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07KYIV3165, ECONOMIC POLICY AND THE NEW GOU: PROGRESS, BUT WITH

December 28, 2007

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Reference ID Created Released Classification Origin
07KYIV3165 2007-12-28 12:58 2011-08-30 01:44 UNCLASSIFIED//FOR OFFICIAL USE ONLY Embassy Kyiv

VZCZCXRO1224
RR RUEHIK RUEHLN RUEHPOD RUEHVK RUEHYG
DE RUEHKV #3165/01 3621258
ZNR UUUUU ZZH
R 281258Z DEC 07
FM AMEMBASSY KYIV
TO RUEHC/SECSTATE WASHDC 4641
INFO RUEATRS/DEPT OF TREASURY WASHDC
RUCNCIS/CIS COLLECTIVE
RUCPDOC/DEPT OF COMMERCE WASHDC
RUEHZG/NATO EU COLLECTIVE

UNCLAS SECTION 01 OF 06 KYIV 003165 
 
SIPDIS 
 
TREASURY FOR LEE 
DEPT PLEASE PASS USTR FOR CKLEIN/LMOLNAR 
USDOC FOR 4201/DOC/ITA/MAC/BISNIS 
USDOC FOR 4231/ITA/OEENIS/NISD/CLUCYK 
 
SENSITIVE 
SIPDIS 
 
E.O. 12958: N/A 
TAGS: ECON EFIN ENRG EINV PGOV PREL UP
SUBJECT: ECONOMIC POLICY AND THE NEW GOU: PROGRESS, BUT WITH 
PRODDING 
 
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 
together. 
 
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. 
 
KYIV
 00003165  002 OF 006 
 
 
 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 
 
KYIV 00003165  003 OF 006 
 
 
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 
 
KYIV 00003165  004 OF 006 
 
 
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 
system. 
 
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 
 
KYIV 00003165  005 OF 006 
 
 
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 
 
SIPDIS 
moratorium with the hope of passing them through the Rada in the 
next several weeks.  Due to the difference with BYuT, however, it is 
 
KYIV 00003165  006 OF 006 
 
 
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. 
 
PETTIT

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