Cablegate: Economic Policy and the New Gou: Progress, but With

DE RUEHKV #3165/01 3621258
R 281258Z DEC 07





E.O. 12958: N/A

Ref: A: KYIV 2336; B: KYIV 3058; C: KYIV 2985; D: KYIV 2892; E:
KYIV 1962; F: KYIV 2857

Sensitive But Unclassified. Not for Internet Distribution.

1. (SBU) Summary and comment: Prime Minister Yulia Tymoshenko has
sent out mixed signals on her plans for the Ukrainian economy. She
continues to say many of the right things on economic matters, yet
some of her populist campaign promises convey a different message.
Nonetheless, we expect Tymoshenko to be open to well-timed
recommendations on how best to improve the investment and commercial
climate. Her choice of ministers for the key portfolios of energy
and finance is encouraging, and we expect them to be more willing
than their immediate predecessors to address some of the more
egregious problems facing public finances and the energy sector.
The coalition's razor-thin majority in the Rada (parliament) will
make progress difficult, however, and many reform measures will
unavoidably affect entrenched interests within the ruling coalition
itself, testing Tymoshenko's ability to hold her government

2. (SBU) We expect Tymoshenko to tackle gas relations with Russia
and to address the question of intermediaries, even if she may still
not have decided on specifics of her approach. It is also likely
that she will maintain momentum on WTO accession, follow up on her
campaign promises to address corruption, and avoid a repeat of the
re-privatization polices of her first term as PM. The budget
deficit will likely grow as the new GOU tries to keep social
spending and wage increases ahead of inflation, which will reach
about 15 percent in 2007 and remain high in 2008. The ban on sales
of agricultural land will continue for the time being due to
disagreements among the coalition partners. Because of its thin
majority in the Rada and its conflicting goals, the new government
will need to be prodded on an ongoing basis to remain on track with
economic reforms. In our discussions with the new GOU, Embassy
plans initially to focus on discrete measures to improve the
investment climate, such as corporate governance legislation and
resolving the OPIC dispute, as well as addressing VAT refund
arrears, completing WTO accession, and enhancing energy security.
End summary and comment.

A Chance For Reform, But With Lots of Prodding
--------------------------------------------- -

3. (SBU) Tymoshenko's own track record in government and her
campaign promises have sent mixed messages about her true intentions
on economic policy. In her "Contract With Investors" (ref A), she
said all the right things about the need to accelerate economic
reform in Ukraine. At the same time, her campaign rhetoric was
often purposely populist, with some anti-reform undertones.
Tymoshenko's populist rhetoric can be over-interpreted, however, and
she is likely open to economic reform. She is also very sensitive
to her reputation in the western world, so we expect her to listen
to well-placed messages on the need to move forward with reform. We
expect the new ministers with the most important economic portfolios
-- Finance Minister Pynzynyk, Energy Minister Prodan and Economy
Minister Danylyshyn -- to be both readily accessible and open to
ideas on how best to improve Ukraine's economic and investment
climate. Nonetheless, the new government will need to be pushed
into action, since enacting reforms will be challenging. The
razor-thin majority in the Rada will make progress difficult,
particularly when reforms affect deeply entrenched interests within
the new ruling coalition itself. Many reform measures, such as
strengthening budget discipline, will be highly unpopular (Comment:
potentially affecting any chances for Tymoshenko to run for
President in 2009.) and contradict populist promises that she made
during the campaign. And finally, many measures will demand
long-term political focus, discipline and staying power, all of
which are not widespread in the short-term realities of Ukrainian
politics, and could be in particularly short supply for a government
that will invest much of its energy and political capital in keeping
its coalition together.

Economic Conditions Will Likely Remain Favorable
--------------------------------------------- ---

4. (SBU) The economic environment should remain generally favorable
for the new government in 2008. Continued strong economic growth
will give the government room to maneuver, although growth is
expected to slow somewhat, from about 7 percent in 2007 to roughly 5
percent in 2008. High world prices for Ukraine's steel and chemical
exports have favored economic growth in the past two years.
Consumer spending and business investment will likely remain strong.

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At the same time, risks do exist. Were prices for steel and
chemical exports to drop, there would be a major ripple effect on
Ukraine's growth, and particularly a worsening of the growing
current account deficit. Inflation, about 15 percent in 2007, will
remain high. The new government has already increased its inflation
forecast for 2008 to 16 percent. Keeping inflation under control
could be the most difficult economic challenge facing Ukraine in the
coming year. Like the outgoing government, Tymoshenko's government
could be tempted to combat inflation with administrative measures
such as price and export controls. There will also be pressure on
the new government to use the budget to keep wages growing at least
as fast as inflation. Some believe that the risks in Ukraine's
booming banking system, which has depended greatly on foreign
borrowing for growth, might become critical if the worldwide credit
crunch continues far into 2008. Large capital inflows are now
funding the current account deficit, and this should continue next
year unless the credit crunch worsens.

Gas Relations With Russia: Expect Changes

5. (SBU) Tymoshenko has regularly criticized the outgoing
government's track record of gas politics vis-a-vis Russia. She has
vowed to abolish intermediaries RosUkrEnergo (RUE) and UkrHazEnergo
(UHE), and to place Ukraine's energy relations with Russia on a new
footing. No one doubts her intentions, but it is not clear how she
plans to approach gas relations with Russia. It is possible that
even she and her top energy advisors do not yet know. Although
Tymoshenko at one point suggested that the GOU take Russia to
international arbitration for violating the 2004 agreement, her
pronouncements lately have been less provocative. In the short
term, she will likely have no realistic alternative to the 2008
price hike that was negotiated in early December between the
outgoing government and Gazprom. (Note: In 2008 Ukraine will pay
$179.50 per tcm, up from $130 this year. End note). She will also
need to acknowledge, at least temporarily, the presence of RUE and
UHE in the market. As her track record shows, however, Tymoshenko
is not afraid to take on entrenched economic interests in the energy
sphere, so it is safe to assume that she will try to follow up on
her campaign promises in the medium term. Ukraine still needs to
define and implement a long-term energy strategy with Russia that
envisages market-based pricing for energy imports, diversification
of energy supplies and modernization and improved management of the
gas transit pipelines and the domestic distribution network. Taking
on the vested interests that benefit from the lack of transparency
in Ukraine's gas sector will require strong political will and
support. Tymoshenko may have the former, but the question is
whether she has the backing to reform this sector.

New Government Will Maintain Momentum on WTO

6. (SBU) Maintaining the momentum on WTO accession will be a top
priority of the incoming government. The GOU still needs to find a
solution with the EU on export duties, the last remaining major
hurdle to Ukraine's joining the WTO. Ukraine also still needs to
amend about 10 laws and regulations as part of its WTO commitments
to the U.S. The outgoing government promised to do this in omnibus
legislation that the Rada would pass at the time it ratifies
Ukraine's WTO accession. If the new GOU reaches agreement with the
EU soon, the accession could be put before the Rada sometime in the
first quarter of 2008. Despite its small majority, the new
government should be able to push the necessary changes through the
Rada. All of Ukraine's major political parties (aside from the
Communists) have committed to finalizing WTO accession as soon as
possible. The vote to ratify WTO accession may give Tymoshenko an
opportunity to generate broad bipartisan support for an important
piece of legislation.

Energy Minister Prodan: A Step in the Right Direction
--------------------------------------------- --------

7. (SBU) The choice of Yuriy Prodan as Minister of Energy and Fuels
is a positive step. His immediate predecessor, Yuriy Boyko, was
widely seen as a corrupt insider with close ties to Russia. Prodan
often criticized Boyko's plans for Ukraine's energy market, which
Prodan felt were a thinly disguised attempt to privatize strategic
energy assets. Prodan and the CabMin have already abolished
UkrAtomProm, created by Boyko and outgoing EnergoAtom President
Andrey Derkach in a move that many feared was a first step towards
stealth privatization of Ukraine's most important nuclear energy
assets. Prodan has a generally favorable track record as regulator
of Ukraine's electricity market, where he was seen as a

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professional, independent player capable of defending a strong
position as well as someone who could find compromises. He also
worked closely on power market issues with Tymoshenko when she was
deputy prime minister for energy and is reported to have a good
working relationship with her. He is also known to be loyal to
President Yushchenko. Prodan is largely an outsider to the murky
world of Ukraine's gas sector. This may be good news, since unlike
Boyko, who earlier served as CEO of NaftoHaz, Prodan has no vested
interests in the gas sector. Significantly, the new CEO of
Naftohaz, Ihor Dubyna, also is not a NaftoHaz insider.

Nuclear Energy: Fewer Roadblocks to Cooperation
--------------------------------------------- --

8. (SBU) We experienced numerous roadblocks to cooperation in the
nuclear sector under Derkach and Boyko, and expect the situation to
improve under Prodan. While at the National Security and Defense
Council, Prodan told us that he backed the Nuclear Fuels
Qualification Project, and we expect him to be supportive of efforts
to get EnergoAtom and Westinghouse to reach agreement on the
commercial aspects of a nuclear fuel supply deal. We also do not
expect Prodan to thwart progress on the construction of a central
spent fuel storage facility in Chernobyl (a project won by
U.S.-based Holtec) as Derkach at EnergoAtom had tried to do. Much
will depend on the new President of Energoatom. There is some
speculation that former Energoatom CEO Yuriy Nedashkovskiy, who is
currently an acting Deputy Minister of Fuel and Energy, will return
to his old job. Nedashkovskiy supported the Holtec project in the
past. In any case, under Prodan and a new Cabinet there is hope for
more opportunities for non-Russian FDI in the nuclear sector.
Recent press reports indicate that France and Canada are actively
studying possibilities to enter the Ukrainian market to provide
technology for the construction of new reactors.

Rescuing NaftoHaz from Bankruptcy

9. (SBU) The precarious financial situation of state-owned energy
company NaftoHaz (ref B) is already demanding the immediate
attention of the new Cabinet. The new government has announced that
it will provide subsidies and guarantees to avert bankruptcy at
NaftoHaz. Administratively set prices currently force NaftoHaz to
sell gas to households and municipal heating companies at below
cost. To put the company on a more stable financial footing in the
longer run, the new government will need to allow significant price
hikes for gas and heat rates, creating a conflict with Tymoshenko's
more populist campaign promises to shield the public from rising
prices for municipal services.

Combating Corruption Will Test Tymoshenko's Will
--------------------------------------------- ---

10. (SBU) Tymoshenko has promised to make combating corruption a top
priority. On her first day in office she announced that all state
agencies would immediately undergo what she called a corruption
audit. Corruption is endemic in Ukrainian political and commercial
life, and any successful and sustainable anti-corruption campaign
cannot avoid hitting the interests of some business and political
interests within the ranks of the ruling coalition, including those
of some of Tymoshenko's wealthiest and most influential supporters.
Tymoshenko's determination to follow through on her anti-corruption
campaign promises will likely be challenged on a repeated basis, and
will test her ability to exercise discipline over her coalition.

OPIC and the Need for Action on Euro 2012

11. (SBU) The Overseas Private Investment Corporation (OPIC) is not
insuring new investments in Ukraine because of repeated Ukrainian
governments' inability to pay off a claim linked to an expropriation
case. OPIC's return would support increased U.S. investment in
Ukraine. In its final weeks in office, the outgoing government made
promising overtures to pay off the claim, yet it is still unclear
whether the new government will maintain the momentum or opt to
start the process from the beginning. The new government will also
need quickly to address the challenges surrounding the staging of
the European soccer championships in 2012 (ref C). This massive
event, a nearly month-long circus of matches with 16 national soccer
teams, hundreds of thousands of visitors and countless journalists,
should unleash an investment boom, stimulate further economic
liberalization and allow Ukraine to showcase itself to Europe.
However, the event requires coordinated public sector support, and

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the outgoing government did little despite lots of rhetoric. The
new government highlighted the importance it attaches to this effort
by appointing veteran official Yevhen Chervonenko as Euro 2012
coordinator with the rank of Deputy Prime Minister. If the new GOU
fails to act effectively, Ukraine might actually lose the games,
which would be a blow both to the investment climate and to
Ukraine's image in Europe.

Re-Privatization: No Repeat of 2005 Expected

12. (SBU) Tymoshenko made clean and transparent privatization a
central theme of her election campaign and a leading indictment of
the Yanukovych government. It is reasonable to expect that her
government will attempt to bring more accountability and openness
into Ukraine's privatization policies. None of the country's most
powerful businessmen and Party of Regions supporters can expect to
manipulate privatizations as long as Tymoshenko is in power.
However, both BYuT or OU-PSD have wealthy and influential
businessmen in their ranks, and Tymoshenko's proclaimed intention to
attack corruption in privatization could be seriously tested if any
of them attempt to manipulate privatizations to their own advantage.
Much will depend on the political and bureaucratic acumen of
whoever is chosen to lead the State Property Fund. Since becoming
PM, Tymoshenko has already announced that she plans to "review" some
of the privatizations conducted under the outgoing government.
However, nobody expects Tymoshenko to repeat the re-privatization
policies of her first term as Prime Minister. During the election
campaign, Tymoshenko vowed to return to state control certain
companies sold under the Yanukovych government, most notably
DniproEnergo, partially sold to Party of Regions financier Rinat
Akhmetov in a non-transparent debt-for-equity swap (ref D).
Tymoshenko later changed her rhetoric, and is now saying that any
questionable privatizations will be addressed in Ukraine's court

Pynzenyk: A Good Choice Who Speaks His Mind

13. (SBU) The appointment of Victor Pynzenyk as Minister of Finance
was widely applauded in Ukraine. He is recognized as knowledgeable,
serious with broad experience in government, including a stint as
Finance Minister under Tymoshenko's last government and under
Tymoshenko's successor Yekhanurov. He is a fiscal conservative who
is not afraid to speak his mind. In a meeting with the Ambassador
prior to the elections, Pynzenyk criticized Tymoshenko for paying
too much attention to social themes while ignoring the importance of
social and economic reform. Ukraine's system of social benefits was
"expensive and immoral" and making people too dependent on the
state, he said. He acknowledged that he was a minority within BYuT,
and as Finance Minister he will likely face political pressure to
maintain high levels of social spending. (Comment: To be fair,
outgoing Finance Minister Mykola Azarov was also a fiscal
conservative, and lamented to the Ambassador that he could not
withstand pressure to maintain what he felt were excessively high
levels of social spending. End comment.)

Budget Deficit to Rise as Lost Savings Are Repaid...
--------------------------------------------- -------

14. (SBU) Pynzenyk has already submitted a new draft budget to the
Rada. The expected budget deficit will rise because of increased
social spending. Tymoshenko had promised to remove what she has
called grossly corrupt state subsidies to the energy sector, in
particular a UAH 1 billion ($200 million) cut in coal subsidies.
While it is expected that many of the subsidy cuts will target
businessmen affiliated with the Party of Regions, the cutbacks could
also affect well-positioned business interests within the ruling
coalition, testing Tymoshenko's political resolve and the ability of
the coalition to manage a conflict within its own ranks. Tymoshenko
is also moving forward with her promise to reimburse Ukrainians who
lost about UAH 120 billion ($24 billion) in savings at the
state-owned USSR Sberbank (now Oshchad' Bank in Ukraine) during the
hyperinflation of the early 1990s. Pynzenyk's new draft budget
includes UAH 20 billion as a first step to reimburse lost savings,
which he proposes to fund through increased privatizations. Most
outside economists fear the reimbursement could prove an
inflationary stimulus in 2008.

...And Social Spending to Remain High

15. (SBU) Strong increases in public sector wages, pensions and the

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minimum wage have fueled economic growth and the boom in private
consumption in recent years. The new government will face broad
pressure to maintain high levels of such spending, particularly
since inflation will remain high in 2008. Tymoshenko will also be
careful not to risk alienating voters in the run up to the 2009
presidential elections. Yanukovych's draft budget limited social
spending to 30 percent of total budget outlays, down from 46 percent
and 52 percent in 2006 and 2005, respectively. We expect Tymoshenko
will probably be inclined to reverse this trend.

Value Added Tax: Hoping for End to Corruption

16. (SBU) Corruption surrounding VAT refunds spiked under Yanukovych
and Azarov. Both foreign and Ukrainian firms told us that the State
Tax Administration (STA) demanded bribes between ten and thirty
percent of the outstanding refunds to process VAT claims. We hope
the problems surrounding VAT refunds will improve significantly
under Pynzenyk, who by all accounts has a clean image and in whose
previous tenure as Finance Minister arrears of VAT were
significantly reduced. Because of the large amount of outstanding
VAT refunds, we do not expect him to solve the problem quickly, but
we will want to ensure that he makes the issue a priority. Much
will also depend on Serhij Buryak, the new head of the STA, whose
views on the issue are unknown. During the election campaign,
Tymoshenko also promised to clean up tax administration and replace
VAT with a type of end user tax. Most observers doubt whether
Tymoshenko will ultimately undertake the complex task of introducing
the new tax, and Pynzenyk, although critical of current VAT
administration, would likely oppose such a move. Before the
elections he told the Ambassador that, should he become Finance
Minister, he would resign if Tymoshenko attempted to abolish VAT.

Fixing the Procurement Mess

17. (SBU) The public procurement system has been effectively
expropriated by vested economic interests representing most parties
in the Rada (ref E). Amendments to the State Procurement Law,
adopted in March, worsened the situation, with purchases by many
government agencies almost coming to a halt. Anecdotes abound on
the destructiveness of the current procurement regime. This year's
relatively modest budget deficit is partly due to the government's
inability to spend on procurement. In another example, the planes
of the Ukrainian air force were grounded for four months because of
an inability to purchase fuel. Addressing the procurement system
should be a top priority, but the coalition will run up against
interests in its own ranks if it does so.

Addressing Long Overdue Commercial and Tax Legislation
--------------------------------------------- ---------

18. (SBU) Some laws that would modernize commercial life in Ukraine
made little or no progress under the Yanukovych government. For
example, a draft law that would overhaul Ukraine's tax system is
stalled in the Rada. A draft joint stock company law, which would
strengthen the rights of minority shareholders and prevent many of
the expropriation cases that are all too common in economic life,
has languished in the Rada for years. Most experts agree that the
country's poorly drafted commercial code is not needed and should be
withdrawn. Ukraine is also in desperate need of a new Labor Code
based on market principles. While domestic and international
experts have long advocated reforms in all these areas, Tymoshenko's
willingness to address them is questionable. These issues did not
have a prominent place in her program, and reportedly some of her
business supporters oppose them.

Ending The Land Sale Moratorium: No Solution in Sight
--------------------------------------------- --------

19. (SBU) The moratorium on the sale of agricultural land
represented a major policy difference between BYuT and OU-PSD during
the election campaign, and it will likely continue to serve as a
sticking point between the coalition partners in the near future.
Tymoshenko, however, appears to have taken a step back from her
aggressive campaign platform which hinted at keeping the moratorium
in place indefinitely (ref F). She acknowledged that the current
laws only engender a large black market for lands and that
legislative reforms are necessary. In the mean time, Yushchenko and
his team continue to make the issue a priority, as the Presidential
Secretariat has fine-tuned the two laws necessary to lift the

moratorium with the hope of passing them through the Rada in the
next several weeks. Due to the difference with BYuT, however, it is

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unlikely that the legislation will move swiftly. The prospects for
quick action could be further dimmed if an attempt is made to draw
the Litvyn Bloc, which wants to extend the moratorium by at least
two years, into the ruling coalition.


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