YANUKOVYCH ACOLYTES PREACH ECONOMIC ORTHODOXY

C O N F I D E N T I A L SECTION 01 OF 04 KYIV 002124 SIPDIS STATE FOR EUR/UMB AND EEB/OMA E.O. 12958: DECL: 12/09/2029 TAGS: ECON PGOV ENGR PREL EFIN UP SUBJECT: YANUKOVYCH ACOLYTES PREACH ECONOMIC ORTHODOXY REF: A. KYIV 1920 ¶B. KYIV 2110 Classified By: Economic Counselor Edward Kaska for Reasons 1.4 (b) and (d) ¶1. (C) Summary. Viktor Yanukovych's top economic advisors are counseling liberal market reforms, despite the Party of Regions' pre-election populist appeals. Shadow Minister of Finance Mykola Azarov and shadow Minister of Economy Iryna Akimova separately told embassy officers that Yanukovych as president would seek to renegotiate Ukraine's gas contracts with Russia, tighten government spending, support EU integration, and implement tax and other reforms to improve the business climate. ¶2. (C) Whereas Azarov, considered to be Regions' power behind the candidate, railed against the IMF for undue flexibility toward the Tymoshenko government, Akimova was more conciliatory, choosing to directly blame the Prime Minister for her misuse of IMF loan funds. Azarov and Akimova touted the recent Regions-backed social standards law as necessary for the most vulnerable populations, though both clarified this by stating Yanukovych would limit the law's fiscal impact. End summary. ¶3. (U) This is the second in a series of cables on the economic platforms of Ukraine's presidential candidates. YANUKOVYCH'S ECONOMIC PLAN -------------- ¶4. (C) According to Party of Region's shadow Minister of Economy Iryna Akimova, Yanukovych's core pledges on the economy were to: -- increase economic growth and social standards -- improve the investment climate and secure property rights -- reform tax administration, lower taxes, and reduce red tape -- reverse recent increases of state debt -- heighten fiscal discipline -- bolster the bank recapitalization scheme -- ensure the independence and accountability of the National Bank of Ukraine (NBU) -- promote coordination between the NBU and the Ministry of Finance REGIONS ON TYMOSHENKO'S LEGACY -------------- ¶5. (C) Akimova told Econoffs that Yanukovych would capitalize on Tymoshenko's mishandling of Ukraine's economic crisis. Akimova explained that Regions' key concern was increased GOU debt. She warned that short-term borrowing could lead to macroeconomic instability and cause exchange rate pressure, further bank failures, and a "second wave" shock to the real sector and households. ¶6. (C) Shadow Minister of Finance Mykola Azarov separately told Emboffs that Ukraine's economy and financial system had been "totally ruined". Ukraine was entering 2010 with no IMF program, a depleted borrowing limit, a huge budget deficit, and had extensive corporate debt that would need to be rolled over in 2010. Roughly 30% of the loans in the banking sector were high risk or non-performing, according to Azarov's calculations. FISCAL POLICY -------------- ¶7. (C) Azarov complained Tymoshenko had not only wasted IMF Stand-By Arrangement (SBA) loan monies over the last year; she had also burned through $2 billion in IMF Special Drawing Rights (SDRs) for budget and gas payments. Tymoshenko's "incomprehensible" economic policy-making had left a depleted treasury in December and "nothing" for the January 7 gas payment. ¶8. (C) Ukraine would have to endure strict fiscal discipline in 2010. A Party of Regions government would have "no option" but to cut expenditures by 20%, even though it would be "difficult" and "unpopular", said Azarov. Regions would impose trict control over spending. According to Azarov, this was an "elementary" step to rein in the corruption of Tymoshenko's government. ¶9. (C) Akimova separately explained that Ukraine's UAH 40 KYIV 00002124 002 OF 004 billion (roughly $5 billion) unfinanced core budget deficit had caused Tymoshenko to issue short-term securities (with 3-6 month maturities) at interest rates around 30%. This "desperate" plan resembled Ponzi schemes in late 1990s Russia, especially since there were no clear sources of financing for the rollovers of this debt that would be needed in April. Nonetheless, commercial banks were buying Tymoshenko's risky but profitable debt rather than lending, further drying up remaining liquidity. ¶10. (C) Sovereign external debt payments due in 2010 were $2.3 billion, an amount Akimova believed was manageable if the GOU did not accrue more short-term obligations. However, the size and speed of state debt accumulation was "scary" and "enormous" -- 36% of GDP by the end 2009 (total sovereign plus sovereign-guaranteed borrowing),44-46% in 2010, and up to 60% of GDP (the Maastrict red line) in a couple of years, according to Regions' projections from current trends. ¶11. (C) On the Regions-backed social standards law criticized by the IMF (ref A),Akimova explained that Yanukovych supported a "reasonable" approach. It was important to raise minimum wage and pension payments for Ukraine's poorest citizens, especially if gas and utility prices increased. However, Akimova insinuated that Regions would not favor re-indexing all public sector wages and pensions based on the new subsistence minimum. Re-indexing of social payments is the prerogative of the Cabinet of Ministers, she noted. An increase in minimum wages and pensions does not necessarily trigger increases across the board, according to Akimova, contrary to what the Tymoshenko government had publicly implied. ¶12. (C) Azarov noted that the international community had been "misled" by Tymoshenko's "unreliable calculations" on the cost of wage and pension increases. Tymoshenko was "bluffing" to gain an electoral advantage. Her suggestion that increases in social standards would cost UAH 70 billion was nowhere near the real cost of the law, which Regions calculated would be closer to UAH 6 billion ($750 million) in ¶2010. Azarov said the recipients of the increases in minimum wages and pensions would likely spend their additional payments on domestic products (butter, eggs, bread) and stimulate the domestic economy. TAX POLICY -------------- ¶13. (C) Akimova vowed to put order into the State Tax Administration (STA),whose inefficiencies were among highest in the world. She promised that Yanukovych would lower enterprise profits taxes (EPTs) from 25% to 19% by 2011 to stimulate investment, arguing that "if government can't fund investment, then the private sector has to be incentivized." Akimova supported a five-year moratorium on EPTs for small and medium-sized enterprises, and she said a 3-4 year moratorium on changes to tax legislation was necessary to provide greater stability and transparency for investors. ¶14. (C) Azarov, who once headed the State Tax Administration and the Rada budget committee, commented that VAT refund arrears would be a "huge" burden for a successor government, especially since the STA had already collected advanced enterprise profit taxes into 2010. The Party of Regions would support tax and pension reform after the economy returned to 2-3% growth, according to Azarov. BUSINESS CLIMATE -------------- ¶15. (C) Akimova separately confirmed that Tymoshenko had demanded advance payment of enterprise profit taxes through the first quarter of 2010. Companies with wage arrears had received threats from tax and labor authorities. Tymoshenko had claimed she would take over privatized firms if they failed to make payroll. In an environment where savings rates and investment had plummeted, Tymoshenko was scaring off both domestic and foreign investors, according to Akimova. Yanukovych would campaign on the slogan that Regions could be trusted to respect business contracts and privatizations. A "NAIVE" IMF -------------- ¶16. (C) The IMF had lost an opportunity to use its "colossal leverage" over the GOU, suggested Azarov. The Party of Regions wanted to fulfill the IMF action plan, but it could KYIV 00002124 003 OF 004 not be "tougher than the cop". The IMF was "naive" to believe Tymoshenko's promise to raise rates for gas consumers. A lack of IMF prodding for real reform had been a "disservice" to Ukraine and had caused Regions to determine the international community was providing political support for Tymoshenko, whose government had been kept afloat with IMF financing. Ukraine needed at least $20 billion to survive in 2010. Pointedly Azarov asked, "Are you (Americans) ready to provide this? If not, why did you maintain this stance with the IMF?" ¶17. (C) Akimova's criticisms of the Fund were more nuanced. Accumulating debt could be necessary in a crisis; IMF money should have been targeted to stabilize the financial and real sectors. Instead IMF monies were spent on gas payments, leaving systemic problems untouched, said the Regions' representative. The IMF program had hardly addressed Ukraine's underlying macroeconomic instability. Recent signs of growth were only due to the base effect (a dramatic drop in H2 2008 GDP). ¶18. (C) Most concerning to Akimova was the IMF's allowance for dramatic increases of internal borrowing. The budgeted limit in 2009 domestic borrowing was UAH 37 billion, but the GOU had already taken on UAH 62 billion in new liabilities, using Cabinet of Ministers' decrees to get around borrowing restrictions. TYMOSHENKO'S ENERGY POLICY: A BETRAYAL -------------- ¶19. (C) Azarov told us that Ukraine had misplayed the "aces in its hand" with Russia. "Putin had won and Ukraine had lost" from Tymoshenko's negotiation of gas contracts that "betrayed her country", according to Azarov. ¶20. (C) If Yanukovych won the presidential election, he would push to renegotiate all gas deals with Russia. Current prices for gas imports will lead to an "impossible" situation in the chemicals industry, which requires heavy gas inputs and is not profitable when import prices are above $250 per thousand cubic meters. According to Azarov, the gas price for domestic consumers should rise 20% to recover import costs. ¶21. (C) Azarov reasoned that the coziness between Tymoshenko and Putin at the November Yalta talks did not undermine the Party of Regions' claim that it is the faction to best restore "friendly, neighborly" relations with Russia. Regardless of who is in power, according to Azarov, it is "vital" for Ukraine to have a constructive policy towards Russia. ¶22. (C) For her part, Akimova expressed concern that the Yalta announcement by Putin and Tymoshenko had not led to a written deal waiving fines for lower gas intake. Akimova worried that per the original terms of the January 19, 2009 gas supply contract, Ukraine could be penalized between $8-9 billion for the under-purchase of gas in 2009. Akimova called Putin's promise "an instrument of political and economic pressure" and said the Russians were willing to "actualize" their leverage any time. (Note: Both Gazprom and Naftohaz leadership have stated that they have signed agreements revising volumes and waiving penalties for 2009. Akimova is the only person from whom we have heard concern over the lack of a written agreement since the Gazprom/Naftohaz statements were released. End note.) ¶23. (C) Akimova thought it would be difficult to get Russia to reconsider terms of the gas contracts. Coming to a successful negotiated outcome would be a purely political question. Akimova advocated for gas contract talks "with all three partners" (EU, Russia, Ukraine),which would be the "only way" to gain greater transparency and efficiency. ¶24. (C) Akimova said price increases for household gas consumers were inevitable. Tymoshenko had avoided raising household prices in 2009, but the GOU had implicitly acknowledged in its declared 2010 revenue expectations that it was anticipating increases, according to Akimova. ¶25. (C) Regions' experts had calculated that gas price increases would lead to inflation rates of 15-20%. Targeted subsidies for most vulnerable population were therefore needed, as were efforts to show Ukrainian citizens that the government was doing its utmost to reform utilities and increase energy efficiency. Akimova quipped that people would not pay more if they continued to see gushers of hot KYIV 00002124 004 OF 004 water leaking on the streets, alluding to the inefficiencies of municipal heating companies. EU INTEGRATION -------------- ¶26. (C) "EU integration was the direction Ukraine had chosen," stated Akimova. Yanukovych "more than supports" EU integration and would continue reforms to bring Ukraine in line with EU standards. There was "no other way", Akimova said unequivocally. "Efforts at harmonization were difficult but a necessary step to allow Ukraine to use its economic advantages." ¶27. (C) Azarov commented that the Western media had unfairly stereotyped Yanukovych as solely pro-Russian. Yanukovych was the "most pro-Ukrainian candidate", and he recognized that Ukraine was increasingly "more European in its essence". Azarov speculated that EU integration would happen automatically as a factor of Ukraine's development, and reforms would occur because they were of "systemic" importance. BANKING SECTOR -------------- ¶28. (C) Financial stability was still missing, said Azarov. Bank recapitalization had been conducted via "administrative resources". Although it had had the effect of increasing government debt, bank recapitalization was not stimulating new lending for the real economy. ¶29. (C) Akimova had been closely observing trends in the exchange rate, as any upward movement would be a "disaster" for banks and could lead to another banking crisis. The NBU and Ministry of Finance needed to stabilize the exchange rate through collaborative monetary and fiscal policy-making. A Yanukovych presidency would support NBU reforms to enhance both its independence and accountability, Akimova noted. The NBU Council should not contain any Rada MPs, due to inherent conflicts of interest. (Not%Hy;Qpragmatic, pro-business wing. Despite their differences in style and background, each made notably orthodox arguments promoting economic reform, while tamping down concerns over populist social spending legislation. Most evident was their separate but consistently pragmatic approach to Russia on energy, their willingness to make fiscal sacrifices, and their diagnoses of what had driven away (or could re-entice) investment. If elected President, Yanukovych could be expected to continue to draw advice from his top two economic policy advisors on how to escape what Azarov called the most difficult moment in Ukraine's post-independence history. With their business-friendly policies, it is clear why many of Ukraine's oligarchs support Yanukovych, and why a growing numbers of foreigners doing business in Ukraine are comfortable with a Yanukovych presidency. TEFFT