SCENESETTER FOR THE VISIT OF DEPUTY SECRETARY

UNCLAS SECTION 01 OF 04 KYIV 000692

SENSITIVE
SIPDIS

E.O. 12958: N/A
TAGS: OVIP PGOV ECON PREL UP
SUBJECT: SCENESETTER FOR THE VISIT OF DEPUTY SECRETARY
STEINBERG AND SENIOR DIRECTOR LIPTON

Summary
--------------


1. (SBU) Your April 26-28 visit to Kyiv comes in the midst
of Ukraine's unfolding economic and financial crisis. The
IMF has recently concluded its mission review, recommending
disbursement of a second loan tranche that had been delayed
for two months. The agreement with the IMF is a major
accomplishment for Ukraine's authorities, the Prime Minister
in particular, who managed to pass legislation and issue
resolutions to cut the fiscal deficit. Nevertheless, there
remains significant work on bank recapitalization and
resolution, each necessary to prevent a deeper than nine
percent GDP economic downturn that is now foreseen by the
World Bank.


2. (SBU) Complicating resolution of economic issues,
political relations between the president and prime minister
have remained dysfunctional. Some effort has been made
recently to appear more coordinated - the March 23 gas
conference hosted by the European Commission seems to have
ushered in a new era of trying to keep up appearances, and
the mood seems to have been extended by the need to meet IMF
conditionalities on delivery of further tranches.
Nevertheless, the political situation remains the driver of
daily Ukrainian policy making, as the leading political
blocks and their leaders jockey for position in upcoming
presidential elections. Further complicating the political
situation, the Prime Minister and leader of the opposition
are negotiating to form a new, broad coalition that would
push through major constitutional changes.


3. (SBU) Ukraine's relationship with Russia has remained
tense and complicated. Since the August 2008 Georgia-Russia
conflict, Ukrainian perceptions of the potential security
threat presented by Russia have come into greater focus,
particularly against the backdrop of continuing opposition by
some NATO members to MAP status for Ukraine. Changing U.S.
policy toward Moscow has led to speculation that the U.S. has
softened its support of Ukraine as the price of improving
U.S.-Russia relations. End Summary.

Major Themes
--------------


4. (SBU) We see the opportunity with your visit to convey the
following themes to Ukrainian interlocutors:

- Economic: The agreement with the IMF is a major
accomplishment, but you cannot rest on these laurels. In
particular, a great deal of work remains to be done to get
the banking sector out of the deep hole you are still in.

- Political: The political squabble between the President
and Prime Minister was affordable when the economy was
growing at seven percent annually. It is totally
unaffordable when facing a severe economic decline. Yes,
your constitution needs to be amended. But the international
community can only support you if the amendment process
follows your constitution, is democratic, and is broadly
accepted by Ukrainians.

- Political/Security: The Obama Administration strongly
supports Ukraine. Our desire to reinvigorate our
relationship with Russia does not require a change in our
orientation toward Ukraine. We reject zero-sum arguments
that we can pursue positive relations with one, but not both.
Decisions regarding the pursuit of membership in NATO are up
to Ukraine. The U.S. has supported and will support your
decision. NATO's door remains open to Ukraine, but NATO does
not drag countries into the Alliance against their own will.

- Energy/EU: You need to follow through on reforms agreed
on with the EU on March 23 in the energy sector.


IMF Relations and Economic Challenges
--------------


5. (SBU) The IMF mission team recently concluded its review
of Ukraine's progress under the Fund's October 2008 Stand-By
Arrangement. Disbursement of the IMF's second loan tranche
had been delayed since mid-February, due to an unfinanced
budget deficit of roughly 5 percent of GDP (roughly $6.25
billion) and a lack of progress on bank recapitalization. In
recent weeks, the Rada has taken measures to raise excise
taxes on tobacco and alcohol, but when it failed to pass
legislation on April 14 that would have made modest cuts to
pensions and reduced Natohaz's budget deficit, the Cabinet of
Ministers stepped in with 19 resolutions that aim to provide

KYIV 00000692 002 OF 004


the fiscal discipline called for by the IMF. The action was
clearly prepared long before the Rada vote, and appears to
have had the full support of the IMF, which has indicated
that it will accept the resolutions in lieu of laws. The IMF
looks set to disburse its second tranche after the Fund's
board meets in mid-May, and it has indicated it would
increase the tranche from $1.87 to $2.8 billion, with $1.4
billion devoted to the budget gap.


6. (SBU) The IMF's decision to provide budget support --
taken together with Rada-backed excise taxes, CabMin
resolutions, and expected funds from a $500 million World
Bank DPL loan -- do not fully cover Ukraine's expected 2009
budget deficit. With the blessing of the IMF and the World
Bank, Ukraine continues to request budget support from the
United States, the European Union and other key states,
Russia, Japan, China, and Saudi Arabia. Thus far, no
bilateral budget support has been forthcoming. Deputy Prime
Minister Hryhoriy Nemyria is expected to actively follow-up
on this request during his trip to the United States for the
IMF and World Bank spring meetings on April 22-27.
Immediately following your visit to Ukraine, Prime Minister
Yulia Tymoshenko will travel to Moscow to call for Russian
bilateral budget assistance. She is also expected to raise
the matter with German Chancellor Angela Merkel on April 30,
when the two reportedly will meet in Warsaw on the margins of
European People's Party Congress.


7. (SBU) As analysts project that Ukraine's GDP will decline
at least 9 percent in 2009, stresses on the banking sector
have mounted, causing the IMF and World Bank to call for
urgent reforms. A bank recapitalization unit has been
recently established in the Ministry of Finance, and initial
plans have been made for a problem bank unit at the NBU to
oversee bank resolution. Although only a nascent regulatory
framework has been developed for either, the GOU has proposed
seven domestic banks to receive initial recapitalization
funds by May 1. The GOU will likely move to write down
existing shareholders with current regulatory power, but the
basis to do so is weak and could be challenged in court. The
GOU plans to effectively nationalize the banks it
recapitalizes by taking majority stakes. Foreign bankers
have told us that they expect shareholders of parent banks in
Europe, Russia, and the United States to fully finance their
recapitalization costs. Despite concerns of deleveraging, we
have not heard that any foreign-owned banks are seriously
contemplating pulling up stakes.


Renewed Orange Coalition Falters Again
--------------


8. (SBU) Orange Revolution allies Viktor Yushchenko and
Yuliya Tymoshenko united forces following an unexpectedly
strong showing by Tymoshenko's political bloc (BYuT) in the
September 2007 pre-term parliamentary elections. They formed
a coalition and established a government in late 2007 with
Tymoshenko as Prime Minister. Many hoped that they would
work together better than they had in 2005, when Yushchenko
dismissed Tymoshenko after seven months of infighting. In
early September 2008, following a string of mutual
recriminations, Yushchenko's Our Ukraine-People's Self
Defense bloc (OU-PSD) pulled out of its coalition with
Tymoshenko's parliamentary faction.


9. (SBU) The split between Yushchenko and Tymoshenko was
finalized on October 8, when the President dissolved the Rada
and called pre-term elections. PM Tymoshenko opposed the
decision to call pre-term elections, citing the unfolding
domestic economic crisis as requiring political continuity
and stability. Tymoshenko successfully delayed preparations
for early elections, which required the passage of laws in
parliament both on administering and funding the vote, while
cobbling together a new coalition. The new coalition
announced on December 9, thereby avoiding early elections, is
comprised of the PM's bloc, Rada speaker Volodomyr Lytvyn's
bloc and a majority of the now fractured former
pro-presidential OU-PSD bloc. The new coalition, on paper a
majority of MPs, has struggled to pass legislation in the
Rada and has often had to turn to the non-coalition
Communists to successfully push forward its agenda.

Moving Toward Elections - and a new constitution?
--------------


10. (SBU) In the latest salvo in the ongoing feud between
Tymoshenko and Yushchenko, the PM's coalition joined with the
opposition Party of Regions and the Communists to set October
25 as the date for the next presidential election, rather
than a date in December or January as expected. Yushchenko

KYIV 00000692 003 OF 004


has challenged the Rada's decision in the Constitutional
Court, calling the Rada's legal justification for October 25
deeply flawed. However, the President has said that he would
agree to the earlier date if simultaneous early Rada
elections were also held. There is no obvious legal
justification for pre-term parliamentary elections.
Tymoshenko and the coalition are against simultaneous
elections. BYuT and Regions are attempting to negotiate an
entirely new coalition that would seek broad Constitutional
changes in the near term that would have the president
elected in the parliament, and establish a full parliamentary
republic.


11. (SBU) Tymoshenko, Yushchenko, and opposition head and
former PM Yanukovych are all likely candidates for the
presidential election. Recent polls show that Tymoshenko and
Yanukovych are the likely contenders in a presidential
runoff. Arseniy Yatsenyuk, the young liberal former Rada
speaker and foreign minister, is considered a credible
challenger to Yanukovych and Tymoshenko, and has announced
that he intends to run for president. Yushchenko, whose
popularity polls in the low single digits, is not expected to
be a serious contender and some observers speculate that he
may not even run. Polls also show that voters are
disillusioned with the political process, which could lead to
low voter turnout, or an increase in protest voters.

Ukraine's Security Concerns
--------------


12. (SBU) Ukrainian perceptions of potential security threats
have sharpened since the August 2008 Georgia-Russia conflict.
These sensitivities are set against doubts about whether
NATO will ever allow Ukraine Membership Action Plan (MAP)
status. For the most part Ukrainian officials remain
committed to pursuing Euro-Atlantic integration. How long
they will continue to do so in the face of the continuing
lack of Ukrainian public support (at only about 25%) for NATO
membership is not clear. Many of our interlocutors have
questioned whether "the reset button" signals a departure
from our policy of strong support for Ukraine's western
orientation, including its Euro-Atlantic integration.


13. (SBU) The August conflict and Russian occupation of
Georgian territory, and Russia's subsequent recognition of
Georgia's breakaway regions, has raised specific worries
about Russian intentions toward Crimea, and whether Russia
intends to pursue a "South Ossetia strategy" in this
autonomous Ukrainian region. A lack of progress in regular
negotiations regarding the Black Sea Fleet has exacerbated
these suspicions. Rumors continue to circulate that Russia
is issuing passports in Crimea; however, facts do not seem to
bear this out. President Yushchenko has taken a strong
position rejecting Russian actions in Georgia. Ukraine will
not recognize the independence of either breakaway region.
Ukraine does not intend to change its policy allowing arms
sales to Georgia, and intends also to continue Ukrainian
participation in the UN Observer Mission in Georgia (UNOMIG).
Despite the officially strong solidarity with Georgia from
Yushchenko, officials occasionally lament that Saakashvili's
actions in August have caused discord in Ukraine-Russia
relations.


14. (SBU) The non-extension of the Strategic Arms Reduction
Treaty (to which Ukraine is a party) has become a concern in
the context of aggressive Russian rhetoric. Speaker Lytvyn
and MFA officials have raised with us the need for a new
security guarantee for Ukraine. To this end, Prime Minister
Tymoshenko called for greater Ukrainian participation in the
European Security and Defense Policy (ESDP) at this year's
security conference in Munich. Russian foot-dragging on
border demarcation and Russian unwillingness to engage in a
meaningful way through normal bilateral commissions or
working groups have also served to increase the level of
general concern in the GoU regarding the extent of Ukraine's
strategic exposure. Ukrainian officials view Russia's
parallel "one plus two" process on Transnistria settlement
discussions as detrimental to the internationalized 5 2
process, and also to Ukraine's interests.


15. (SBU) Some prominent political figures seem already to
have decided that the prudent course lies closer to Moscow in
today's strategic environment. For example, Rada Speaker
Lytvyn, who has in the past favored neutrality over NATO
membership, recently asserted that the answer to Ukraine's
problems of funding and building a reliable navy is to
request that the Russian Black Sea Fleet protect Ukrainian
naval interests.


16. (SBU) Prime Minister Tymoshenko has maintained an

KYIV 00000692 004 OF 004


understated approach on NATO membership, and has focused her
public commentary instead on increasing Ukraine's ties to the
EU, including her statement at the Munich Security
Conference.

Energy
--------------


17. (SBU) In January 2009, PM Tymoshenko and Russian PM Putin
signed controversial supply and transit contracts ending the
crisis that saw gas shutoffs to EU Member States, and taking,
in some ways, a step toward transparency. The contracts
remove controversial gas intermediary RosUkrEnergo (co-owned
by Russian's Gazprom and Ukrainian oligarch Dymtro Firtash),
and established a fixed formula for determining the price of
imported gas. However, the transit price charged to Russia
remains below market levels, and, while Ukraine is subject to
take or pay provisions in the supply contract, Russia is not
subject to similar provisions in the transit contract. The
price for Russian gas sold to Ukraine will be $270 per
thousand cubic meters (tcm) beginning in second quarter 2009.
Prime Minister Tymoshenko will travel to Moscow for talks
with Putin on April 29 at which she is expected to offer to
negotiate an intergovernmental agreement with Moscow to
govern the Russia-Ukraine gas relationship.


18. (SBU) Ukraine continues to have severe domestic problems
in its energy sector, which both undercut state oil and gas
company Naftohaz's financial viability and prevent
development of domestic oil and gas resources. Domestic
natural gas prices for the general population and municipal
heating companies are well under the import price. State
budget subsidies to Naftohaz aim to bridge the gap between
the import price and the domestic consumer price, but many
domestic consumers still fail to pay on time and in full.
Ukraine's complicated legal procedures for exploration and
development of oil and gas deposits dissuade foreign
investment into the sector.


19. (SBU) The March 23 Brussels conference aimed to bring PM
Tymoshenko and President Yushchenko together to commit to
reforms that would bring Ukraine's gas sector in line with
the EU energy community treaty. Based on the Ukrainian
commitment to these reforms, the World Bank, the European
Bank for Reconstruction and Development, and the European
Investment Bank, pledged they would provide financing for the
modernization of Ukraine's gas transit system (GTS). Ukraine
is to provide a detailed timetable for sector reforms by the
end of 2009 and implement the reforms by 2011, including the
phase out of domestic price subsidies.


20. (SBU) Ukraine's commitment to reform in the energy sector
is yet to be seen. While Tymoshenko and Yushchenko provided
a unified voice in Brussels, their cooperation has flagged
since returning to Kyiv. Moreover, the steps Ukraine will
have to take to implement the reforms required by the EU and
the IFIs will be hard for Ukraine to swallow, especially in
the midst of its economic crisis.

TAYLOR