NEC'S LIPTON WARNS OF UKRAINE'S ECONOMIC HAZARDS

UNCLAS SECTION 01 OF 05 KYIV 000793 SENSITIVE SIPDIS DEPT FOR EUR, EUR/UMB, EEB/OMA E.O. 12958: N/A TAGS: EFIN EREL ETRD PGOV PREL XH UP SUBJECT: NEC'S LIPTON WARNS OF UKRAINE'S ECONOMIC HAZARDS REF: A. KYIV 758 ¶B. KYIV 757 ¶1. (SBU) Summary. Special Assistant to the President for International Economic Affairs David Lipton and Treasury DAS for Europe Eric Meyer met with a wide range of high-level Ukrainian policy makers, businessmen, and bankers on April 26-28. Lipton warned of possible dangers to Ukraine's economy, and offered advice to Ukraine's leaders on the banking sector and the budget deficit. End summary. Dangers Ahead -------------- ¶2. (SBU) Lipton warned his interlocutors on April 26-28 that Ukraine faced considerable economic risks and that the severe economic crisis could turn out to be "catastrophic." Ukraine needed to stay on track with the IMF if it wanted to avoid a further deterioration of confidence, but it also had to do more. An exogenous event such as a further meltdown in the world's financial markets, or a default by a state company could lead to a further run on banks and the NBU's reserves, leading to another swift fall in the exchange rate. That, in turn, would be a disaster for the banking system and the broader economy. Lipton's Message to the NBU -------------- ¶3. (SBU) Lipton told acting National Bank of Ukraine (NBU) Governor Volodymyr Krotiuk that Ukraine needed to work more swiftly and with clear guidelines to recapitalize Ukraine's banking system and take decisive steps to liquidate banks that would be unable to survive the crisis. The NBU and GOU did not have the luxury to wait until after the presidential elections, he said, since the banking sector was deteriorating rapidly and any delays in implementing a strong policy would only allow the situation to become worse. He asked Krotiuk for the status of the NBU's and GOU's recapitalization and resolution plans. ¶4. (SBU) Krotiuk noted that the regulatory basis for bank recapitalization was "99 percent done." The NBU had adopted a number of resolutions simplifying the process to inject and get regulatory approval for fresh bank capital. Other resolutions will make it easier for temporary administrators to reduce the capital value of existing shareholders, and the NBU is working with the Ministry of Finance to get Rada approval for a draft law that would strengthen administrators' ability to reduce capital. A new law raising maximum levels of bank deposits insured by the country's deposit insurance fund now meant that about 98 percent of all deposits were insured, although Krotiuk conceded that the money currently available to the fund was vastly insufficient to actually cover deposits in the event of large-scale bank liquidations. The NBU had identified the first seven banks that would be capitalized using public funds, and the MOF was prepared to move forward with the recapitalization, although it still needed to decide whether additional audits were necessary. Lipton: Administrators Need Clear Instructions -------------- - ¶5. (SBU) Lipton said NBU-appointed temporary administrators needed clear instructions when they assumed control of banks. In particular, they should have the ability to write down shareholders to zero and compel non-deposit creditors to participate in restructuring losses if an administered bank is determined to have negative equity. For the NBU's recapitalization and resolution plan to be viable and convincing, such instructions needed to be known to all stakeholders, Lipton said. In a lengthy reply, Krotiuk and his colleagues from the NBU's banking supervision department pointed out that administrators would have the power to write down shareholders. However, Krotiuk said the administrators would initiate negotiations with creditors to restructure a bank's liabilities (primarily through prolongation) when a bank's exposure was determined not to be serviceable. Calling on the deposit insurance fund to pay out depositors would not work, he said, because it is severely underfunded and not sufficient for even the first seven banks. He admitted that he did not fully understand Lipton's point about the need to write down creditors if necessary. ¶6. (SBU) Lipton pointed out that prolongation had a political KYIV 00000793 002 OF 005 component in the case of bank insolvency. Taxpayer money would be necessary to return a bank with negative equity to solvency if existing shareholders would not contribute and it was deemed that the bank was worth rescuing. There was a political risk committing taxpayers' money if existing creditors were not expected to participate in a bank's rescue. Many could ask why public money should be committed if non-deposit creditors, who had willfully taken on a risk and received interest for doing so, were not subject to the pain of restructuring. Krotiuk conceded that "there was still a discrepancy in views" on how to implement the recapitalization and resolution process, adding that Lipton's points were "very interesting and would be considered." Exchange Rate Management -------------- ¶7. (SBU) Krotiuk and an NBU colleague from the currency department stated that they were "proud" of the NBU's transparent system of intervention, which was designed to overcome "fluctuations" in the forex market. Lipton told the NBU's Krotiuk that the NBU needs to communicate a clear policy on its exchange rate interventions. The markets do not understand whether the NBU's current policy to smooth "fluctuations" refers to the use of a fixed amount of reserves that can be used for interventions or is tantamount to setting an exchange rate target. Krotiuk did not say explicitly that the NBU would observe the IMF's foreign reserve (NIR) floor, in the event that the NBU needed to rely on reserves to defend a rapidly depreciating currency. NBU staff were unable to explain the exchange rate policy beyond referring to the IMF floor. NBU Refinancing Policy Non-Transparent -------------- ¶8. (SBU) Lipton asked the NBU to explain whether its tender system for refinancing was based on price or volume. The NBU's Krotiuk informed Lipton that the central bank does not fix either price or volume. Instead, it collects and reviews application from banks that provide a proposed rate and volume. Lipton suggested that this was not a transparent auction, as the NBU decides how much to lend and to whom. A more transparent system should have been in place 15 years ago, Lipton suggested to us in private, and will remain an essential impediment to generating trust between the NBU and banks. Pynzenyk, Poroshenko, Bankers Downbeat on NBU -------------- ¶9. (SBU) Former Finance Minister Viktor Pynzenyk, who resigned earlier this year, told Lipton that the recapitalization plan was still not being implemented quickly enough. During an animated dinner conversation hosted by the Ambassador and also attended by businessman Viktor Pinchuk, the NBU's Petro Poroshenko, Ambassador Roman Shpek of Alfa Bank, Raiffeisen Aval chairman Volodymyr Lavrenchuk, and former Finance Minister Oleh Mytiukov, Pynzenyk questioned whether the procedures for liquidation were actually in place. Too many high level GOU officials still did not understand the concept of recapitalization and resolution, he said. In addition, the NBU did not have qualified talent to manage the resolution and recapitalization program, Pynzenyk said, urging the U.S. to provide experts for the central bank. Poroshenko, Chairman of the NBU Supervisory Council (a non-executive position with some, albeit limited influence over the governing board),also said the recapitalization plan needed to be implemented more rapidly, and more transparently. Representatives from several foreign banks separately echoed these views, telling Lipton that major aspects of the GOU's and NBU's recapitalization plan were still unclear. They were also skeptical that any western banks would be interested in purchasing and recapitalizing Ukrainian banks in the current environment. There was agreement that the largest state-owned Russian banks might be able and interested in using the crisis to buy up Ukrainian banks. Otherwise, only the state-owned Ukrainian banks Oshchadbank and Ukreximbank could be expected to come to the rescue of other banks in the current environment. ¶10. (SBU) The country heads of Citibank, BNP Paribas, and Unicredit all said they remained committed to Ukraine and expected to increase their capital as stipulated by the NBU after the recent completion of the IMF-mandated diagnostic tests. However, they also noted that a decline in assets KYIV 00000793 003 OF 005 today meant not as much capital may be needed as per the November assessments. BNP Paribas country director Dominique Menu qualified his bank's commitment, saying that it would stay "if the regulatory environment remains stable." The NBU's supervisory measures to deal with the crisis were making it increasingly difficult for his bank to work rationally, he said. All conceded that they were also planning to weather the crisis by a severe contraction of their exposure. ¶11. (SBU) The bankers agreed that asset quality in the banking system was deteriorating rapidly. Non-performing loans in some sectors were estimated to reach between 30 and 40 percent by the end of the year. Banks were already in a process of massively rescheduling their loan portfolios, primarily through prolongations but also some reductions in net present value. Retail clients continued to make efforts to service their debts, whereas problems were mounting rapidly with loans to small and medium sized enterprises, many of whom were simply walking away from their debts. Banks' exposure to Ukraine's largest companies, particularly in the metallurgical industry, were set to become the next big challenge, Lipton heard. All the big steel players had hired western investment banks as restructuring advisors and were not investing in their companies at the moment. Big Ukrainian borrowers were still able to service the interest component of their debts through their cash flows, and banks were rolling over short-term loans to the companies. "You have no other choice," Lipton told them. They said servicing the capital component of long-term debts has become the biggest problem, and that would be at the center of restructuring discussions, with banks likely taking "haircuts" in the process. ¶12. (SBU) Taking non-performing loans into liquidation and seizing collateral was not an option for banks, several bankers said. "The court system here simply won't work in our favor," Citibank country head Nadir Shaikh told Lipton. In addition, most banks had a long-term interest in their Ukrainian clients and were interested in maintaining relationships with the expectation that such an approach will pay off when the crisis has passed. ¶13. (SBU) Lipton asked bankers what needed to be done to improve the operating climate for banks. BNP's Menu said the general regulation of the economy has to be simplified and improved. BNP paid dearly for Ukrsibbank "but now felt cheated," Menu said, because it expected that the GOU would use the good times before the crisis to move forward on economic reform when the price was far less. He suggested that the USG should push for the creation of a council on banking reform, situated in the NBU with full access to the central bank's leadership and staffed by banking experts from major western countries in addition to local officials. Citibank's Shaikh said foreign banks needed the ability to hedge the currency risk of the capital that they inject into their Ukrainian subsidiaries. Earlier, this had been possible by depositing foreign exchange with the NBU, but the central bank abolished this practice before the crisis hit, telling banks that "we don't need your reserves." Budget Deficit Politics -------------- ¶14. (SBU) President Yushchenko, Prime Minister Tymoshenko, and other key interlocutors told Lipton that Ukraine requires financing for a budget deficit that amounts to at least 4 percent of GDP (reftel). He agreed with the President that the National Bank cannot resort to monetizing, as emissions would have a strongly inflationary effect. Expenditures need to be managed, so as not to lead to inflation. Budget spending must also be cut, when necessary and possible, by additional legislation. ¶15. (SBU) Former Finance Minister Pynzenyk doubted that the envisaged budget deficit could be financed. Separately, Lipton asked Acting Minister of Finance Umanskiy whether the budget would perform as envisaged, and how the GOU hoped to finance the budget deficit that it had negotiated with the IMF. Umanskiy conceded that projecting the budget's performance would remain difficult because of the unstable and deteriorating economic situation. The MOF's biggest challenge at the moment was ensuring spending discipline. About ninety-five percent of all outlays were non-discretionary. A sense of entitlement had arisen with regards to social spending, which had risen rapidly in recent KYIV 00000793 004 OF 005 years, Umanskiy said, and it was difficult to convince politicians to cut spending. The GOU was also fearful of submitting draft budget amendments with spending cuts to the Rada, for the parliament could turn around and approve spending increases instead. ¶16. (SBU) Lipton noted that budget arrears should be avoided, though it was not evident how widespread arrears have become. Umanskiy said arrears were not an issue. IMF representative Max Alier told Lipton that he had seen no direct evidence of budget arrears, though he noted that the Prime Minister revealed at a recent press conference that she had been reducing the GOU's stock of arrears. Most stories of arrears are referred to as "bumpy payments," said Alier, with the exception of vast amounts of VAT reimbursements that are owed to exporters. However, Umanskiy admitted there was a problem with the Tax Administration. Alier also noted that tax compliance was deteriorating rapidly, and he could not project whether this would continue or stabilize. Lipton: No Bilateral Budget Support -------------- ¶17. (SBU) Umanskiy conceded that the GOU had yet to identify funding sources for most of the projected budget deficit. He said the GOU now expected a budget deficit of UAH 50 billion ($6.25 billion). About UAH 10 billion could be covered through further savings and other fiscal means, leaving a financing need of UAH 40 billion ($5 billion),"which could be higher." He told Lipton that the GOU had engaged in "encouraging" discussions with the EU, Japan, and Russia over bilateral support, and he said that Ukraine hoped the U.S. would be open to supporting Ukraine as well. ¶18. (SBU) Lipton told all interlocutors that the U.S. Congress was highly unlikely to appropriate money for budget assistance to Ukraine, especially in light of the Administration's pending request to bolster U.S. contributions to the IMF by $100 billion. Thus, any further budget support for Ukraine would likely come through the IMF and the World Bank, pending satisfactory progress on conditionalities and approval by each institution's board. He also told Umanskiy that the idea of a donor's conference had little chance of success and should not be pursued. (Note: Umanskiy was the only interlocutor who brought up the issue of bilateral budget support. It appears that the President, Prime Minister, and their respective advisors had been warned off this topic by the Ukrainian embassy in Washington and/or by Deputy Prime Minister Nemyria, who had been told by high-level U.S. officials prior to the spring meetings of the IMF and World Bank that bilateral budget financing was not likely forthcoming from the U.S. End note.) ¶19. (SBU) In his discussion with Umanskiy, Lipton recounted his roundtable conversation with bankers, who had told him that NBU paper was a far more attractive investment that Ukrainian government bonds, because the NBU tended to pay more realistic interest rates on the debt it issued to banks. He asked Umanskiy how the GOU intended to finance the deficit when, by all accounts, the international capital markets would remain frozen, particularly for countries like Ukraine, and when, domestically, there was either no market or a banking sector unwilling to lend to the government. Umanskiy conceded that the GOU had problems selling its debt domestically, but he said the MOF planned to coordinate its funding strategy more closely with the NBU. He also said the GOU was planning to issue domestic bonds denominated in foreign currency that would target the large amounts of cash dollars being held by the country's population. Bonds would be issued in both U.S. dollars and euros, and would carry an 8 percent coupon. The MOF also planned to issue UAH-denominated bonds with an interest rate of 16 percent. He did not suggest that the proceeds would be sufficient to cover the remaining budget deficit in the absence of alternative sources of funding. Comment -------------- ¶20. (SBU) Lipton's visit highlighted the enormous challenges still facing Ukraine's budget financing and banking sector. More than eight months since the crisis began, the country's bank recapitalization program is still not off the ground, with key procedural impediments being complicated by administrative ineffectiveness in the government and NBU. A plan for the budget and banks may be in place, but questions KYIV 00000793 005 OF 005 about the adequacy of crisis response linger as each lacks clarity, requires significant financing, and may turn out to be hamstrung by politics, corruption, and bureaucratic inefficiency. End comment. ¶21. (SBU) Treasury DAS Meyer cleared this cable. TAYLOR