Geoffrey Smith of Renaissance Capital -

On January 10, Ukraine's Supreme Court upheld rulings by two lower courts that annulled last year's privatisation of the train locomotive manufacturer Luganskteplovoz. This means the 76% stake, sold for less than $60m, will be returned to the State Property Fund.

Just as in 2005, the Orange government acutely needs to establish a track record of free and fair privatisations - both to maximise revenue from its remaining portfolio of holdings, and to build confidence in its general ability to execute the functions of state fairly and effectively, rather than continue an endless cycle of property redistribution.

One ruling does not make such a trend. However, we do not dispute the need for Thursday's decision per se: the auction was contested only by two affiliates of the same company, Russia's ZAO Transmashholding. Other registered bidders, including Siemens, were told the auction had been postponed, and inexplicably only the Transmashholding affiliates received notification of the sale being resumed. Transmashholding paid less than $60m for a stake widely valued at three times that ahead of the auction. Thursday's decision does at least reassure us that the Ukrainian state is able to defend its interests as a shareholder, which is a positive, albeit minimal, precondition for a healthy investment climate in any country.

But the Luganskteplovoz case has an influence on the overall investment climate that goes beyond traditional fears about the security of property rights, and even beyond its ability to plug part of the UAH12bn (€1.6bn) funding gap caused by its compensation scheme for savers in the former USSR savings bank.

Part of the investment case for Ukrainian equities rests on the possibility of their being bought out by Russian strategic investors. To this extent, the news of Evraz's agreement to buy out some of Privat Group's mining and metallurgical assets at the end of last year was extremely positive, being the largest Russian-Ukrainian M&A deal in years. However, given the friendly relations between Privat Group and members of the new government, it didn't prove that all political taboos about Russian ownership of Ukrainian industrial assets had been abandoned.

Transmashholding, in contrast to Evraz, is a company close to one of Russia's largest power centres, state-owned Russian Railways, or RZhD. How the Ukrainian government will treat it in the Luganskteplovoz case this year will be, to a degree, a litmus test of Russian-Ukrainian relations in general.

In purely business terms, Transmashholding is in many ways the most natural buyer for Luganskteplovoz. It needs the diesel locomotives that Luganskteplovoz makes, and it has by far the best contacts with RZhD which, as the world's largest transport company, is likely to remain Luganskteplovoz's biggest customer. However, it is an eminently Russian national champion in the rolling-stock industry, the kind of buyer that cannot expand in Ukraine without touching national sensitivities. An outcome that definitively signals that entities of this kind are also allowed to buy important Ukrainian industrial assets would argue for building a larger buy-out premium, in general, into Ukrainian stocks.

On past experience, it would be well within the capabilities of both sides to sabotage an economically rational deal for reasons of political expediency, or worse. However, we think that an orderly resale, at a proper market price, is the most rational and the most likely outcome. In its heart of hearts, Transmashholding must know that it did not pay a market price for its asset, while, the Yukia Tymoshenko-led government must be aware that its new budget assumptions depend heavily on a sharp rise in privatisation receipts, and that an orderly resale of the asset could generate a good part of that.

The risk to that benign outcome is of course real. Transmashholding could boycott the resale, pull its orders from Luganskteplovoz as promised, and continue to isolate it from its core market. Worse, a credible threat of such behaviour by Transmashholding could deter possible interested parties, such as Siemens and Bombardier, from bidding, leaving the sale to be contested only by Ukrainian bidders and resulting in a lower sale price and yet another round of accusations of naked property redistribution. This could leave all privatised Ukrainian assets to labour indefinitely under political risk discounts.

However, Transmashholding also faces risks from this tactic. RZhD, its main client, is under pressure to invest and modernise rapidly, and Transmashholding's ability to source technically-suitable locomotives from alternative sources within a tight timeframe is limited.

The government has no hard-and-fast list of assets to privatise and renationalise this year. In her election campaign, Prime Minister Tymoshenko largely limited her calls to review the outcome of privatisations to three specific assets - Luganskteplovoz, Dniproenergo and Nikopol Ferroalloys Plant. Any expansion of the agenda beyond these three would clearly be negative for the investment climate, and even these three deals alone have the ability to undermine the Ukraine investment case unless the government goes about its business fairly and transparently. As such, we have substantial room for disappointment, but here, as elsewhere in the Russian-speaking world, hope dies last.

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