Tough words from IMF for Kyiv, but EU prepares to pay bill

By bne IntelliNews November 1, 2013

Ben Aris in Moscow -

The International Monetary Fund (IMF) issued a strongly worded statement on October 31 listing all the things that Ukraine will have to do before it gets access to a new and desperately needed stand-by loan deal. But despite the tough talk, the IMF's statement is largely posturing.

The IMF said a team led by Nikolay Gueorguiev visited Kyiv during October 17-29 to hold discussions with the Ukranian government and while it noted that the economy shows signs of improvement, considerable challenges remain. "Limited exchange rate flexibility, a large budget deficit, and sizable quasi-fiscal losses in the energy sector have given rise to a large external current account deficit and a steady loss of foreign exchange reserves," it noted in the statement. "An ambitious fiscal consolidation is needed to reduce the budget's large financing needs and support external adjustment... The large loss-making energy sector needs to be reformed... Improving the business climate is imperative for high and sustainable growth."

Tough words. But according to reports, the EU and IMF are in emergency talks to work out who is going to foot the bill for taking Ukraine under the EU's umbrella instead of allowing it to join the Russian-led Customs Union. The bottom line is that the IMF has no choice but to restart its stand-by agreement irrespective of whether Kyiv keeps its reform promises or not.

The tug-of-war to win over Ukraine's allegiances will come to a head at the end of November at an EU summit in Vilnius, when Kyiv is expected to sign off on association and free trade agreements with the EU that would effectively shut it out of the Customs Union.

Moscow has been playing hardball and has threatened to, in effect, impose trade restrictions on Ukraine; Russia takes about 40% of Ukraine's exports. But the Russian state-owned gas monopolist Gazprom upped the stakes this week saying it will insist on Ukraine sticking to the take-or-pay gas supply deal and will hit the Ukrainian national gas company Naftogaz with a bill for just under $1bn if it signs on the dotted in Lithuania.

A Ukrainian delegation was rushed to Moscow on October 31 to negotiate with Gazprom, the government announced. But Gazprom released a statement the same day saying no meeting was planned; in any case, a meeting would be unnecessary as the matter was simple: Ukraine owes the Russian company a lot of money and it will have to pay. If it doesn't, either Gazprom will go back to demanding pre-payments from Naftogaz or it will simply turn off the gas spigots in a repeat of the row over unpaid bills in 2006 and 2009.

The fracas has restarted talk of a "gas war" between Russia and Ukraine that could leave a large part of Europe without fuel as the winter closes in. But the issue is simpler than that: the EU has decided to abandon its reservations over letting Ukraine into its club and will have to pay the bill imposed by Russia as a result.

Ukraine's economy is tanking as it goes into its fifth consecutive quarter of recession and hard currency reserves have been dwindling at an alarming rate in recent months. To make matters worse, it faces some $3bn of bond redemptions in the last quarter of this year and another $7.1bn next year. The country simply doesn't have the money to pay and so faces a sharp devaluation and/or a banking crisis as a result.

This was clear from the outset. And despite all the outrage over Russian bullying, Gazprom does have a point: why should Russia subsidise Ukraine with cheap gas, or even give it easy payment terms, if Ukraine is so determined to turn its back on Moscow and join the EU? Former Ukrainian prime minister Yulia Tymoshenko may have agreed to rotten terms with Gazprom in 2009 (which is ostensibly the reason she is in jail, though most suspect it was for political reasons), but a deal is a deal and a contract is a contract, so the fuel has to be paid for unless Ukraine can either renegotiate or find gas supplies from somewhere else.

In the meantime the EU is obliged to bail out Ukraine. Brussels has already said it has put $610m aside to help Ukraine out its current hole, but this money will not even last a month given the size of the bond redemptions coming - not to mention the need to replenish Ukraine's hard currency reserves and bring them back above at least the three months of import cover that economists say countries' need to ensure the stability of their currencies.

It remains to be seen if working so hard to bring Ukraine into the European club will work out to be a good deal for the EU. In the short term it will certainly cost them a pretty penny. In addition to the cash, the EU has already agreed to rush Ukraine's application through and fast track the trade deal in the hope that rising trade will bail the economy out. The other EU-member aspirants at the Vilnius summit, including plucky Moldova which faced down blatant trade sanctions from Russia, have been told it will take years for these same deals to be put into practice. They are miffed.

However, none of the EU's maneuvering will make much difference without a an immediate new IMF deal on the order of $10bn-$15bn.

Part of the reason Ukraine is in such a mess now is that the IMF has been notoriously soft on the country under the previous stand-by deal, which was eventually frozen for non-compliance with its terms after Ukrainian President Viktor Yanukovych assumed office.

The IMF's statement on October 31 trotted out the same terms again, including the key requirement of hiking domestic gas tariffs, in an effort to show that this time round it would actually insist on Kyiv sticking to its promises. However, it seems likely that Yanukovych has made a sweet calculation: the EU can't let Ukraine collapse into crisis almost the next day after signing an free trade association deal. So he can be pretty sure that the IMF will come up with bailout cash very fast irrespective of what he does in the way of reforms (or more to the point, irrespective of what he fails to do in the way of promised reforms).

Yanukovych is playing a purely tactical game. His popularity is sinking just as he faces fresh presidential elections in 2015, yet the country's finances have deteriorated to the point where it will face a crisis before the end of this year and the government has no way of raising more money to see it thought to 2015. The EU deal will give him enough money to muddle through to 2015 and it will also help his election prospects as 60% of Ukrainians want the country to join the EU rather than the Customs Union.

The alternative was to do a deal with the Russians, but that surely would have meant selling off some of the country's industrial crown jewels to Kremlin-connected oligarchs, not to mention losing control over the gas pipelines.

The IMF can say what it likes, but it will have to play ball very soon, or else the EU and everyone else in the West will look extremely foolish.

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