Geoff Smith of Renaissance Capital -

Already tense relations between Ukraine's President Viktor Yushchenko and Prime Minister Yulia Tymoshenko have boiled over into open conflict over the past month. Disputes between the presidential camp and the government over control of the State Property Fund (SPF) and privatisation have escalated to a point where the ruling coalition's collapse seems as likely as any more positive outcome.

Political rivalry between Yushchenko and Tymoshenko emerged almost immediately after the Orange Revolution, in 2004/2005, therefore the travails of the current coalition should come as no surprise. The question arising from this tension has been: what would be the immediate cause of a serious rift? The answer, it seems, is control of the SPF and the execution of privatisations.

The government has been trying to dismiss Semenyuk-Samsonenko, a Socialist Party member appointed as head of the SPF under the former government, to allow it to implement its ambitious privatisation plan for this year. The original list of objects slated for sale included 67.79% of Ukrtelecom (UTEL), 99.52% of Odessa Portside Plant (OPZ), and blocking stakes in six regional electricity distribution companies. The government then added stakes of 60% plus one share in four generation companies (gencos) to the list. The most recent comments from the government suggest that the revised budget draft for 2008 will assume receipts of UAH9bn ($1.78bn) from privatisations this year - a figure that could be exceeded by the sale of the UTEL stake alone, in our view.

Under the constitution, only a vote by the Rada can dismiss the head of the SPF. If Yushchenko's Our Ukraine-National Self-Defence bloc was as committed to dismissing the incumbent as the Bloc Yulia Tymoshenko, the senior coalition partner, this would be a formality, even though the coalition has only a five-seat majority. However, it is not, so no date has been set for such a vote.

For much of January and February, the Rada was blocked by opposition deputies protesting an unrelated issue (namely, Nato membership). Tymoshenko reacted by issuing a decree dismissing Semenyuk-Samsonenko, and appointing her own party colleague, Andrei Portnov, as acting SPF head. Yushchenko then suspended the PM's decree with one of his own. The formal excuse of unconstitutionality was, in our view, well-founded. Nevertheless, remarks by the president's own staff made clear at the same time that they were more concerned by the threat of Tymoshenko using a privatisation windfall to raise social spending, in order to boost her own popularity (consequently fuelling inflation).

As headline inflation surged to 26.2% on year in March, the government appeared to placate the presidential camp and the National Bank of Ukraine by committing itself to keeping public spending at no more than 26.1% of GDP this year, and to keeping surplus privatisation revenues on special treasury accounts, rather than using them to fund current spending. However, the government has still missed more than one self-imposed deadline for presenting a full, revised budget for 2008 to the Rada.

The presidential camp was not convinced. In mid-April, Yushchenko vetoed first the genco sales and then the OPZ deal, identifying them as strategic assets. Until then, Semenyuk-Samsonenko's deputies at the SPF had pressed ahead with technical plans for the privatisations, publishing preliminary auction conditions for OPZ, the distcos and UTEL. Semenyuk-Samsonenko has now suspended Dmitry Parfyonenko, the deputy who led these preparations.

The government has responded with a dramatic escalation. In late April, Tymoshenko ordered Portnov to ignore Yushchenko's veto and proceed with the sales. She also dismissed a protest from the prosecutor-general's office over the decree dismissing Semenyuk-Samsonenko.

Portnov now claims to have appropriated the official stamps and seals of the SPF, despite being barred from its premises by the current head. On May 7, he ordered the destruction of the whole print run of the official daily gazette on privatisation. In such circumstances, we see little chance of any privatisations taking place at all, let alone in the transparent, legally secure and revenue-generating manner that the government promised at the start of the year.

Likely consequences

The longer this situation goes on, the more politically damaging it will be for both sides, in our view. An opinion poll, published last Wednesday by FOM-Ukraine, indicates falling approval ratings for both Tymoshenko and Yushchenko. According to the poll results, Tymoshenko is now the first choice of only 23.7% of Ukrainians as president, while only 8% would vote for Yushchenko. Ex-PM Viktor Yanukovych made up ground on Tymoshenko, but still lags her with 21.2%.

This development is significant, as our core assumption has been that Tymoshenko's rivals would not try to bring her down and force new elections as long as her popularity ratings were improving. Even now, we would be surprised if the government were dismissed, as it suits the opposition for the PM to take responsibility for Ukraine's current inflationary problem over the short term.

However, her rivals may become bolder when the usual seasonal effects bring food inflation down in the summer.

The most market-friendly outcome would no doubt be reconciliation at the top, followed by an orderly vote and a succession of orderly sales within the framework of the informal April agreement. Admittedly, it is difficult to see a way to there from here at present, but as political will created the current situation, we think it can resolve it. Another possible - if unlikely - outcome is that of the Tymoshenko bloc achieving a majority by convincing opposition deputies that the president's stance is damaging the national interest. This would also suppose that Rada speaker Arseny Yatsenyuk, a Yushchenko loyalist, can be persuaded to schedule a vote.

So far, so familiar. Ukraine has seen this all before over the past four years, and the economy has still grown strongly, driven by both household consumption and corporate investment. We would not necessarily expect either trend to break in the event of the current coalition's collapse. However, the country can ill afford a policy deadlock with annual inflation at 30.2% and with the current account deficit widening to 9.3% of GDP in 1Q08 (we expect a deficit of 8.1% of GDP for the full year). A government collapse could also delay reforms - especially those on pensions and the liberalisation of Ukraine's land market - that, in our view, are central to the country's medium-term investment case.

Choice of tactics causes concern

We are also concerned by the government's increasing recourse to the courts, and to the threat of criminal investigation of those blocking its political aims. In our view, the emergence of democracy and a genuinely law-based society in Ukraine, with all the benefits that must bring for the investment climate, depends on the government of the day refraining from interference in the judicial system, however great the provocation. As it is, prosecutors have opened a criminal investigation into Semenyuk-Samsonenko on allegations of irregularities in past privatisation deals. Local media reported her as denying any wrongdoing and calling the accusations politically motivated.

As regards this year's planned sales, the government is basing the legality of its actions on a ruling from a Kyiv district court suspending Yushchenko's vetoes - a tactic familiar from the corporate disputes that have given the country such a bad name among investors for most of the past 17 years. We also note the threat implicit in Tymoshenko's comments casting doubt on the legality of over 1,600 land privatisations, which stands in stark contrast to her much-moderated rhetoric on corporate privatisations before last year's elections.

Nonetheless, we think the PM is justifiably frustrated with her coalition partners, whose overriding aim at present appears to be to stop her from establishing a record for competent government. At the instigation of presidential chief-of-staff Viktor Baloha, several heavyweights in the president's bloc have defected to form a new party, which is attacking Tymoshenko much more openly than her coalition partners can. Small wonder that Interior Minister Yuri Lutsenko, head of the National Self- Defence wing of the party, is now calling for Baloha's dismissal.

Whatever the legality of Yushchenko's decrees, we note that the presidential camp's intervention in the government's management of the economy and budget contradicts at least the spirit of the coalition agreement. The Tymoshenko bloc may be failing to live up to its part of the bargain - notably in missing deadlines to present a revised 2008 budget to the Rada - but the division of cabinet portfolios in December made it quite clear that the president's natural sphere of influence is rather internal and external security.

We also find it inconsistent that Yushchenko is investing such political energy in defending Semenyuk-Samsonenko, on whose record he poured scorn at a press conference in the Kremlin in February. The only deal of note she oversaw last year was the sale of 76% of Luganskteplovoz (LTPL) for a price well below what we consider to be its true value at an auction contested only by two affiliates of the same company. It has since been overturned by the Supreme Court. The allegations against her relate to other deals.

Conclusions

Unless the parties patch up their differences and concentrate on fighting inflation, we think equity valuations are likely to receive little support from the political and macroeconomic environment.

Such political disputes have always been characteristic of Ukraine's young democracy, which has a separation of powers that tends to weaken government and encourage competition between various organs of state. Therefore, whatever the outcome of the current dispute, we think similar tensions are likely to recur until constitutional reform tilts the balance of power firmly towards either the president or the parliamentary majority. This appears unlikely to happen until after the next presidential elections.

In the meantime, we view the rivalry between Yushchenko and Tymoshenko as natural and legitimate. In a coalition-based system, divisions between coalition partners always dominate the political press, and Ukraine is no different from Germany in this regard. Where it differs from Germany (and is more similar to Italy and Belgium) is in the inability of its political elite to commit to a coalition agreement and see it through for a full parliamentary term. The Western European experience suggests that countries with such political indiscipline are doomed to lower growth rates and higher inflation. It's a lesson that the economic data are already emphasising.

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