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Cablegate: Concerns On Ukraine's 2009 Budget Deficit

VZCZCXRO9248
PP RUEHDBU RUEHIK RUEHLN RUEHPOD RUEHSK RUEHSL RUEHVK RUEHYG
DE RUEHKV #1611/01 2611538
ZNR UUUUU ZZH
P 181538Z SEP 09
FM AMEMBASSY KYIV
TO RUEHC/SECSTATE WASHDC PRIORITY 8436
INFO RUEATRS/DEPT OF TREASURY WASHINGTON DC
RUCPDOC/DEPT OF COMMERCE WASHINGTON DC
RUCNCIS/CIS COLLECTIVE
RUEHZG/NATO EU COLLECTIVE

UNCLAS SECTION 01 OF 03 KYIV 001611

SENSITIVE
SIPDIS

STATE FOR EUR/UMB, EEB/OMA

E.O. 12958: N/A
TAGS: EFIN EREL ELAB ECON ETRD PGOV PREL XH UP
SUBJECT: CONCERNS ON UKRAINE'S 2009 BUDGET DEFICIT

REF: KYIV 1557

SENSITIVE BUT UNCLASSIFIED, NOT FOR INTERNET DISTRIBUTION

1. (SBU) Summary. Extensive government manipulation of the budget
and coerced advance payment of corporate taxes have kept Ukraine in
the black so far this year, but revenue from these measures is
exhausted and the Government of Ukraine (GOU) has numerous outlays
in the balance of the year. Analysts project that if current
revenue and expenditure projections remain, the GOU will face a 9.2%
of GDP deficit, without any clear source of financing beyond (still
uncertain) IFI loans. In the absence of external financial support,
analysts speculate that Kyiv authorities will rely particularly on
monetization by the National Bank of Ukraine (NBU), since the
ability to generate revenue in other ways is limited. While the
economic crisis has made local budgets more dependent on transfers
from the central budget, oblast and municipal leaders complain that
the Ministry of Finance is squeezing the localities by delaying
payments. End summary.

GOU REPORTS REVEAL FALSE PARITY
-------------------------------

2. (SBU) Tax and non-tax revenues for the first seven months of
2009, according to recently released data by the GOU, totaled UAH
115.8 billion (roughly $14.5 billion). This figure was 6.2% lower
than over the same period last year, a relatively small drop given
GDP declines of 20.3% and 18%, respectively, in the first and second
quarters of this year. The GOU achieved these revenue figures by
forcing pre-payment of taxes and by extensively manipulating non-tax
revenues. Such tactics have left Ukraine's budget in a dire
situation for the balance of 2009, with the government now unable to
cover the gaps that are emerging.

3. (SBU) Reports of near parity between expenditures and revenues
for the first seven months of 2009 do not reflect the projected
annual deficit. The IMF and other local budget analysts continue to
foresee a deficit of 6.5% of GDP, excluding financing necessary for
Naftohaz and bank recapitalization, which reaches UAH 55 billion ($7
billion) and in large part must be financed over the balance of
2009. Budget estimates that include financing needs for Naftohaz
and bank recapitalization raise the projected deficit to 9.2% of
GDP.

4. (SBU) The IMF has already provided Ukraine with $4.8 billion in
budget support from its second and third loan tranches. Absent
another IMF loan tranche dedicated to the budget or World Bank DPL
fiscal support (both of which could be held up by GOU noncompliance
with required prior actions), Ukrainian authorities find themselves
with few financing options. This has raised fears in the business
community that the government will continue to use coercive means to
extract payments. It has also raised alarms about the possibility
of monetization of the outstanding deficit.

MANIPULATION AND EXTORTION OF TAXES
-----------------------------------

5. (SBU) The decline of tax revenues in the first half of 2009
would have been more severe had the GOU not required companies to
pay enterprise profits taxes in advance. We have heard reports that
most major companies were forced to pay their annual enterprise
profits taxes in the spring and summer months of 2009, more than
half a year before such taxes would have been due under more normal
circumstances.

6. (SBU) A senior partner in a Kyiv-based law firm told us that
many of his business clients had been tacitly threatened with visits
from the tax inspector or had been hit with trumped up fines for
various code violations. He indicated that most businesses had
complied with GOU requests for advanced tax payments rather than
face ongoing legal hassles.

7. (SBU) The American managing director of a major manufacturing
plant told us on September 18 that his firm had been visited
repeatedly by tax authorities in recent weeks. He said the tax
inspector had told him each business in Ukraine was assigned a "fine
quota" and that authorities were expected to deliver this amount
before the end of the year. The American apparently was told that
he could hand over a UAH 150,000 fine on the spot for non-existing
violations, or else he had go to court to protest UAH 2 million
taxes supposedly evaded, but "either way he would have to pay." The
American manager said the entire story had been made up by the
inspector and could not be justified by the company's financial
paperwork. Ukrainian colleagues were fearful of non-compliance, he
commented, and had no trust in the legal system to resolve the
case.


KYIV 00001611 002 OF 003


8. (SBU) State-owned companies have also been affected. Forced to
cover much of the GOU's revenue shortfall, energy monopoly Naftohaz
transferred UAH 19.2 billion (roughly $1.95 billion) in taxes to the
budget in the first half of 2009. This amounted to a 45.8% increase
over the same period last year, constituting roughly 20% of
Ukraine's budget revenue for the first half of 2009. In previous
years, Naftohaz's tax payments had corresponded to about 10% of the
state budget revenue. Given Naftohaz's receipt of subsidies and
recapitalization funds, however, most analysts suspect its tax
payments amounted to a financial shell game.

2009 TAX REVENUE STRUCTURE
--------------------------

9. (U) Ukraine relies on various tax sources for nearly 75% of
budget revenues. Major taxes include VAT (40% of the budget
revenue), enterprise profits tax (20%), import duties (6%), and
excise duties on tobacco, alcohol, petroleum products, and
transportation (6%).

10. (U) The country's sharp economic downturn has resulted in a
13.4% decline in tax revenue in the first seven months of 2009,
year-on-year. Import duties fell the most dramatically (down 54%),
followed by a 19% decline in revenue from the enterprise profits
tax, and 14% decline in revenues from the value added tax (VAT).

11. (U) The only sources of increased tax revenue in 2009 resulted
from IMF-supported legislation on excise duties on alcohol and
cigarettes, which grew for both imported and domestic goods by 39%
and 54%, respectively, though the total net effect of these revenues
was a fairly negligible UAH 3.5 billion ($430 million).

GOU COOKS (NON-TAX) REVENUE BOOKS
---------------------------------

12. (U) Non-tax revenues sources are estimated to be roughly 25% of
total state budget revenues in 2009. The most important of these
are rent fees and profits from government business activities,
equaling 40% of non-tax revenues and 10% of total revenues. Within
this category, the most important sources are profits from the
National Bank of Ukraine (NBU) and fees levied on oil and gas
producers. Ukraine receives other non-tax revenues from
administrative fees (such as the issuance of passports), land sales,
and special energy-related surcharges.

13. (SBU) Declining tax proceeds have been offset by increasing
non-tax revenues, which grew 20% in first half of 2009, y-o-y.
These increases were almost entirely the result of creative
accounting. For example, the Ministry of Finance included a UAH 4
billion ($90 million) sovereign-guaranteed loan for state
transportation monopoly Ukravtodor in its 2009 revenue indicators.


14. (SBU) The GOU also forced the NBU to transfer UAH 4 billion of
its future profits, calculating that the central bank would earn at
least this amount from its financing operations. Instead, NBU
Governor Stelmakh recently reported that the central bank will only
earn UAH 600 million in profits, entitling it to roughly UAH 3.4
billion in refunds. Stelmakh made his statement in light of a Rada
(Ukraine's parliament) plan to force the NBU to pay another UAH 9.8
billion for Euro 2012 infrastructure projects, money that was to
have been debited against further 2009 profits (reftel).

LOCAL DEPENDENCY INCREASES
--------------------------

15. (SBU) Local revenue sources also have been burdened this year.
Localities typically rely on transfers from the central government
for 40% of their revenues. Failure by state treasury authorities to
provide transfers has left local budgets facing unfunded mandates,
creating a relationship of even greater dependence on the central
government. Localities have very limited spending discretion, as
over 80% of expenditures fund so-called protected articles,
including social payments and public sector wages, as well as
funding for hospitals and schools.

GOU MASSAGES TREASURY ACCOUNT
-----------------------------

16. (SBU) The single treasury account, which services central and
local government revenues, has dipped to historic lows in 2009,
falling to levels around UAH 1.5 billion prior to the May and August
IMF loan disbursements. The paucity of cash is linked to falling
2009 revenues (which, in turn, resulted from a collapse in GDP and
industrial output), as well as to the GOU's allocation of roughly $1
billion for Pension Fund and Naftohaz deficits.


KYIV 00001611 003 OF 003


17. (SBU) Regional officials, such as Sumy Governor Mykola Lavryk,
have blamed the state treasury account's low cash balance for delays
in transfers from the central government to localities. In a formal
press statement, the Cherkasy mayor likewise maintained that the
state treasury had "frozen" payments to municipalities, in order to
accommodate cash imbalances in the state budget.

HRYVNIA EMISSION INEVITABLE
---------------------------

18. (SBU) There is little appetite, either internationally or
domestically, for GOU debt, depriving the government of the option
of issuing bonds to cover its deficit. As a result, to cover the
budget shortfall, the GOU has returned to its practice of
monetization. Via the issuance of treasury bills that are purchased
by the NBU, the government has monetized roughly UAH 25 billion ($3
billion) in 2009. The NBU now holds about 48% of all domestic
treasury bills, equaling UAH 33.8 billion ($4 billion). Its total
holdings constitute a four-fold increase over 2008.

COMMENT
-------

19. (SBU) Despite its dire budget situation, the GOU has not made
any spending cuts in 2009. Rather, with the aid of the IMF's loans,
it has increased budget expenditures by 6.4% in the first seven
months of 2009, y-o-y. Even with another loan tranche that would be
dedicated to the budget, a policy position not normally adopted by
the IMF, the GOU would still have trouble meeting its growing fiscal
obligations, let alone face the external commitments that will come
due in 2010 after massive corporate roll-overs this year.

PETTIT

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