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July 30, 2009

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Reference ID Created Released Classification Origin
09KYIV1264 2009-07-30 14:56 2011-08-30 01:44 UNCLASSIFIED//FOR OFFICIAL USE ONLY Embassy Kyiv

DE RUEHKV #1264/01 2111456
R 301456Z JUL 09

E.O. 12958: N/A 
(U) Sensitive but unclassified.  Please handle accordingly. 
Not for Internet. 
1. (SBU) Your August 6-8 visit to Kyiv follows by two weeks 
that of the Vice President, who reassured Ukrainians that the 
"reset" of U.S. relations with Russia would not come at 
Ukraine's expense.  The Vice President also called on 
Ukraine's leaders to put their antagonisms aside and move 
forward on the economic and energy security reforms needed to 
obtain financial support from the IMF and other international 
financial institutions.  Such support is critical to putting 
Ukraine's economy -- which may see a 15 percent decline in 
GDP this year -- on a path to recovery. 
2. (SBU) The pace of economic and energy reform that is 
needed has been slowed by the political rivalry between 
former Orange Revolution allies President Yushchenko and PM 
Tymoshenko.  The two remain bitterly at odds and will 
compete, as will their 2004 antagonist, Party of Regions 
leader Yanukovych, in the January 17, 2010 presidential 
election.  Yanukovych currently has a lead in pre-election 
opinion surveys.  Tymoshenko's popularity has suffered as a 
result of the poor economy and Yushchenko barely registers in 
the low single digits.  A "second wave" of economic crisis 
this year could help bring Yanukovych to power.  Conversely, 
if the economy were to begin to recover, Tymoshenko, a strong 
campaigner, could turn the tables on Yanukovych.  End Summary. 
Vice President Calms Nerves 
3. (SBU) The "reset" of relations between Washington and 
Moscow had left some Ukrainians uneasy about Ukraine's 
standing with the Obama Administration.  The Vice President, 
during his July 20-22 visit, made clear -- in meetings with 
leaders and in a major speech -- that the reset of relations 
with Russia would not occur at Ukraine's expense and that it 
would not in any way alter Ukraine's right to pursue 
membership in alliances of its choice.  He underlined that 
the Administration rejected the notion of a Russian "sphere 
of influence" over the former Soviet states. 
4  (SBU) The Vice President reiterated U.S. support for 
Ukraine's economic development.  He called on Ukraine's 
fractious leadership to look to the national interest and 
address economic reforms and energy security.   He underlined 
U.S. support for Ukraine within the IMF and other 
international financial institutions and urged Ukrainian 
leaders to meet the conditions that would allow the release 
of future tranches of the IMF's current $16.4 billion 
program.  The Vice President also called attention to the 
need to work on transparency, anti-corruption measures and 
good governance to attract foreign investment, especially in 
the energy sector. 
5. (SBU) The Vice President commended Ukrainian civil society 
-- a success of the Orange Revolution.  NGOs in Ukraine 
operate freely and there is a vibrant media.  The politics, 
albeit chaotic, are competitive.  If Ukraine were to succeed 
in consolidating a functioning, free, prosperous state, it 
has the potential to inspire democracy advocates in its less 
free neighbors. 
Economic Crisis Continues 
6. (SBU) Your visit comes at a time when Ukraine is 
experiencing its worst economic crisis in a decade.  After 
several years of buoyant growth following the Orange 
Revolution, GDP grew by only 2.8 percent last year and is 
expected to contract by some 15 percent this year.  The 
national currency, the hryvnia, has lost 60 percent of its 
value since last October, and net foreign reserves have 
fallen from a high of $38 billion in September 2008 to about 
$20 billion at present.  The country's banking system is 
teetering after Ukrainians withdrew large sums of money from 
their banks and foreign lenders turned their backs on the 
country. Despite budget cuts, the GOU is still facing a 
significant budget gap this year, which the IMF now estimates 
at 6 percent of GDP.  Unemployment is now nearly 10 percent. 
Hopes Hang on IMF 
KYIV 00001264  002 OF 004 
7. (SBU) The GOU and central bank's initial policy response 
to the economic crisis was hapless, but the IMF provided some 
short-term stabilization after it agreed to support Ukraine 
with a $16.4 billion loan last October.  Two tranches 
totaling $7.4 billion have already been disbursed, and the 
IMF Board on July 28 approved disbursement of the next, $3.2 
billion tranche.  In return for its support, the IMF has 
required Ukraine to move towards a more flexible exchange 
rate policy, establish a mechanism to recapitalize and, if 
necessary, liquidate banks, and reform the pension system and 
the heavily subsidized domestic energy sector, both of which 
have created an unsustainable drain on public finances. 
8. (SBU) The IMF loan was originally meant to help Ukraine 
meet its ex
ternal debt obligations, but the IMF has already 
agreed to allow the GOU to use part of the loan to cover the 
glaring budget deficit.  The World Bank may provide some 
budgetary support in return for GOU delivery on long-promised 
economic reforms, but otherwise it is improbable that budget 
help from outside sources will be forthcoming.  The GOU 
likely will close any remaining budget gap through a mixture 
of central bank borrowing and further cuts in spending. 
9. (SBU) Ukraine's economy is one of the most energy 
intensive in the world, and it remains heavily dependent on 
energy imports from Russia, purchasing about 70 percent of 
its natural gas, 60 percent of its crude oil, and 100 percent 
of its nuclear fuel from its northern neighbor.  There is a 
general consensus that Ukraine needs to diversify its sources 
of energy and greatly increase energy efficiency, but little 
has been done since independence to encourage energy 
efficiency or attract the foreign investment that could help 
the country to modernize its Soviet-era energy infrastructure 
and further develop domestic sources of oil and gas. 
10. (SBU) About 80 percent of the natural gas that other 
European countries purchase from Russia passes through 
Ukraine's strategically sensitive gas transit system (GTS). 
The January 2009 gas conflict between Ukraine and Russia that 
led to a two-week cutoff of Russian gas supplies to central 
and western Europe demonstrated to Europe that transit 
security still cannot be separated from the bilateral 
Russian/Ukrainian gas relationship.  In March, the EU and 
international financial institutions offered $3 billion in 
loans for technical upgrades to ensure the reliability of 
Ukraine's GTS and increase it efficiency.  In return, they 
expect Ukraine to improve both transparency and 
accountability in the gas sector, and to create a viable 
commercial basis for the gas transit network.  To date, 
little progress has been made in adopting the reforms 
expected by the donors in return for their support 
11. (SBU) Instead, the GOU has focused on the challenge of 
meeting its monthly gas payments to Russia.  The gas supply 
and transit contracts signed by the Ukrainian para-statal 
Naftohaz and the Russian firm Gazprom in January did increase 
transparency in the bilateral gas relationship.  The hastily 
concluded agreements have created new problems for Ukraine, 
however.  Ukraine's prices for Russian gas are now moving 
towards European levels far faster than the fees Russia pays 
to ship gas through Ukraine's GTS.  Ukraine committed to 
purchasing minimum amounts that are now higher than what the 
country needs in the wake of the economic downturn.  While 
Russia thus far has not penalized Ukraine for taking less 
than the contracts stipulate, the provision does give Russia 
significant leverage over Ukraine.  In addition, Ukraine now 
needs to pay for gas it pumps into its vast underground 
storage facilities during the summer months as it is 
delivered, and not, as earlier, as it was withdrawn and 
consumed in the winter. 
Naftohaz's Financial Problems 
12. (SBU) This last provision has created the need for 
significant bridge financing, as Ukraine's state-owned and 
cash-strapped energy company, Naftohaz, is short on liquidity 
during the summer months, when consumption is low. 
Naftohaz,s financial problems are growing more severe by the 
month, as GOU regulations force it to sell natural gas to 
households at prices far below cost.  The need to pre-finance 
gas deliveries is now exacerbating Naftohaz,s financial 
problems.  The GOU subsidizes Naftohaz,s losses, and despite 
a recent GOU statement (made at the insistence of the IMF) 
that gas prices for households and industry will be increased 
KYIV 00001264  003 OF 004 
by 20 percent in the autumn, the subsidies remain an 
unsustainable burden on the GOU budget. 
13. (SBU) Each month a guessing game ensues as to whether 
Naftohaz can pay its monthly gas bill to Gazprom, with 
various Russian voices warning Ukraine of sanctions foreseen 
in the January contracts if Naftohaz fails to pay.  To date, 
the GOU and central bank have enabled Naftohaz to make its 
monthly payments on time by drawing down precious foreign 
reserves and eroding the strength of state-owned banks, but 
the strategy is not sustainable over the longer run.  The GOU 
recently announced plans to significantly increase 
Naftohaz,s capital, a move that will give the company some 
breathing room, but the move further increases the GOU's 
budget deficit and does nothing to address Naftohaz,s 
underlying problems and those of the gas sector as a whole. 
14. (SBU) The GOU has now asked both Russian and the 
EU/international financial institutions for up to $5 billion 
in bridge loans to secure gas purchases from Gazprom until 
the winter.  The European Bank for Reconstruction and 
Development and the World Bank are now considering providing 
a substantially smaller amount to assist with gas purchases, 
but have indicated they would expect viable and convincing 
reforms in the gas sector, and it remains to be seen whether 
the GOU will agree to the broad array of reforms that would 
be required. 
Nuclear Power and U.S. Firms 
15. (SBU) Ukraine's nuclear sector generates approximately 
half of the country's electricity, while Russia provides 100 
percent of Ukraine's nuclear fuel and stores all of its spent 
fuel.  U.S. Department of Energy assistance has helped 
Ukraine boost the operational capacity of its reactors and 
significantly reduce reportable events.  American firms 
Westinghouse and Holtec have proposed projects that would 
diversify Ukraine's nuclear fuel supply and allow spent fuel 
to be stored domestically.  The USG is the largest single 
country donor to the Chernobyl Shelter Fund and a significant 
contributor to the Nuclear Safety Account.  The new safe 
confinement structure to cover the destroyed Chernobyl 
reactor is estimated to be completed in late 2012 or early 
Presidential Elections: January 2010 
16. (SBU) Amid the ongoing economic and energy crisis, 
Ukraine has scheduled presidential elections for January 17, 
2010.  PM Tymoshenko, President Yushchenko, and former PM and 
Party of Regions head Yanukovych have all announced that they 
will participate.  Arseniy Yatsenyuk, a young centrist former 
Rada speaker and foreign minister, is considered a credible 
challenger to Yanukovych and Tymoshenko, and has polled in 
third place.  Yanukovych currently enjoys a comfortable lead 
in the polls and is expected to win the first round of 
voting, but remains vulnerable in the second round.  Pol
also show that voters are disillusioned with the political 
process, which could lead to low voter turnout, or an 
increase in protest voters.  Analysts speculate that the 
presidential campaign will be hard-fought, with a high 
probability for vote buying and dirty tricks.  That said, the 
last two parliamentary elections (2006 and 2007) were 
generally free and fair -- a major improvement from the first 
rounds of the 2004 presidential election, which were marred 
by fraud. 
Yushchenko's Priorities 
17. (SBU) President Yushchenko, wary of Russian influence, 
remains a strong advocate for Ukraine's entry into NATO as 
the best way to guarantee Ukraine's security and territorial 
integrity.  However, he has been unable to significantly 
expand support for NATO accession in Ukraine.  The NATO 
Information office in Kyiv estimates that only 20-30 percent 
of Ukrainians support NATO membership.  A recent Rada vote 
provides an indicator: the Rada -- including MPs ostensibly 
allied with Yushchenko -- failed to approve a bill that would 
have allowed foreign military forces to conduct exercises in 
Ukraine this year.  This resulted in the cancellation of key 
exercises with the U.S. and other NATO partners for 2009. 
18. (SBU) Yushchenko is also focused on the issue of energy 
security.  He is an advocate for U.S. and EU investment in 
KYIV 00001264  004 OF 004 
the Ukrainian pipeline network, which he describes as "an 
integral part of the European gas market."  He strongly 
favors the departure of the Russian Black Sea Fleet from its 
base is Sevastopol (Crimea) when its lease runs out in 2017. 
Tymoshenko's Priorities 
19. (SBU) The Prime Minister's portfolio is centered on 
economic issues.  As such, she is the target of blame -- some 
justified, some not --  for the impact of the economic 
crisis.  Tymoshenko has unsuccessfully sought bilateral 
budget support from the U.S., but would appreciate any 
additional advocacy for Ukraine from the U.S. with 
international financial institutions.  She has said that she 
is committed to the IMF assistance program and her government 
complied recently with the program's conditions to receive a 
third tranche of funds.  The Prime Minister also believes 
that the issue of energy independence is an important one for 
Ukraine.  However, her negotiation on a gas deal earlier this 
year with Putin remains a point of contention with 
Yushchenko.  Yushchenko regards it as a bad deal for Ukraine, 
with Ukraine paying market or near-market prices for gas, 
while Russia pays below-market transit fees. 
20. (SBU) Tymoshenko has populist impulses.  As such, it has 
been and will continue to be difficult for her to enact 
painful economic reforms in an election year.  Unlike 
Yushchenko, she avoids the topic of NATO membership because 
of its lack of resonance with voters.  She has sought a 
pragmatic relationship with the Kremlin, but maintains her 
independence.  Yushchenko warns, however, that she (and 
Yanukovych) would be overly deferential to Russia if elected 
21. (SBU) Tymoshenko has emphasized enhancing Ukraine's 
relations with the EU, which is popular with the Ukrainian 
public.  Ukraine is in negotiations with the EU on an 
Association Agreement, which includes a Free Trade Agreement. 
 If concluded -- perhaps as early as 2010 -- it would mark a 
significant step forward and boost reform efforts.  Enhancing 
relations with the EU, including the pursuit of membership, 
is something on which all major political forces in Ukraine 


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