in Ukraine are on
the shoals due to GOU non-compliance -- reveal a startlingly
clear picture of the country's coming difficulties. IFIs'
portentous words of warning, combined with skittish market
behavior, indicate that analysts are again pondering
worst-case scenarios.

PETTIT