VZCZCXRO0516
PP RUEHIK
DE RUEHKV #0226/01 0411302
ZNR UUUUU ZZH
P 101302Z FEB 10
FM AMEMBASSY KYIV
TO RUEHC/SECSTATE WASHDC PRIORITY 9305
INFO RUEATRS/DEPT OF TREASURY WASHINGTON DC
RUCPDOC/DEPT OF COMMERCE WASHINGTON DC
RUCNCIS/CIS COLLECTIVE
RUEHZG/NATO EU COLLECTIVE

UNCLAS SECTION 01 OF 04 KYIV 000226 
 
SENSITIVE 
SIPDIS 
 
STATE FOR EUR/UMB, EEB/OMA 
 
E.O. 12958: N/A 
TAGS: EFIN EREL ELAB ECON ETRD PGOV PREL XH UP
SUBJECT: UKRAINE'S 2010 ECONOMIC OUTLOOK: UNCERTAINTY REMAINS AFTER 
THE COLLAPSE 
 
KYIV 00000226  001.2 OF 004 
 
 
SENSITIVE BUT UNCLASSIFIED, NOT FOR INTERNET DISTRIBUTION 
 
¶1. (SBU) Summary.  Ukraine suffered one of Europe's worst recessions 
in 2009, with real GDP declining nearly 15%.  The economic slump was 
prompted by a sharp fall in global demand for steel and chemical 
products, combined with the global credit crunch and vulnerabilities 
in the Ukrainian financial sector.  The GOU's reaction to the 
crisis, which included demanding advanced tax payments from 
corporQons and non-payment of overdue VAT refunds worth over $1.5 
billion, further harmed investor confidence.  As the January 2010 
presidential election approached, Prime Minister Tymoshenko refused 
to increase gas prices, reduce industrial subsidies, or reform the 
pension system.  Ukraine's 2010 outlook depends on the pace of 
political consolidation after the presidential election, external 
demand for Ukraine's key export products, and implementation of 
reforms that bring back the IMF, prompt investment, and facilitate 
lending.  End summary. 
 
UKRAINE'S GDP FREE FALL 
----------------------- 
 
¶2. (U) Ukraine's real GDP plummeted an estimated 14.8% in 2009, 
while overall industrial production declined 21.9%, according to 
recently released data from the State Statistics Committee and the 
National Bank of Ukraine (NBU).  Key labor intensive industries 
constituting 55% of the overall economy were hardest hit, with 
machine building suffering the largest decline (65.1%), and 
metallurgical and chemical sectors falling 26.6% and 23.2%, 
respectively. 
 
¶3. (U) In 2009, real household incomes fell 6.8% percent; the 
exchange rate, which depreciated over 40% from the start of the 
crisis, continued to fluctuate; and consumer lending froze up.  As a 
result, Ukraine's construction and retail sectors shrunk by 48% and 
16.6%, respectively.  The only bright spot in the economy was 
agriculture, whose 0.1% growth resulted from a bumper crop and 
steady domestic demand. 
 
FISCAL WOES 
----------- 
 
¶4. (SBU) Ukraine's 2009 total budget deficit reached an estimated 
10% of GDP, due to a collapse in revenues and the failure of 
Tymoshenko's government to cut spending.  A substantial portion of 
the fiscal gap was monetized by the NBU, which bought UAH 34.89 
billion ($4.36 billion) in domestic treasury bills in 2009.  Loans 
provided by the IMF and World Bank, in addition to the conversion of 
IMF special drawing rights, proved fungible sources of extra cash. 
The GOU also filled the budget gaps by requiring businesses to make 
enterprise profit tax payments in advance and by arm-twisting the 
NBU into transferring UAH 4.6 billion ($575 million) in expected 
future profits to government accounts. 
 
¶5. (SBU) By the end of 2009, the GOU had accumulated UAH 19 billion 
($2.38 billion) in outstanding VAT refund claims.   Of that figure, 
overdue (more than 60 days) payments are at the "record" level of 
UAH 12 billion ($1.5 billion), according to Kyiv-based experts. 
Embassy contacts have confirmed that the Tymoshenko government, 
under severe budget pressure, issued instructions in the fourth 
quarter of 2009 to withhold VAT refunds until after the presidential 
election. 
 
¶6. (SBU) An internal Cabinet of Ministers' memo, leaked to local 
media sources on January 27, showed that the GOU failed to pay 
significant sums to numerous ministries in 2009.  The overall 
shortfall was UAH 2.41 billon ($301 million), of which UAH 344 
million had been dedicated to the swine flu prevention effort, UAH 
480.43 million for election preparation, UAH 91.9 million for 
defense programs, UAH 121.4 million for the Ministry of Internal 
Affairs, and UAH 106.89 million for the Ministry of Agrarian Policy. 
 
 
DOMESTIC BORROWING SPIKED 
------------------------- 
 
¶7. (SBU) Attempting to finance the budget deficit in 2009, the GOU 
placed particular emphasis on expanding the domestic debt market. 
It sold UAH 18.8 billion ($2.35 billion) in short-term domestic 
treasury bills at primary auctions in 2009.  Weighted yields 
averaged 20.7% but spiked to 25% in December 2009, when the GOU 
struggled to make wage and pension payments while also rolling over 
maturing domestic securities.  The latest auction on February 2 
raised UAH 1.16 billion ($145 million) for domestic debt payments, 
with six-month bills sold at 23% and 32-month bills purchased at 
26%. 
 
 
KYIV 00000226  002.2 OF 004 
 
 
¶8. (SBU) Analysts expect that the short-term treasury bills will 
create debt servicing problems as early as the second quarter of 
2010, when the GOU needs to repay UAH 8.1 billion ($1.01 billion). 
To roll over these maturing domestic securities, the GOU may need to 
issue more treasury bills, possibly at higher interest rates. 
Another concern is that high bond yields will continue to "crowd 
out" investment in the real economy. 
 
FRAGILE BANKING SECTOR 
---------------------- 
 
¶9. (SBU) Large volumes of non-performing loans accumulated by banks 
(often exceeding 30%), combined with speculative pressure on the 
domestic currency, forced the NBU to tighten monetary policy and 
reserve requirements in 2009.  Banks have also fought against low 
consumer confidence, reporting an overall 8.3% decline in deposits. 
New lending remains extremely limited, with loan portfolios posting 
only 5% nominal growth in 2009, most of it to state-owned 
enterprises.  Mortgage loan volumes decreased ten-fold from 2008 
levels, according to industry sources.  Progress in creating bank 
restructuring mechanisms was offset by ongoing uncertainties over 
Nadra and Ukrprombank, two major financial institutions that have 
been under temporary administration for the past year. 
 
¶10. (SBU) Statistical indicators show that Ukraine's banking sector 
remains dangerously unstable.  Seven of the top eighteen banks in 
Ukraine have a capital adequacy ratio (CAR) of less than 10%, 
according to non-published statistics passed to the Embassy.  NBU 
refinancing has been doled out unevenly and in large quantities, 
with 11 of the top 18 banks receiving liquidity injections that 
constitute more than 10% of their total hryvnia-based credit 
portfolio.  Of Ukraine's top tier banks, 13 maintain provisions 
equal to at least 10% of their total credit portfolio, with three 
holding provisions at more than 40%.  Eight major banks rely on 
foreign currency lending for at least 60% of their credit portfolios 
and are thus heavily exposed to exchange rate fluctuations. 
 
IMBALANCE OF PAYMENTS 
--------------------- 
 
¶11. (U) Ukraine's current account deficit moved to $1.9 billion in 
2009, an improvement over the $12.8 billion deficit registered in 
¶2008.  This shift reflected a significant decline in imports of 
manufactured and consumer products for the year, combined with 
growth in steel and chemical exports during the second half of 2009. 
 
 
¶12. (U) The financial account worsened in 2009, due to the stoppage 
of foreign capital flows, foreign debt repayments by the banking 
sector, and a surge of hard currency purchases.  Compared to the 
same period in 2008 when inflows were $9.6 billion in surplus, 2009 
financial account figures indicated a deficit of $11.8 billion. 
 
¶13. (SBU) Ukraine's population continues to horde hard currency, 
especially dollars, as a store of wealth and as a hedge against 
currency depreciation.  In an uncertain political environment and 
where trust in the banking sector remains low, Ukraine's total hard 
currency purchases were $9.6 billion in 2009.  The NBU covered the 
imbalance with its gross currency reserves, which stood at $26.5 
billion at the end of 2009, equivalent to roughly five months of 
imports. 
 
EXTERNAL MARKETS MODERATE EXPORT DECLINES 
----------------------------------------- 
 
¶14. (SBU) Ukrainian steel and chemical exports were supported by 
currency depreciation, transportation subsidies for steel producers, 
and energy subsidies for steel and chemical plants.  Although steel 
and chemical exports for the year fell significantly, recovery in 
the markets of Ukraine's major trading partners, particularly Russia 
and China, provided some relief by the end of the year. 
 
¶15. (U) All major steel indicators fell sharply in 2009.  Crude 
steel production plummeted 20% to 29.8 million tons, pig iron fell 
17% to 25.7 million tons, and finished rolled steel output declined 
15% to 26.9 million tons, according to government statistics. 
 
¶16. (SBU) Steel producers have told Embassy officials that 
short-term orders from Russia and East Asia helped Ukraine register 
a jump in industrial production in recent months, with statistics 
benefitting from low 2008 base numbers.  December industrial output 
grew 7.2%, year-on-year, with metallurgy advancing 27.3% and 
chemicals gaining 17.4%.  January 2010 steel output also jumped 
significantly, with finished rolled steel production up 20%, y-o-y, 
to 2.4 million tons.  Without much external demand, however, the 
machine building sector was stagnant, with no signs of recovery in 
 
KYIV 00000226  003.2 OF 004 
 
 
the fourth quarter and a 2.5% decline in December, y-o-y. 
 
MODERATE INFLATON 
----------------- 
 
¶17. (SBU) Ukraine had comparatively moderate price growth in 2009. 
Its lower than expected 12.3% inflation rate reflected the 
government's decision to postpone most major increases in utility 
rates, particularly residential gas rates that had been slated to 
rise toward cost recovery levels.  Utility rates grew only 8.2% in 
2009, as opposed to 28.2% in 2008.  The bulk of the price increases 
(6.9%) was registered in the first four months of 2009, mostly 
driven by inflation in imported products and sharp currency 
depreciation at the end of 2008.  As Ukraine's currency stabilized 
and demand for consumer products fell, inflation moderated during 
the latter half of 2009.  Ukraine's strong 2009 harvest limited food 
price growth to 10.9%, down from 24.5% in 2008.  Public 
transportation rates grew only 10% in 2009, as opposed to 46.6% in 
¶2008. 
 
¶18. (SBU) Expected increases in 2010 transportation and residential 
gas rates will likely add 3-6 percentage points to inflation, 
according to Kyiv-based analysts at Astrum Investment and Concorde 
Capital.  As a result, experts project Ukraine's 2010 inflation 
could exceed 2009 levels, contrary to the official forecast of 9.3%. 
 
 
2010 ECONOMIC OUTLOOK 
--------------------- 
 
¶19. (SBU) Ukraine's 2010 outlook depends on the pace of political 
consolidation after the presidential election, external demand for 
Ukraine's key export products, and implementation of reforms to 
bring back the IMF, prompt investment, and facilitate lending.  A 
protracted Tymoshenko challenge of the second round presidential 
election results, despite the apparent victory of Viktor Yanukovych, 
would postpone the formation of a new government and delay needed 
economic reform.  This, in turn, would place significant pressure on 
the IMF, which has put off its engagement until political 
consolidation yields a slate of authorities with which it can 
negotiate. 
 
¶20. (SBU) Budget problems are likely to remain the largest concern 
for the GOU in 2010.  After the presidential election, the new 
government may have more political maneuverability to address its 
deficit by passing a sound budget and enacting tough reforms to 
address gas pricing and the pension system.  However, the state 
cupboard is now bare, making broad first quarter budget arrears all 
but inevitable. 
 
¶21. (SBU) Ukraine's difficult business environment, which has only 
worsened during the 2009 fiscal crisis, will continue to have a 
negative impact on investment in 2010.  The obligation to pay back 
accumulated VAT refund arrears will also be a challenge for 
Ukraine's cash-strapped government.  The Ministry of Finance has 
already announced it will allocate only UAH 1.3 billion monthly to 
pay VAT refunds during the first quarter of 2010, lower than the 
2009 minimum monthly refund of UAH 2 billion.  Further accumulation 
of VAT arrears has severely limited corporate working capital and 
poisoned the well for potential investors. 
 
¶22. (SBU) To improve investor confidence and bring back the IMF and 
other external lending, the new President and government will have 
to push through a major, and painful, reform package in the early 
days after the inauguration.  Without reforms that put the IMF 
program back on track, investment and bank lending will continue to 
be absent.  Investors are wary, but many still think some of 
Ukraine's key sectors (especially agriculture, pharmaceuticals, and 
food processing) are excellent medium-term bets. 
 
¶23. (SBU) Most experts project modest economic growth in 2010, 
including 2.7% GDP forecast by the IMF and 3% GDP growth foreseen by 
the EBRD.  The revival of Ukrainian metallurgy sector is expected to 
be the largest economic driver and will also contribute to shrinking 
Ukraine's current account deficit.  However, factors causing an 
imbalanced 2009 financial account (i.e. a sharp decline in 
investment inflows and increased corporate payments to external 
creditors) will likely continue in 2010.  Any political uncertainty 
could ward off sources of financing and further distress investors 
and the banking sector. 
 
COMMENT 
------- 
 
¶24. (SBU) In an environment where fiscal pressures will likely lead 
to significant payment arrears in March, a signal from the IMF that 
 
KYIV 00000226  004.2 OF 004 
 
 
it is reengaging is considered vital.  On the other hand, the IMF 
will run into reputational risks if it comes back too early or if 
Yanukovych follows through on a budget-busting promise to raise 
state sector wages and pensions.  IMF and World Bank-supported 
reforms will likely be accepted by the public and are unlikely to 
lead to large-scale social unrest.  Our baseline expectation is that 
investment numbers will not increase notably until later in 2010. 
Business investors will be watching for the new President's economic 
reform agenda, anxious to see signals of commitment before coming 
back to Ukraine in anything but a very tentative fashion. 
 
TEFFT