Tim Gosling in Moscow -

Stuck between demands for further reform and rapidly dwindling popularity, Ukraine's government is predicted by analysts to opt for the populist route ahead of parliamentary elections next year and postpone cooperation with the International Monetary Fund (IMF). It should get away with it - as long as global liquidity remains high.

Kyiv agreed to implement a raft of reforms when it secured a $15bn bailout with the IMF in summer 2010, and promptly provoked outrage amongst the population when it raised gas prices and proposed changes to the tax regime soon after. That earned the government two tranches under the IMF stand-by programme totaling $3.4bn.

However, despite pushing on with independence for the central bank and liberalisation of the foreign exchange markets, progress on the most important issues has slowed dramatically this year in the face of opposition from the electorate. Meanwhile, although the IMF has softened its stance somewhat, it looks unwilling to cede further ground, having already delayed the next payment by two months.

The IMF's Ukraine representative Max Alier repeated on May 16 that among the key requirements to qualify for a third tranche are pension reform - including moving the female pension age to 60 - and another rise in utilities prices. But with reports suggesting as much as 90% of the population opposes these measures, they may be too tough a sell for the government right now - especially given President Viktor Yanukovych's approval ratings plummeted close to single digits in April. Despite almost daily appeals by officials in the media looking to persuade the population that pension reform is "vital," such reform is yet to even make it into the Verkhona Rada for initial discussion, and time is running out. "While the government has been understandably leery of pushing too hard on the reform peddle, hoping to avoid a black eye like the pushback surrounding its tax reform in fall 2010, we have also seen little activity to involve critics on developing more palatable solutions," points out Brad Wells at Concorde Capital.

The current parliament session breaks on July 8 for its summer recess, and with parliamentary elections set for October 2012, it's starting to look unlikely that Kyiv will satisfy the IMF's demands soon. "A more likely scenario," reckons Olena Bilan at Dragon Capital, is that "Ukraine will turn to the IMF again after the parliamentary elections, when the window of opportunity for unpopular policy measures will reopen."

In other words, Ukraine and the IMF look likely to embark on a temporary separation until 2013 at least.

Wiggle room

Adding weight to such ideas is the relatively healthy state of the government's finances, which should give the government some political wiggle room. Replenished by earlier IMF disbursements and inflows of foreign capital, central bank reserves hit a new historical high of $38bn in April, whilst economic recovery and strong budget revenue growth (28% in the first quarter of the year) offer the option of delaying cooperation. That position of strength also suggests the country is unlikely to face short-term economic challenges. Conversely, "raising charges for utilities and gas would only add to rising inflation," points out Alexei Moiseev, chief economist at VTB Capital.

Neither should the lack of new IMF loans hit Ukraine's ability to borrow internationally to plug a budget deficit expected to come in at a minimum of 2.8% this year - at least not in the short term.

Although Ukrainian Eurobond spreads are likely to move out as the mid-June deadline for the reforms approaches, the cost increase for the country to borrow should be limited enough. Bilan expects five-year credit default spreads for Ukraine (contracts that protect bondholders against the risk of default), currently at 455 basis points (bps), could widen by about 100 bps in response, with sovereign Eurobond yields adjusting accordingly, "but we still expect the Finance Ministry to tap the Eurobond market later this year."

Moiseev believes the immediate impact is likely to be minimal as long as global liquidity remains so high. However, he says the country's access to debt markets could suffer next year following the US move to normalise its monetary policy. "Historically, Ukraine has always been seen as one of the most risky emerging markets, and is the first to lose access."

Cutting loose from the anchor

The less tangible effects of Ukraine's timeout in its relationship with the stand-by programme provide more reason for apprehension, however. "The key concern," suggests Bilan, "is that without the external anchor the IMF has been, fiscal discipline may worsen ahead of the elections and actual contraction of the general government deficit in the coming years will be much more modest than demanded by the IMF (from 5.7% of GDP in 2010 to 2.8% this year and 2.5% in 2012), despite strong budget revenue growth.

Moiseev, meanwhile, worries about the effects a temporary estrangement could have on investment. "The IMF programme is most important in terms of the comfort it offers to foreign banks, which are needed to power economic development by leaning to private investors. The private banks don't want to be the lenders of last resort - they only like to lend when a country doesn't really need to borrow of course," he notes.