IMF COMPROMISE WOULD LEAVE SEVERE UKRAINE BUDGET

C O N F I D E N T I A L SECTION 01 OF 03 KYIV 000360

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DEPT FOR EUR, EUR/UMB, EEB/OMA

E.O. 12958: DECL: 02/24/2019
TAGS: EFIN EREL ETRD PGOV PREL XH UP
SUBJECT: IMF COMPROMISE WOULD LEAVE SEVERE UKRAINE BUDGET
GAP

REF: A. KYIV 288

B. KYIV 265

C. KYIV 349

Classified By: AMBASSADOR WILLIAM B. TAYLOR, REASONS 1.4 (B) AND (D)


1. (C) Summary. Ukraine faces a glaring budget gap this
year, even if it meets all IMF conditionalities and
introduces severe budget discipline. The GOU has thus far
failed to complete "prior actions" articulated by the IMF,
necessary before the Fund can pay out the next tranche of its
$16.4 billion Stand-By Arrangement (SBA). Unfulfilled
measures for cutting the budget deficit may be the largest
impediment to the return of the IMF mission team, though the
local IMF representative remains confident that the GOU will
eventually move to enact minimal reforms.

2. (C) The IMF estimates that Ukraine will need $2.6 billion
in external budget support in 2009, funds that can only come
from international donors as long as the world's capital
markets remain frozen. We continue to weigh in with the GOU
leadership on the need to meet IMF conditionalities, and we
encourage Washington to be prepared to work with EU partners,
the IMF, and the World Bank to give Ukraine financial
support, but only if Ukraine fulfills IMF prior actions and
World Bank structural reforms. Ukraine's political
leadership must demonstrate unity and a greater willingness
to do everything in its power to tackle the crisis, which is
growing more serious by the day. End summary.

IMF Sanctions a "Compromise" on Budget
--------------


3. (SBU) In order to return to Ukraine to complete the first
review of its $16.4 billion SBA, the IMF has stipulated GOU
action on reducing the budget deficit, ensuring central bank
independence, improving crisis coordination, and devising a
mechanism for bank restructuring. It has also sought a joint
declaration by PM Tymoshenko, President Yushchenko, and
Speaker Lytvyn on their readiness to implement tough economic
reforms.


4. (SBU) Among these IMF "prior actions," budget politics
are proving the most complex. According to the IMF, the 2009
budget passed by the GOU faces a UAH 50 billion deficit
($6.49 billion or 5 percent of GDP). While Lytvyn has
referred to IMF figures as authoritative, PM Tymoshenko told
the Ambassador on February 17 that the budget deficit will be
much smaller than the IMF has estimated, equivalent to only 3
percent of GDP. (Note: She suggested the cost of bank
recapitalization would add another 3 percent of GDP to
overall GOU expenditures in 2009, equaling a total fiscal gap
of 6 percent or $7.8 billion. End note.)


5. (SBU) Ukraine's economic circumstances have worsened
considerably since the SBA was signed, causing the Fund to
relax its original balanced budget conditionality and
introduce a "compromise" budget plan. In this plan, IMF
officials tell us they expect the GOU to cut spending and/or
increase revenues to generate an expected savings equal to at
least UAH 20 billion ($2.6 billion or 2 percent of GDP).
That would still leave a gap of UAH 30 billion, or 3 percent
of GDP. Of this gap, the IMF hopes that Ukraine would
receive roughly $2.6 billion of external financing, equal to
2 percent of GDP. This entire compromise package would then
leave a residual financing need equivalent to one percent of
2009 GDP (roughly UAH 10 billion or $1.3 billion),a figure
the IMF expects Ukraine can finance domestically, even under
the current circumstances. With credit markets closed to
Ukraine, the IMF concludes that any external financing would
take the form of lending from sovereign and multilateral
donors.

Measures for the Deficit
--------------


6. (SBU) According to the IMF's Kyiv-based resident
representative Max Alier and the World Bank's Kyiv-based
senior economist Pablo Saavedra, the GOU has been given a
wide ranging "menu" of potential measures to cut the budget
deficit. From this menu (including value-added tax reforms,
pension targeting, and reductions in energy subsidies),the
GOU has told the IMF it will make limited amendments to the
state pension scheme, while also imposing higher excise taxes
on tobacco and alcohol. The IMF concedes the GOU's proposal
would only implement a portion of the IMF and World Bank's
total menu, as the GOU appears ready to resist any further

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measures that it feels are politically unfeasible in the
run-up to 2010 presidential elections.


7. (SBU) Of the two measures selected by the GOU to cut the
budget deficit, a proposal to increase excise taxes on
alcohol and cigarettes has not yet been tabled in the Rada by
the GOU. The pension bill is further along in parliament.
Rada MPs are currently deliberating over legislation (bill
number 3556) that would reduce expenditures by pegging
pensions to 2007 wage levels, instead of to 2008 levels,
which would reduce pension outlays significantly, since
nominal wages have increased substantially in recent years.
MPs have also debated technical tweaks to the pension bill
that would increase payroll taxes and bolster the overall
Pension Fund, 30 percent of which is to be financed by the
2009 budget (Ref A).

External Financing
--------------


8. (SBU) To date, only $500 million, via a World Bank
Development Policy Loan (DPL),has been offered by
international donors to help Ukraine finance its budget
deficit this year. No other donors or bilateral lenders have
come forth to cover the remaining $2.1 billion the IMF says
Ukraine will need. The World Bank DPL is scheduled for
disbursement in summer 2009, and it comes with strings (known
as "structural measures") attached: The GOU must a) pass a
public procurement law, b) increase support for the poorest
of Ukraine's citizens through a World Bank-approved pension
targeting mechanism, c) place a floor on infrastructure
funding, and d) pass legislation to improve Ukraine's
business environment.


9. (SBU) PM Tymoshenko has appealed to the World Bank to
move up the disbursement date of the DPL. However, according
to Saavedra, World Bank President Robert Zoellick told
Tymoshenko on February 20 that the $500 million DPL would
only be disbursed in mid-2009, and only if the GOU adhered to
IMF conditionalities and implemented World Bank-proposed
measures. Tymoshenko reportedly requested additional budget
support beyond the World Bank's current pledge. Zoellick
responded by saying that needed structural measures are still
unmet by the GOU, so it is too early to talk about any
further loan program. World Bank officials have stated that
they welcome using the DPL as a "platform" for other donors.


10. (C) Even the Russian bilateral loan (Ref B) now looks to
be in trouble. The IMF's Alier commented to us that the
Russians will not lend money to Ukraine, because they have
huge problems at home and Ukraine will not accept Russian
political conditionalities. At the rate Russia is burning
foreign exchange to prop up the ruble, it will be out of
reserves in less than a year, Alier said.


11. (C) Separately, Ukrainian Ministry of Foreign Affairs
official Andriy Nadzhos told Econoff that although the "zero
option" (on Soviet-era assets and liabilities -- see below)
was the only conditionality formally on the table from
Moscow, he suspected Russia would gain significant political
leverage and "greater access to economic assets" if a deal
were to go through. Nadzhos had learned from contacts at
Ukraine's Justice Ministry that the bilateral loan deal was
being held up on the Russian side. Apparently, Ukraine's
Justice Ministry has requested from Moscow records of total
Soviet-era assets abroad before it agrees to revert control
of these assets to Russia in exchange for Moscow paying
vestigial Soviet-era debts. Ukraine seeks to verify whether
its share of Soviet-era external property exceeds Ukraine's
proportion of Soviet-era debt. Moscow has thus far refused
to provide the requested information.


12. (C) In lieu of a bolstered World Bank program or Russian
bilateral support, the IMF has increasingly weighed in with
Kyiv-based G7 ambassadors to help Ukraine cope with its 2009
budget deficit. IMF chief envoy Ceyla Pazarbasioglu has told
the Ambassador and his G-7 colleagues on numerous occasions
that Ukraine cannot cover its budget deficit without external
financing. She has also given her blessing for PM Tymoshenko
and President Yushchenko to reach out to foreign countries
for additional support.


13. (C) If the remaining $2.1 billion is not forthcoming
from bilateral or multilateral donors, the IMF will expect
Ukraine to take further difficult fiscal measures to rein in
the budget deficit. Besides the IMF and World Bank-proposed

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menu options for cutting spending and/or increasing revenues,
Alier told us that "monetizing debt is the most unacceptable
option, given that inflation would immediately take off."

On the IMF Coming Back
--------------


14. (C) Alier said he expects that the IMF mission,
previously slated to return this week, will eventually come
back, but he cautioned that Ukraine still needs to take
concrete steps before that will happen. He pointed out that
the pension bill had not been voted upon, the excise bill had
not been forwarded by the GOU, bank recapitalization and
restructuring measures remained in draft form at the National
Bank, and a mandatory joint declaration (by PM Tymoshenko,
President Yushchenko, and Speaker Lytvyn) was mired in
acrimonious politics. (Note: On February 20, Yushchenko
signed a 13 percent import tariff into law, in what appears
to be a violation of WTO rules and IMF continuing performance
criteria (Ref C). As of February 24, Alier told us he still
had not received official comment from IMF headquarters on
the tariff law, which may further complicate Ukraine's IMF
program. End note.)

Comment
--------------


15. (C) Although it appears Ukraine's IMF program will
remain stuck in the coming days, we continue to expect
Ukraine's leaders to take joint actions that have been
expressed as mandatory preconditions for further
international donor engagement. In the event Ukraine shows
it will move to implement IMF prior actions and World Bank
structural reforms, the USG should team up with the EU, IMF,
and the World Bank to establish an emergency loan facility
for Eastern Europe that will allow Ukraine and other
threatened countries to meet external financing and budget
obligations. We encourage continued outreach with European
partners to develop a joint response to Ukraine's economic
crisis, recognizing that failing banks, falling currencies,
and possible large-scale defaults in Eastern Europe are an
imminent threat to the European banking and business
communities. EBRD President Thomas Mirow told the Ambassador
on February 16 that the issue of a regional response may be
raised at the next ECOFIN meeting on March 10. USG views on
a regional plan will be useful prior to that meeting. End
comment.
TAYLOR