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October 10, 2006

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Reference ID Created Released Classification Origin
06KIEV3906 2006-10-10 16:16 2011-08-30 01:44 CONFIDENTIAL Embassy Kyiv


DE RUEHKV #3906/01 2831616
R 101616Z OCT 06

C O N F I D E N T I A L KIEV 003906 
E.O. 12958: DECL: 10/10/2016 
REF: A. KIEV 3755 
     B. KIEV 3670 
     C. KIEV 3783 
     D. KIEV 3905 
Classified By: Ambassador for reasons 1.4 (b) and (d) 
1.  (C) Summary: After eight weeks in power, the Yanukovych 
government's record on economic policy in a number of areas 
has not been as bad as some expected, nor as good as others 
hoped.  The conventional wisdom among the foreign business 
community has swung from "let's give them a chance" to "deja 
vu all over again."  Apparently forgetting their frustration 
with the Tymoshenko and Yanukovych government's failure to 
enact their reformist agendas, many businessmen point out 
that the Yanukovych agenda seems to lack economic reform 
altogether.  Separating alarmism from real GOU policy moves 
presents a more nuanced picture.  Some of the moves taken to 
date have been negative: the freezing of VAT refunds, the 
GOU's embrace of RosUkrEnergo, and the imposition of 
restrictions on grain exports.  At least one move seems 
clearly positive: maintaining the policy that Ukraine would 
not sacrifice EU aspirations for integration with the Single 
Economic Space.  In most other areas -- including WTO 
accession, the reactivation of special economic zones, and 
the budget -- the GOU's rhetoric and policy steps have so far 
been ambiguous and its intentions are still indecipherable. 
The record to date is therefore mixed, but trending negative. 
 We will be watching policy moves in key areas to see if that 
trend continues.  End Summary. 
2.  (C) The return of Viktor Yanukovych as Prime Minister was 
bemoaned by some as a betrayal of the Orange Revolution, and 
welcomed by others as a chance for effective government after 
a period of disappointing inaction.  Although the Party of 
Regions has prominent members who represent powerful 
industrial interests associated with Kuchmaism, many 
observers hoped the oligarchs would steer the party toward 
enlightened pro-market and pro-Western policies rather than 
reverting to the cronyism and kleptocracy of the past.  The 
USG has adopted a pragmatic approach, judging the government 
on the actions it takes. 
3.  (C) Hopes that the new Yanukovych government marked a 
significant break with the past were dampened by Mykola 
Azarov's appointment as First Deputy Prime Minister and 
Minister of Finance, the dual role he had occupied under 
Yanukovych and President Kuchma.  Certainly Azarov is 
widely-acknowledged to be decisive, intelligent, and to have 
real managerial talent.  If this energy is harnessed to serve 
reformist goals, then it would be a welcome change from the 
policy paralysis of the previous two governments.  Azarov, 
however, was also renowned for his willingness to use 
administrative power against the regime's enemies or to 
enrich the well-connected.  As Head of the State Tax 
Administration (STA) from 1997 to 2002, his tax police were 
much feared and the system of authorizing VAT refunds 
notoriously corrupt.  As a recent article in "Delovaya 
Stolitsa" put it, Azarov represents the old Donetsk clan of 
veteran Soviet nomenclatura, rather than the new Donetsk clan 
of rich businessmen. 
Scorecard: Negative 
4.  (C) At the top of the "negative" column is the freezing 
of VAT refunds to exports.  As one of Azarov's first moves, 
this seemed to confirm that he was bringing back the old 
system of extensive administrative control.  In his second 
week in office, he instructed the STA to suspend the 
repayment of VAT refunds to exporting businesses.  Press 
reports in early September claimed that the only VAT refunds 
the STA had paid in August went to Donetsk firms.  Rumors 
held that the Donetsk firms in question all belonged to Party 
of Regions sponsor Rinat Akhmetov.  In response to these 
reports, President Yushchenko ordered the Prosecutor General 
to investigate August VAT repayments.  Discussions with U.S. 
investors, including non-agricultural firms, confirmed VAT 
arrears have soared.  However, some non-Donetsk firms (e.g., 
Mittal Steel Kryvyi Rih) say they have had no problem with 
VAT refunds. (Note: Azarov has on three occasions -- most 
recently on September 26 -- promised Ambassador or Deputy 
Chief of Mission that he would make sure U.S. agricultural 
processing and trading companies received their refunds, 
which now approach $100 million.  Azarov's office called the 
Embassy this week and requested additional information on 
these businesses.  One of the business received a small 
partial refund on October 3. End Note.) 
5.  (C) State Tax Administration officials attribute any 
delays in VAT refunds to the necessity of carr
ying out 
crosschecks of the entire supply chain of exporters before 
authorizing a refund.  Since even local tax offices 
themselves have admitted to businesses that they are unable 
to carry out such crosschecks, the policy amounts to a de 
facto freeze on most refunds. 
Scorecard: Ambiguous 
6. (C)  Azarov's proposed 2007 budget falls into the "too 
early to tell" category.  While engaging in the typical 
politician's ploy of blaming his predecessors for the mess 
they left him, Yanukovych in actuality has been fortunate in 
inheriting a rather healthy economy and fiscal situation. 
Some of Finance Minister Azarov's budget proposals, e.g. 
curbing the growth of social spending and addressing pension 
reform, seem sensible.  Critics point out, however, that the 
cuts in some forms of social spending are more than offset by 
proposed rises in others.  They also criticize the proposed 
creation of a three billion hryvnia stabilization fund to be 
used at the discretion of the Cabinet of Ministers, and the 
emphasis on state-directed investment.  While the draft 2007 
budget's deficit (now planned for 2.55% of GDP) is not 
excessive, there are worrisome signs.  The GOU has embarked 
on renewed borrowing.  Promises of tax reduction for 
business, combined with privatization receipts that are 
likely to be even smaller than planned in the budget, point 
to a danger of a growing budget deficit.  Keeping the fiscal 
deficit low and adequately financed was one of the successes 
of the post-Orange Revolution governments - the new 
government seems to have abandoned this hard line. 
Scorecard: Ambiguous 
7.  (C) It is also premature to judge Azarov's efforts to 
reactivate the special economic zones (SEZs).  The GOU's 
current proposal appears to be an improvement over the system 
that was in place prior to April 1, 2005, when Tymoshenko's 
budget ended the regime of tax and customs privileges offered 
businesses in the SEZs.  Although some companies operated 
legitimately within them, the SEZs had been notoriously 
corrupt.  Shell firms could reap huge profits by channeling 
flows of funds through the zones to avoiding taxes; importers 
used the zones as a customs-free channel for goods to enter 
the Ukrainian market, making the zones WTO inconsistent. 
Tymoshenko's cancellation of these privileges, although 
criticized for being abrupt and for penalizing legitimate 
investment within the zones,  was generally welcomed as a 
blow against corruption and for sound fiscal policy. 
8.  (SBU)   The GOU's draft legislation, released on 
September 22, seems designed to avoid some problems of the 
past.  Consideration of the draft legislation is reportedly 
far off, and the text, in any case, is subject to possible 
changes in the Rada.  As it stands, the draft vests authority 
in the Ministry of Economy, rather than with local officials, 
for approving projects for privileged tax treatment.  By 
centralizing the power to decide who gets the tax and customs 
privileges, Azarov may be reducing opportunities for local 
level corruption, but is gathering still more power into a 
Cabinet of Ministers that he dominates. 
9.  (SBU) To aid new investment projects it provides customs 
duties exemptions for goods used to construct investment 
projects, and a three-year corporate income tax holiday for 
new investment projects.  For export processors, it provides 
facilitation of VAT and customs payments on non-agricultural 
goods temporarily imported and sets out general rules for 
applying customs and VAT to goods leaving the zones and 
entering Ukraine's Customs territory. (Note: Without more 
details on these rules and, perhaps, a track record of 
implementation, it is difficult to say whether the proposed 
SEZ regime would be WTO consistent.) 
10.  (C).  Although designed to address Ukraine's real need 
to compete with neighboring countries for FDI dollars, and to 
facilitate export processing, the reactivation of the SEZs, 
even if they function ideally, remains a controversial 
approach.  Many observers suggest that Ukraine would be 
better off concentrating on creating favorable conditions for 
investment and easing customs processing procedures for 
businesses throughout the country, rather than granting 
privileges to firms in special zones.  (Comment:  Given their 
checkered record in Ukraine, post remains skeptical that SEZs 
will be implemented in a transparent and corruption-free 
Scorecard: Ambiguous 
11. (SBU) Though WTO accession is nominally at the top of its 
priority list, the GOU has sent conflicting signals about its 
actual intentions.  Rhetorically, the GOU has backed the 
potentially incompatible goals of protecting domestic 
producers and acceding to the WTO in 2006 (Ref B).  Both 
Yanukovych and Azarov have flirted with the idea of seeking a 
rollback in some of Ukraine's commitments made to date in WTO 
negotiations in order to protect domestic producers.  Azarov 
has suggested that many of the tariffs that the Tymoshenko 
government lowered should be restored to higher rates.  He 
advocates import substitution and export promotion to spur 
growth, policies that are difficult to achieve without 
WTO-inconsistent measures. 
12. (SBU) In actual practice, the GOU has taken two worrisome 
steps: it has delayed consideration of WTO legislation and, 
in a September 28 Cabinet of Ministers' decree, instituted 
export licensing on wheat in an effort to keep prices low for 
millers.  The delay has come from Yanukovych's insistence on 
giving businesses and Rada members a chance to review the 
benefits of WTO membership in general, and the accession 
terms specifically.  The grain trade restrictions seem likely 
to seriously complicate WTO accession. 
Scorecard: Positive 
13. (SBU) Yanukovych's position on economic integration 
within the Single Economic Space (with Belarus, Kazakhstan, 
and Russia) has so far not differed from that expressed by 
previous governments dating back to Kuchma.  He has held to 
the line that Ukraine is interested primarily in the SES 
becoming a free trade area, but not a customs union.  Joining 
an SES customs union would complicate WTO accession and be 
inconsistent with aspirations for a free trade agreement with 
the EU.  Yanukovych backs close economic ties with Russia 
more vociferously than his predecessors, but he has not yet 
closed any doors to Ukraine's increasing its economic 
integration with the EU. 
Scorecard: Worrisome 
14. (C) Perhap
s the most important question about GOU policy 
that still remains unanswered is how far Ukraine will go to 
get favorable energy terms from Russia.  With the appointment 
of former NaftoHaz CEO Yuriy Boyko, a figure who was involved 
in the founding of RosUkrEnergo (RUE), as Minister of Fuels 
and Energy, the new GOU rejected decisively the efforts of 
some previous government officials to undermine or revise the 
basic arrangements of the January 4 gas agreement.  Instead, 
the GOU has cemented the central role of shady middleman RUE, 
half of which is owned by Gazprom.  It has also benignly 
encouraged the expansion of the activities of UkrHazEnergo, a 
joint venture between NaftoHaz and RUE created by the January 
4 deal to handle the sale of imported gas within Ukraine. 
Despite efforts in early 2006 by the GOU to limit 
UkrHazEnergo's role in the market, the joint venture has 
succeeded in taking over much of NaftoHaz's business of 
selling gas to industrial consumers, and has begun efforts to 
expand into other aspects of energy distribution.  While this 
process began under the previous government, the new GOU has 
given UkrHazEnergo a freer rein in roaming into new areas 
(such as production and distribution).  This is distressing 
to those who see the joint venture as a Trojan horse for 
15. (C) In order to obtain adequate natural gas supplies and 
an optimal price from Russia, Ukraine has been discussing 
broad "strategic cooperation" with Russia.  So far the 
contours of Ukraine-Russia "strategic cooperation" are not 
clear, pending the results of the November Yushchenko-Putin 
Interstate Commission and 2007 gas price negotiations.  Both 
GOU and Russian officials have hinted at linkages to 
electricity exports, nuclear power station construction, as 
well as openness to joint ventures in the energy sector 
itself.  For example, Ukraine may indirectly participate in 
joint oil and gas production projects on Russian territory. 
16. (C) A central concern is whether strategic cooperation 
will result in some ceding of control over key assets of 
Ukraine's economy to Russian entities including Gazprom. 
Encouragingly, the new GOU has said Ukraine's gas pipeline 
system remains off-limits to Russian control via a vehicle 
like the International Gas Consortium, but Minister Boyko has 
shown willingness to allow Russian firms to acquire Ukrainian 
regional gas distribution companies.  Talks are currently 
underway for sale of as many as eight of these companies 
either to RUE or to UkrHazEnergo.  Russian oligarch Viktor 
Vekselberg reportedly bought four other regional distribution 
companies in July. 
Scorecard: Worrisome 
17. (C) The new GOU's approach to natural gas and oil 
exploration and development in the Black Sea as well as 
onshore suggests hostility to foreign productive investment. 
In contrast to the previous GOU's efforts to attract foreign 
investment and technological expertise, Minister Boyko 
announced that future exploration and development task should 
be left to Ukrainian state-owned firms, perhaps with foreign 
financing. (Comment: NaftoHaz's abysmal reputation as a 
borrower and their lack of know-how makes this strategy 
dubious, to say the least.) 
18. (C) Boyko's statement seemed to threaten the production 
sharing concession that Houston firm Vanco had already won in 
April 2006 for a block in the Black Sea off Crimea.  When 
Minister of Environment Dzharty then announced that Vanco was 
in procedural violation of its terms and could lose the 
contract, it reflected what was rumored to be a widespread 
GOU view that the deal should be scuttled.  While in meetings 
with GOU officials Vanco officials said they made some 
progress in September, it appears that some GOU officials' 
opposition to Vanco came from a combination of ignorance of 
the terms of the deal and grumbling by losing bidders.  Boyko 
told the Ambassador October 4 the GOU is committed to finish 
the negotiations with Vanco (Ref C).  Prime Minister 
Yanukovych the same day reiterated that view to Deputy 
Assistant Secretary David Kramer (Ref D).  (Comment: 
However, neither Vanco nor post believes they are out of the 
woods yet.) 
Scorecard: Negative 
19. (SBU) Serious privatization of state enterprises seems to 
be at a standstill, and there apparently is an indefinite 
suspension of plans to sell Ukrtelecom, local energy 
companies, or port facilities.  The Tymoshenko government 
took the first tentative steps on these privatizations, but 
never moved to completion.  Azarov's government has not yet 
turned to them.  Methods of privatization are becoming less 
transparent, with open tenders replaced by insider awards. 
For example, a planned tender for a Luhansk locomotive plant 
was cancelled and instead the government plans to sell to a 
hand-picked buyer. 
Scorecard: Ambiguous 
20. (C) In recent meetings with members of the American 
Chamber of Commerce, foreigners doing business in Ukraine 
expressed their suspicions of Azarov.  All agreed he was now 
the undisputed tsar of economic policy, especially as 
non-political diplomat Volodomyr Makukha appears to have 
little policy clout as Minister of Economy.  To many 
businessmen's ears, Azarov is sounding like an old-school 
dirigiste manager, announcing a five-year plan for Ukraine's 
re-industrialization that is dependent on state selection of 
priority sectors and budget-supported investment.  His moves 
on VAT refunds and the SEZs are seen as consolidating his 
power, which, businessmen tell us, they expect he will use to 
favor those politically connected to the regime. 
21. (SBU) Many businessmen complain that the GOU's impact on 
the business climate will come as much from what it does as 
from what it has no apparent intention of doing.  Missing 
from the Yanukovych/Azarov set of economic policy priorities 
is the agenda of reforms businessmen and international 
observers have been advocating to no avail for several years, 
including under the Tymoshenko and Yekhanurov governments. 
These include judicial reform, deregulation, passage of a 
joint stock company law, abolition of the commercial code, 
and ending the moratorium on sale of agricultural land. 
22. (C) There is no question that many of the policies 
pursued by the Yanukovych government are not what western 
businessmen and economists consistently prescribe. 
Nonetheless, it is important to remember that the record of 
the Tymoshenko and Yekhanurov governments on economic reform 
was thin, despite their greater rhetorical support for the 
reformist agenda.  The record so far of the Yanukovych GOU's &#x00
0A;actual policy steps is mixed, but trending negative.  We will 
be watching developments in all the key areas cited above to 
see if the GOU can polish its rapidly tarnishing image on 
economic policy. 




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