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DE RUEHKV #0229/01 0331641
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C O N F I D E N T I A L KYIV 000229 
 
SIPDIS 
 
DEPT FOR EUR, EUR/UMB, EEB/OMA 
 
E.O. 12958: DECL: 02/02/2019 
TAGS: EFIN EREL ETRD ECON PREL XH UP
SUBJECT: UKRAINE ASKS A GUARDED IMF TO SUPPORT A BUDGET 
DEFICIT 
 
Classified By: AMBASSADOR, REASONS 1.4(B) AND (D) 
 
¶1. (C) The IMF told the Ambassador on February 1 that the GOU 
says it cannot run a balanced budget this year.  It has asked 
the IMF for flexibility on this key conditionality of the 
$16.4 billion loan package, Ceyla Pazarbasioglu, head of the 
IMF mission performing the first formal review of the loan 
package, told the Ambassador.  Ukraine now hoped to get 
additional financial support from the international community 
to reduce the need to finance the deficit via central bank 
borrowing.  The GOU was preparing a new budget proposal for 
the IMF, Pazarbasioglu said, adding that any changes in the 
loan program would require IMF board approval.  Acknowledging 
that a balanced budget had become difficult in the worsening 
economic environment, Pazarbasioglu nonetheless stated that 
the IMF was not yet convinced that the GOU, President 
Yushchenko and the Rada were actually prepared to take the 
difficult political steps needed to keep a budget deficit 
manageable.  The IMF was also concerned about the 
inflationary impact of a deficit financed through central 
bank borrowing. 
 
¶2. (C) When formulating its response to Ukraine's request, 
the IMF would also take into consideration what, if any, 
additional financial support donors might extend to Ukraine, 
Pazarbasioglu said.  She called the World Bank's financial 
support to date "timid," said EU countries were not 
interested, and asked whether the USG would extend financial 
support to Ukraine.  Pazarbasioglu called the current 
economic situation dire, but still "manageable" if things did 
not get worse.  The NBU and GOU still needed "to get their 
act together" on the next steps of bank recapitalization, but 
the IMF was encouraged by news that a coordinator might be 
named to manage the difficult relationship between NBU and 
the Ministry of Finance.  Pazarbasioglu said PM Tymoshenko 
chided the IMF for not weighing in heavily with Morgan 
Stanley after it called an outstanding loan to Ukraine.  The 
Ambassador promised to follow up with Washington on 
Pazarbasioglu's request for USG budgetary support.  End 
summary. 
 
GOU Asks IMF Approval to Run a Deficit 
-------------------------------------- 
 
¶3. (C) The IMF's Ceyla Pazarbasioglu told the Ambassador on 
February 1 that the GOU was insisting it could not run a 
balanced budget this year, and was seeking IMF flexibility on 
this key conditionality of the $16.4 billion Stand-By 
Arrangement (SBA).  Pazarbasioglu, who leads the IMF mission 
completing the first formal review of the SBA, acknowledged 
that economic conditions in both Ukraine, and around the 
world, had deteriorated since the program was adopted last 
October.  A key assumption of the program - that the world 
economy would rebound in the second half of 2009 - was 
looking less likely, she said. 
 
¶4. (C) However, running a deficit was one matter, but 
financing it was another, and raising the funds was nearly 
impossible in the current environment, she said.  Ukraine 
would unlikely be able to borrow much either domestically or 
abroad.  The domestic market was not sufficiently developed 
to cover the vast borrowing foreseen in the 2009 budget, and 
international markets would probably remain closed to Ukraine 
even if the world economy improved.  The GOU could expect to 
borrow little from domestic banks, and the IMF was no longer 
confident that state-owned banks Ukreximbank and Oschadbank 
were as strong as was often claimed in Ukraine.  Hence the 
GOU would have little option but to monetize the debt, i.e. 
borrow from the National Bank of Ukraine (NBU), if it were to 
run a sizable deficit that went beyond the borrowing (for 
bank recapitalization and project finance) that the IMF had 
foreseen in the SBA, she said. 
 
¶5. (C) Monetizing the debt also had implications for 
inflation, and for the IMF's efforts to reestablish 
confidence in the NBU, she said.  She pointed out that part 
of the SBA loan, when used to recapitalize banks, would also 
be monetized, potentially adding to inflationary pressures. 
The NBU, as an institution, had lost trust in both Ukraine 
and abroad because of its handling of the Hryvnia 
devaluation, and a large monetization of the debt could 
further undermine whatever confidence remained. 
 
IMF Board Would Need to Approve Changes in Loan Program 
--------------------------------- --------------------- 
 
¶6. (C) Pazarbasioglu said the IMF was engaged in an ongoing 
discussion with the GOU on whether, and by how much, the IMF 
was willing to tolerate a budget deficit.  The GOU was 
preparing a series of measures to modify the budget and 
reduce the deficit, and Pazarbasioglu said she hoped to reach 
a basic understanding with the GOU before the IMF mission 
left Ukraine on February 6.  Any agreement to accept a budget 
deficit would need subsequent IMF board approval.  That 
approval would only be forthcoming if the IMF got clear 
commitments from the GOU to reign in the deficit, and if the 
IMF were confident that President Yushchenko and the Rada 
would support whatever commitments the GOU made to the IMF. 
Pazarbasioglu added that she feared that any agreement could 
unravel quickly amidst the political infighting between PM 
Tymoshenko and Yushchenko. 
 
GOU Looks To Donors to Plug Budget Hole 
--------------------------------------- 
 
¶7. (C) When framing its response to the GOU request, the IMF 
might also take into consideration what budgetary assistance 
other donors and/or governments would be willing to give 
Ukraine, she said.  While applauding the technical assistance 
that the international community was providing, she indicated 
that no governments had provided significant budgetary 
support.  She described the World Bank's support to date as 
"timid."  (Note: The World Bank lent Ukraine $500 million in 
direct budget support in late 2008, is planning to provide up 
to $750 million for bank recapitalization this year, and may 
extend additional budget support at the end of the year, the 
World Bank's Lalit Raina told us.)  Pazarbasioglu and IMF 
residential rep Max Alier said the GOU had already asked 
numerous governments for direct financial support. 
Pazarbasioglu asked the Ambassador whether the USG would be 
willing to provide support as well.  The Ambassador confirmed 
that Deputy PM Turchinov had asked him directly for support 
last week, and said he would broach the request with 
Washington.  Pazarbasioglu ruled out a modification of the 
SBA.  The IMF would not increase the total package, nor would 
it accelerate disbursements scheduled for later this year or 
in 2010, she said. 
 
"Black Holes" in Pension Fund, Naftohaz 
--------------------------------------- 
 
¶8. (C) Pazarbasioglu said deficits in the pension fund and at 
Naftohaz were the "two black holes" in the budget.  Pension 
spending equal to 15 percent of GDP was not sustainable, she 
said.  She said neither Tymoshenko nor Yushchenko was 
apparently willing to take the politically difficult steps to 
reign in the budget deficit, and she expressed exasperation 
that both Tymoshenko and Yushchenko never missed an 
opportunity to attack each another.  Hence both were reticent 
to act out of fear of being undermined by their political 
opponent.  The IMF would thus insist on assurances that the 
Rada and Yushchenko would support any additional agreements 
that the GOU struck with the IMF. 
 
¶9. (C) Pazarbasioglu suggested the GOU might limit wage and 
pension increases to less than the rate of inflation, or 
increase domestic energy tariffs faster than had been 
foreseen in the SBA.  (Note: PM Tymoshenko shared the GOU's 
plans with the Ambassador on February 2.  Post will report 
septel.)  All budget amendments would require Rada approval. 
Hence parliamentary buy-in, and a commitment by the President 
not to attack an arrangement with the IMF, were critical, she 
said.  She added that the IMF may also take into 
consideration true structural changes that point to a serious 
intent to reform the economy, even if they do not save much 
money this year.  As an example, she cited badly needed 
reforms to the pension system, such as changes in the 
retirement age or an improved targeting of benefits. 
 
Situation Dire, But "Manageable" 
-------------------------------- 
 
¶10. (C) Although the economic situation had deteriorated 
substantially since October, it was still manageable if 
things did not get worse, Pazarbasioglu said.  Ukraine should 
meet its sovereign debt obligations without a problem, but 
the IMF was receiving more reports that the non-banking 
corporate sector might default of much of its debt.  The IMF 
was trying to get a better understanding of the non-bank 
corporate debt, she said. 
 
Fulfilling Conditionalities To Date 
 
----------------------------------- 
 
¶11. (C) Pazarbasioglu confirmed that the IMF was satisfied 
that the NBU maintained reserves above the $26.7 billion 
floor foreseen for December 31.  She gave the NBU good marks 
for the quality and timing of the recently completed 
diagnostics of the country's 17 largest banks.  The NBU board 
now needed to act and make recommendations for individual 
recapitalizations.  The ball would then be in the MOF's 
court, which "still needs to get its act together," as little 
had been done to create a mechanism for state-funded 
recapitalization. 
 
¶12. (C) Pazarbasioglu criticized the poor cooperation between 
the NBU and MOF, although she was encouraged that the GOU, 
NBU and Rada might install an overall coordinator for the 
recap and resolution process.  Former NBU Governor and 
current Swedbank chairman Sergey Tyhypko was being named as a 
possible candidate for the position, she said.  She expressed 
concern at the continued absence of NBU Governor Stelmakh, 
"because it's not clear who actually is in charge at the NBU." 
 
Tymoshenko Chides IMF Over Morgan Stanley 
----------------------------------------- 
 
¶13. (C) Pazarbasioglu acknowledged that the IMF has 
participated in discussions with the GOU, its advisors and 
Morgan Stanley over the GOU guarantee for the $465 million 
loan to Ukravtodor.  The IMF's Monetary and Capital Markets 
Department led the discussions, which  alerted all parties to 
the implications that default could have for the SBA.  Should 
Ukraine default, an IMF board would need to approve the 
continuation of the program.  The board would do so if 
Ukraine was making a serious effort to address the arrears, 
she said. 
 
¶14. (C) She said the IMF had cautioned the GOU about the need 
to respect foreign debt obligations.  The IMF was worried 
about the number of cross-triggers in many of Ukraine's 
sovereign debt borrowings.  Because of the expected 
monetization pressures emanating from the budget deficit, it 
was unlikely that Ukraine could, in addition, monetize the 
entire foreign debt that would suddenly come due in the wake 
of a default, Pazarbasioglu said.  She recounted her 
discussions with Tymoshenko, who was furious that Morgan 
Stanley called its loan after Ukraine was downgraded. 
Tymoshenko criticized the IMF for not reigning in Morgan 
Stanley, reasoning as follows:  "The IMF gave Ukraine a loan, 
the U.S. is a major shareholder in the IMF, and now a U.S. 
company is trying to drive Ukraine into default." 
 
Comment 
------- 
 
¶15. (C) Tymoshenko's aforementioned comment notwithstanding, 
Pazarbasioglu said the Prime Minister had finally begun to 
understand the true scope of the economic problems facing 
Ukraine.  Last October this was not the case, Pazarbasioglu 
said, when the IMF had the impression that Tymoshenko did not 
understand, or want to understand, the full extent of the 
crisis.  Pazarbasioglu gave Yushchenko better marks, saying 
that the President had grasped the challenges facing Ukraine 
from the outset.  Nonetheless, such joint understanding of 
the gravity of the situation has not made Yushchenko and 
Tymoshenko place their rivalries aside to address the crisis, 
as demonstrated this past weekend, when both politicians hit 
the airwaves to make the other responsible for the country's 
problems.  As Pazarbasioglu pointed out, the political 
discord is making it difficult for the IMF to be flexible in 
the face of a worsening economic situation, for it is losing 
confidence that Ukraine's political leaders have the will to 
support the tough actions that are needed for Ukraine to 
overcome the crisis with IMF support.  End comment. 
TAYLOR