NEC'S LIPTON WARNS OF UKRAINE'S ECONOMIC HAZARDS

UNCLAS SECTION 01 OF 05 KYIV 000793

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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

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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

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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

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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

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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