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The Ukrainian government has been making progress in meeting the IMF demands before it starts receiving the money from the latest $14.9bn stand-by deal, but the process hit a snag on July 13 after the Fund's sister organisation, the World Bank, accused the central bank of covering up the true state of problems in the banking sector.

Officials from the World Bank said that the lack of growth in lending in the banking sector, despite a return to economic growth, was due to the dire state of banks' finances in the country and "evidence of ineffective large-scale financial support for credit and financial institutions by the National Bank of Ukraine (NBU)," according to World Bank project coordinator for Ukraine Angela Prigozhina.

"The NBU issued large amounts of funds to the banking system. Why is the banking system not crediting the economy?... It's probably that many of the institutions [that gained NBU's stabilization credits] are actually insolvent. They cannot credit the economy today under any circumstances," she said at a roundtable, reported Interfax.

The government encouraged investors the following day when it voted through 50% hikes to gas tariffs for domestic consumers, which has been a key demand of the IMF, but ignored by the previous Ukrainian administration under former prime minister and now Ukrainian opposition leader Yulia Tymoshenko. The gas tariff hike is a big deal: it shows that the government is prepared to bite the bullet on this key issue. Still, the picture is mixed, as there are many other issues that need biting too.

First Deputy Economy Minister Anatoliy Maksiuta said that the situation with credit is very challenging. "We establish a fact that the Ukrainian financial sector does not fulfil the function of financially supporting stable economic development in the proper way... We do not, in fact, have long-term resources and we cannot realize long-term public and private goals," he said, reported the newswire.

The accusation is serious, as while the press were triumphant on the new IMF deal, in reality the announcement was only a "staff level agreement" that is a technical agreement. It means that the IMF has agreed in principle to release the money, if, and only if, the conditions laid out in the agreement are met. In other words the money may not appear if the state fails to jump through all the hoops specified in the staff level agreement and the stand-by agreement is not a done deals.

Wrongheaded

The decision to hike gas tariffs shows that the government is committed to attempting to meet the IMF's demands, but the World Bank's criticism shows too that the gap to be closed is still wide.

What worries investors is that the government's motives are wrongheaded. "It is all about getting cash at the moment," says a banking source in Kyiv. "The government is totally focused on raising money from where ever it can, but this doesn't mean there is any kind of plan and none of the money raised so far - like the Russian $2bn loan - has been earmarked for investment projects into things like infrastructure. They are just driving up debt at the moment."

In response, the NBU immediately called on banks to get their house in order. The NBU has demanded they take active measures to improve their financial state and their observation of the requirements of banking law. "The banks are to take urgent measures to cut risks that impact, or could impact, their financial state, create the threat of the non-fulfilment of banks' liabilities to their clients, or lead to infringements of current banking laws and NBU resolutions," reads an NBU letter to banks, which was forwarded to Interfax.

The letter says that the NBU is waiting for the banks to fulfil the liabilities they undertook in financial readjustment and liquidity increase programmes in order to receive NBU refinancing credits.

The World Bank's harangue also restarted the debate over the creation of a so-called "bad bank" where banks' bad debt can be parked as part of an effort to clean up their balance sheets following last year's crisis. "The banking system won't work until we find an effective solution to the problem of bad assets. We should find financing [for the creation of a bailout bank] even in the existing conditions," Yuriy Poluneyev, the secretary of the parliamentary committee on finance and banking activity, was quoted by Interfax as saying.

The government needs to allocate UAH3bn-5bn for the creation of a bad bank before the end of the year as part of a total UAH10bn that's estimated would be needed to make the bad bank effective. Other analysis says that the banking sector as a whole needs some UAH40bn of recapitalisation to put it back on its feet.

However, the idea of a bad bank remains controversial too. The head of Ukraine's IFC office Olena Voloshina said this week of the bad bank idea: "We don't think this is a good idea. This [the problem of bad assets] should be solved through private sector structures. The state, for its part, should simply create the rules of the game."

Consolidation

Still, some progress is being made on other fronts. The NBU may be fluffing the deal with the big banks, but it has started pushing for consolidation in the sector, which is also badly needed.

The NBU has mandated a boost in the minimum capital requirements for banks that should result in reduction in the number of small banks, as more of Ukraine's limited resources will be concentrated in the pockets of bigger banks - a good thing. As reported, NBU resolution No. 273, which was registered in the Justice Ministry on July 6, will come into effect on July 19. In the resolution, the NBU obliged Ukrainian banks to bring their regulatory capital to at least UAH120m by January 1, 2012.

The rule will certainly bring some short-term pain. "The public will see negative consequences from this innovation, as depositors are restricted in the selection of banks to place their funds. Small and medium banks are deprived of a chance to boost their deposit portfolios, as sources for raising funds will be decreased for these financial and credit institutions," reads an UCBU press release, reports Interfax. "The new requirements on the size of regulatory capital will lead to a cut in competition on the banking service market, as medium and small banks and non-banking institutions are effectively being forced out of the financial sector. The level of services will worsen and their cost will grow."

More worrying is the state's efforts to curb the independence of the NBU: despite the central bank's middling performance on rescuing the banking sector, it remains a competent regulator. But like in most young democracies, some in central government are lusting after more control over the bank and its billions of dollars in resources.

The government has put up amendments to the law on the NBU that will reduce its independence and caused howls of protest by the World Bank. Angela Prigozhina said at a roundtable on July 13 that the realization of key requirements of the law aimed at increasing the central bank's independence from political forces and business groups is being delayed: the NBU Council will continue to have members who have conflicts of interest. "Unfortunately, the requirement [safeguarding the NBU Council from representatives of political forces or business circles] takes effect no earlier than two to five years, depending on the dates of appointments of council members. This undermines confidence in effectiveness of the law," she said. "The requirement should come into effect immediately."

Prigozhina also slammed the present system for banks' access to the NBU resources and supported the introduction of instruments that are alternative to deposits, so that the public can invest their money (including in state-secured instruments).