Welcome to the U.S.-Ukraine Business Council

Friday, August 7, 2009
Kyiv, Ukraine
UKRAINE BUSINESS NEWS: FOUR ARTICLES

1.  UKRAINE - Q2 BALANCE OF PAYMENTS PROVIDES ROOM FOR OPTIMISM 
Analysis & Commentary: Timothy Ash 
Local Markets Strategy, LM Alert, CEEMEA
Royal Bank of Scotland, London UK, Thursday, July 23, 2009 

2.  UKRAINIAN PRESIDENT MEETS WITH SIX U.S. CONGRESSMEN
Presidential Press Service, Kyiv, Ukraine, Friday, August 7, 2009

3. CHEVRON JOINS THE U.S.-UKRAINE BUSINESS COUNCIL (USUBC)
Finding Newer, Cleaner Ways to Power the World, Providing Energy for Human Progress
U.S.-Ukraine Business Council (USUBC)
Wash, D.C.,Wed, Aug 5, 2009 

4. UKRAINE TRIP REPORT: POLITICAL OUTLOOK, RUSSIA, GAS,
IMF, BUDGET/DEBT FINANCING, BALANCE OF PAYMENTS, 
EXCHANGE RATE, BANKING SECTOR REFORM
Ukraine Trip Report: By Timothy Ash, RBS GBM
Royal Bank of Scotland, London, UK, Monday, July 20, 2009 
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1. UKRAINE - Q2 BALANCE OF PAYMENTS PROVIDES ROOM FOR OPTIMISM 

Analysis & Commentary: Timothy Ash 
Local Markets Strategy, LM Alert, CEEMEA
Royal Bank of Scotland, London UK, Thursday, July 23, 2009 

The National Bank of Ukraine (NBU) has released balance of payments data for Q2 2009, which does show some encouraging signs/prospects for a period of greater stability for the UAH.

HIGHLIGHTS HEREIN INCLUDE: 

(1) The current account actually recorded a surplus of US$162m in Q2 2009, a remarkable turnaround from the US$3.4bn deficit posted for the comparable quarter in 2008. This also represented the first quarterly surplus recorded since Q3 2006. On a 12m moving average basis the current account deficit is currently running at around US$6.5bn, half the record US$12.9bn deficit posted for the full year in 2008. Given current trends for the full year in 2009, the current account is expected to come in flat.

(2) Much of the improvement on the current account was driven by the improving merchandise trade account. Herein the deficit narrowed to US$655m in Q2 2009, from US$4.4bn one year earlier. While exports were down by 51.4% YOY largely driven by lower prices/volumes of steel exports (40% of exports), imports were lower by a staggering 57.4% YOY.

The 40%+ nominal depreciation of the UAH, and the huge deflation in domestic demand on-going which might have produced a 15-20% YOY contraction in real GDP in H1 2009, has driven this latter contraction.

(3 The surplus on services narrowed slightly to US$422m in Q2, from US$492m one year earlier, perhaps reflective of much lower gas transit through Ukraine from Russia.

(4) The deficit on the income account rose to US$657m in Q2 2009, from just US$283m one year earlier, a reflection of the increase in the stock of external debt to around US$100bn as of April 1 2009, from US$87.8bn one year earlier, plus obviously higher risk premiums attached to Ukrainian debt/EM risk in general.

(5) Net transfers rose to reach US$1.1bn in Q2 2009, from US$833m one year earlier.

ON THE CAPITAL/FINANCIAL ACCOUNT SIDE: 

(1) Net FDI inflows slowed to US$1.1bn for the quarter, one third the year earlier level (US$3.1bn). Still this does suggest full coverage of the current account in 2009 from non-debt creating inflows which is a positive.

(2) Net portfolio flows were flat (minus US$2m), from net inflows of US$68m in Q2 2008, albeit the stock level is very low - most foreign portfolio investors long departed Ukraine;

(3) M&LT debt flows posted a net outflow of US$2.5bn in Q2 2009, versus a net inflow of US$3.5bn in Q2 2008 (US$13.5bn in net inflows from this source for the full year in 2008) - one year earlier Ukraine was still benefitting from flush global markets. Net disbursements of M&LT debt amounted to US$8.3bn in Q2 2008, falling to just US$2.7bn one year earlier. Net repayments, meanwhile, totalled US$5.2bn in Q2 2009.

(4) Short term loans posted a net outflow of US$354m, compared to a net inflow of US$1.1bn one year earlier, albeit the good news is that the level of outflows slowed from US$2.2bn in Q1 2009, and US$1.1bn in Q4 2008.

(5) Other investment (which probably is the closest proxy for capital flight) slowed to a net outflow of just US$527m in Q2 2009, down from US$2bn one year earlier, and compares with a huge net outflow from this source of US$12.2bn between June 2008 and the end of March 2009, i.e. at the height of the global crisis.

(6.) Q2 2009 saw a US$2.1bn draw down in FX reserves, an improvement from the US$5.2bn lose in reserves in Q1 2009, and US$3.1bn draw down in Q4 2009.

IN CONCLUSION
In conclusion the NBU data suggests a much more supportive backdrop for the UAH, particularly on the current account. Banks/other sectors continue to struggle to roll external liabilities falling due as disbursements are much reduced; essentially foreign creditors are still in the process of taking risk off the table.

The provision of official IMF financing has helped to stabilise the balance of payments, and in the short term the release of the next tranche of US$3.3bn in IMF financing should help Ukraine get thru the peak in debt service payments looming in August/September.

Thereafter the risk is that the commencement of the election campaign for presidential elections in January begins to increase capital flight, pressurising the UAH somewhat and probably to around UAH9:US$1  at year end 2009 - again most flight capital has already probably left Ukraine, suggesting much less scope for a repeat of the meltdown from H2 2008.

Assuming a "constructive" outcome to those elections, the BOP position suggests some scope for the UAH to bounce back, probably to close to current levels by mid-2010.

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2.  UKRAINIAN PRESIDENT MEETS WITH SIX U.S. CONGRESSMEN

Presidential Press Service, Kyiv, Ukraine, Friday, August 7, 2009

KYIV - President Victor Yushchenko held a meeting with a delegation of the U.S. Congress headed by the House Republican Minority Leader John Boehner.

"Our relations with the USA are significant for us. We think they are developing very rapidly", said Victor Yushchenko opening the meeting. He expressed the belief that our countries have clear priorities for development of bilateral relations, particularly the Strategic Partnership Charter and Ukraine - United States Action Plan.

V. Yushchenko also noted active diplomatic relations between our countries. "It is very important for us that Ukrainian policy of democratization of political processes saw large internal and external support", noted the President pointing to role of such support from the American government.

The President expressed appreciation of the Congress members' initiative to visit Ukraine saying that such a step is very important especially in the context of the recent visit of the U.S. Vice President Joe Biden.  "It means a lot for us to have active dialogue with the American authorities and American opposition", emphasized the President.

From his part John Boehner assured that the Congressmen came to Ukraine as its friends. "We are interested in developing better understanding of democracy in Ukraine and prospects of its further advance", he said.
During the meeting the sides have also dwelled on a number of topical questions on the agenda of Ukrainian-American strategic partnership, particularly strengthening the energy security of Ukraine, Euro-Atlantic integration course of Ukraine and overcoming the financial crisis, including development of cooperation between Ukraine and the IMF.

House Republican Leader John Boehner (R-OH) is heading the U.S. delegation. The delegation also includes Congressmen Dan Boren (D-OK) , Jo Bonner R-AL), Dave Camp (R-MI) , Tom Latham (R-IA), and Greg Walden (R-OR).
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2. CHEVRON JOINS THE U.S.-UKRAINE BUSINESS COUNCIL (USUBC)
Finding Newer, Cleaner Ways to Power the World, Providing Energy for Human Progress

U.S.-Ukraine Business Council (USUBC), Wash, D.C.,Wed, Aug 5, 2009 
 
WASHINGTON, D.C. - Chevron, one of the world's largest integrated energy companies, has been approved for membership in the U.S.-Ukraine Business Council (USUBC), the USUBC executive committee announced today on behalf of the entire USUBC membership of over 100 companies and organizations who have business operations, investments or other development programs in Ukraine. 

Chevron,headquartered in San Ramon, California, conducts business in more than 100 countries.Chevron explores for, produces and transports crude oil and natural gas; refines, markets and distributes transportation fuels and other energy products; manufactures and sells petrochemical products; generates power and produces geothermal energy; provides energy efficiency solutions; and develops the energy resources of the future, including biofuels and other renewables.
GLOBAL SCOPE 
Chevron's diverse and highly skilled workforce consists of over 60,000 employees worldwide . In 2008, Chevron produced 2.53 million barrels of net oil-equivalent per day. About 75 percent of that volume occurred outside the United States in more than 20 different countries. Chevron had a global refining capacity of more than 2 million barrels of oil per day at the end of 2008.

Chevron's marketing network supports more than 22,000 retail outlets on six continents and they have invested in 13 power-generating facilities in the United States and Asia.

CHEVRON AND USUBC
Thomas R. Bard, Exploration and New Ventures Manager - Eurasia, San Ramon, CA, will represent Chevron on the USUBC board of directors.  USUBC will also be working closely with Diana Sedney, Manager, International Relations, Policy, Government and Public Affairs, Chevron, Washington D.C. and Kosta Jovanovic, Commercial Manager, Chevron Corporate Business Development.  

TECHNOLOGY AND EMERGING ENERGY 
Technology is propelling Chevron's growth with a focus on technologies that improve their chances of finding, developing and producing crude oil and natural gas. They also are investing in the development of emerging energy technologies - such as finding better ways to make nonfood-based biofuels, creating hydrogen fuel systems, devising commercial uses for nano-materials and expanding their renewable energy resources.

COMPANY ROOTS - MERGERS WITH GULF OIL AND TEXACO
Chevron traces their earliest roots to an 1879 oil discovery at Pico Canyon, north of Los Angeles, which led to the formation of the Pacific Coast Oil Co. That company later became Standard Oil Co. of California and, subsequently, Chevron. The company took on the name "Chevron" when they acquired Gulf Oil Corp. in 1984, nearly doubling their worldwide proved oil and gas reserves. The merger with Gulf was at that time the largest in U.S. history.

Another major branch of the family tree is The Texas Fuel Company, which was formed in Beaumont, Texas, in 1901. It later became known as The Texas Company and eventually Texaco. In 2001, the two companies merged to form ChevronTexaco.

The name was changed to Chevron in 2005 to convey a clearer, stronger and more unified presence around the world. The acquisition of Unocal Corporation in 2005 strengthened Chevron's position as an energy industry leader, increasing our crude oil and natural gas assets around the world.

More information about Chevron is available at www.chevron.com.

USUBC MEMBERSHIP CONTINUES TO GROW
"USUBC is especially pleased to have a major international company like Chevron as a member, " said Morgan Williams, Director, Government Affairs, Washington Office, SigmaBleyzer Emerging Markets Private Equity Investment Group, www.SigmaBleyzer.com, who serves as President/CEO of the U.S.-Ukraine Business Council (USUBC).  

"USUBC has increased its membership four times over the past two and one-half years and now has a membership base of over 100 companies
(http://www.usubc.org)  and organizations which allows USUBC to provide its new members such as Chevron, with a full-time operation and a significantly expanded program of work on behalf of the members and their business and development work in Ukraine," according to Williams.  
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3.  UKRAINE TRIP REPORT: POLITICAL OUTLOOK, RUSSIA, GAS,
IMF, BUDGET/DEBT FINANCING, BALANCE OF PAYMENTS, 
EXCHANGE RATE, BANKING SECTOR REFORM

Ukraine Trip Report: By Timothy Ash, RBS GBM
Royal Bank of Scotland, London, UK, Monday, July 20, 2009 

LONDON - We visited Kiev on July 16-17, meeting with government officials, representatives of local banks, diplomats and IFIs.

POLITICAL OUTLOOK 

The focus is increasingly turning to presidential elections due in January 2010. Opinion polls put the leader of the opposition Regions of Ukraine party, Viktor Yanukovych, as heading the field with a 25-30% rating. The prime minister, Yulia Tymoshenko, has dropped back in the polls, partly due to a backlash over the impact of the on-going economic crisis. She does, however, still poll second with a rating of 15-20%.

The incumbent President Viktor Yushchenko is lagging in the polls with support in the very low single digits, and appears to have recognised that he has little chance of winning a second term. His focus has thus moved to positioning to perhaps secure the election of a proxy candidate.

Herein, the former speaker of parliament (and a former foreign minister and minister of economy, appointed by Yushchenko), Arsenyi Yatseniuk is emerging as a potential alternative "proxy"candidate for the Yushchenko camp; indeed we noticed election campaign posters already around Kiev backing a fresh-faced "Arsenyi" for the presidency.

Yatseniuk's candidature is being backed, allegedly, by various oligarchs, in addition to Yushchenko, including Pinchuk, and Firtash. Firtash has in the past been close to Regions, and his support for Yatseniuk may be more of an effort to undermine support (splitting the Orange vote) for Tymoshenko (currently his nemesis), as the two remain at loggerheads over the ousting of RosUkrEnergo (to which Firtash was a key shareholder) from Ukraine's lucrative gas transit business.

Yatseniuk is regarded as a fresh face, albeit he has gained an impressive CV in government office in recent years. He speaks good English and is seen as very investor friendly; he was instrumental in getting parliament to finally approve key reforms central to securing an IMF programme last autumn.

Yatseniuk's weakness remains his lack of a grass roots political movement, which is expected to put him at a major disadvantage in the run up to the presidential elections. Unlike Tymoshenko he also lacks pan-Ukrainian appeal; also a weakness for Yanukovych. The consensus is thus still that Yanukovych and Tymoshenko will be the top two candidates come January, contesting the final presidential run-off vote.

It is a close call as to who will emerge victorious from these two. Our sense still is that Tymoshenko's remarkable campaigning prowess, pan-Ukrainian appeal, new-found backing from Moscow, and her ability still to coral the rump Orange vote, will see her elected as president.

Whether Tymoshenko or Yanukovych emerge as president a key question will remain as to the respective balance of power between the presidency, the executive and parliament. At the moment Ukraine is something of a hybrid presidential-parliamentary democracy with lines of demarcation still not that clearly defined, and hence conflicts all too often end up in the Constitutional Court, and typically thereafter in stalemate.

Tymoshenko is promising constitutional reform, albeit whether this will ultimately end up in Ukraine emerging as a parliamentary democracy as is the West European norm, or a presidential style system, as is now dominant in the CIS, is open to question. Ultimately this is likely to depend on who ends up in the presidential palace.

President Yushchenko is promising early parliamentary elections, perhaps in a last gasp effort to secure for himself a more secure power base in parliament, ready for his departure from office. Early parliamentary elections are however thought unlikely, indeed perhaps even constitutionally a non-runner. However, either the Block Yulia Tymoshenko, or indeed Regions might seek early parliamentary elections to try and overcome the current "hung" nature of parliament, but only after the presidential elections.

The prospect of "cohabitation" between Tymoshenko and Yanukovych in the post presidential election period appears high. Both have appeared close to agreeing coalition agreements on numerous occasions in recent years; at least four times in our reckoning.

Perhaps the prospect of alternative coalitions being formed (e.g. with Yushchenko's Our Ukraine) and in Tymoshenko's case, fear of undermining her support amongst the Orange constituency ultimately saw hopes of such coalitions dashed.

This time around, with presidential elections out of the way and with Yushchenko perhaps exiting the political scene, the Tymoshenko and Yanukovych camps may finally be forced to work together, albeit the process of dividing out the political spoils of office might prove painstakingly slow, suggesting that a new government may emerge only slowly after the parliamentary elections, perhaps in the Spring of 2010, suggesting still an extended period of weak/ineffective government.

RELATIONS WITH RUSSIA, GAS AND ALL THAT JAZZ

Note that we visited Kiev directly from an earlier week trip to Moscow, and hence were able to get a bigger picture view of relations between Russia and Ukraine, and the regional/geopolitical setting. In many respects after the January and April gas price/supply agreements, there has been something of a lull in battles over gas supply/pricing.

Moscow appears happy with the gas price agreement secured, which in effect moves Ukraine to market prices for gas by the end of 2009, fixes gas transit prices at US$1.7 per 1,000 cu metres (tcm) of gas per 100km, and also obliges Ukraine to purchase 42 billion cu metres (bcm) of gas annually from Russia.

On this latter note, Russia has not kept Ukraine to the contract in 2009, allowing Ukraine to import lower quantities of gas, reflective of a marked reduction in consumption of gas in Ukraine as the economy has slowed (consumption has likely reduced to 55 bcm, from ~ 72 bcm annually in recent years).

It was suggested to us by observers in Moscow that Russia's own current economic problems mean that it is eager to avoid a repeat of the European gas crisis which hit at the turn of the last year, but rather assure supply of gas and hence gas export receipts.

Gazprom itself is working on the assumption that gas export volumes slow to around 142 bcm in 2009, from 156 bcm earlier planned; some two thirds of these were planned to be transited through Ukraine albeit in the year to date gas transit through Ukraine is down by around 60%.

All the above said, Moscow still has the ability to destabilise Ukraine via its right to demand that Ukraine sticks to the requirement to purchase 42 bcm of gas in 2009, as contracted. Given Ukraine's, and indeed Naftogaz' (Ukraine's gas transit company) parlous financial state, the demand to buy an additional 10-12 bcm of gas in 2009, could potentially provide the straw that broke the camels' back, requiring Naftogaz to find an additional US$2-2.5bn in gas import finance to year end in 2009.

Obviously gas supply is linked to the broader issue of Russia-Ukraine relations. Russia, by general recognition, is willing to use the gas supply issue to exert leverage over the domestic political process in Ukraine itself, and perhaps more widely to extract political capital from a regional/global context of energy security.

Russia clearly has an interest in bringing Ukraine more closely within its sphere of influence, both for business and geopolitical reasons, and herein weakening Ukraine's driver for greater Euro-Atlantic integration. This policy has thus far proved relatively successful, with PM Tymoshenko taking a noticeably more pragmatic approach towards Russia during her second term in office than during her first stint as prime minister which ended in September 2005; the January/April gas price agreements were clear evidence herein.

Russia's drive to bring Ukraine back more within its fold has certainly been helped by the West's lack of real and meaningful engagement with Ukraine. The EU has, for example, consistently failed to give Ukraine a clear perspective to EU membership and prefers to keep Ukraine in something of a twilight zone, which itself has undoubtedly resulted/contributed to policy drift/inertia itself in Ukraine; note herein we would argue that it was only the clear timetable towards EU membership, with benchmarked decision dates which drove forward reform in Central and Eastern Europe after the Copenhagen summit set the date of the first wave of enlargement as May 2004.

Ukraine simply lacks this perspective and hence lacks the key reform anchor which its Central and East European peers benefited from in the decade to 2004. Explanations for this real lack of engagement of Ukraine by the EU probably come down to Russia's own success in driving divisions within the EU over strategy to Ukraine; key EU powers such as Germany, Italy and France thus appear to value the relationship with Moscow far more highly than that with Ukraine, and herein have exercised an effective veto on deepening Ukraine's EU perspective.

In any event this lack of EU perspective for Ukraine has served to disillusion/undermine the position of Europhiles within successive Ukrainian administrations. The bottom line is that Russia continues to show much more interest in Ukraine than either the EU or US, and this is beginning to sway politicians such as Tymoshenko.

In summary to the above, while Russia's rough-edged strategy towards Ukraine in the run-up to the Orange revolution proved entirely counter-productive, since then its much more nuanced strategy, alongside the indecision of the EU and apparent disinterest of the US in Ukraine (the new Obama administration in the US appears to have set a low priority in terms of relations with Ukraine; Obama went to Moscow, Biden to Kiev), is bearing fruit.

This is evidenced by the January/April gas price agreements, and also by the fact that the two key contenders in the 2010 presidential elections, Tymoshenko and Yanukovych, are both now minded to look East, rather than West. As a result, in terms of Russia's willingness to use the gas card again before the 2010 presidential elections, we sense that it will probably prefer to keep its powder dry, pending a better showing by a candidate such as Yatseniuk, deemed more inclined to the Western/Yushchenko camp.

Notwithstanding the state of relations with Moscow, there are concerns that Ukraine's current parlous financial state could still provoke a repeat of last year's European gas crisis, if it is unable to buy sufficient gas into storage prior to the October - May heating season this year. Herein there have been warnings that Ukraine needs to buy 30 bcm of gas into storage in preparation for the beginning of the heating season and that it will require US$5-6bn in financing to do this.

As of writing though, Ukraine had already bought 19 bcm of gas into storage, and our understanding is that to maintain normal supply of gas to Europe through the winter it needs to have accumulated only 24-25 bcm of gas into storage by the autumn. This hence suggests a need for only an additional 5-6 bcm of gas, which at current market prices suggests a cost of only around US$1.1bn. This seems manageable, given Ukraine's access to official multilateral financing channels, and could likely be financed over the period August - September.

RELATIONS WITH THE IMF 

An IMF mission visited in July for the second review under the SBA, and indeed left with a recommendation for the release of the next tranche of US$3.3bn in IMF funding (two tranches were in fact combined). The Fund noted the need for certain prior actions, but indicated progress on key issues such as the recapitalisation of the banking sector.

The Fund agreed to hike the budget deficit target to 6% of GDP, reflective of a recognition that the impact of the global financial crisis has been much more severe than initially expected and hence the impact on budget finances has been very severe. The IMF is also placing a high emphasis on the need to consolidate the deficit of Naftogaz (targeted at 2.6% of GDP) with that of the general government. The consolidated budget deficit target, including Naftogaz, is thus 8.6% of GDP.

There is a big debate, amongst investors particularly, that the IMF has been much more understanding/generous to Ukraine than perhaps some of its regional peers (e.g. perhaps Latvia and Serbia) reflective of Ukraine's geopolitical importance to some of the IMF's larger shareholders. Obviously this might well be disputed by the Fund; albeit we would argue that the IMF has to adopt a case by case approach, recognising different political settings and understanding best how to deliver on its goals of improving the policy environment over perhaps a longer time frame.

The speed/ease by which Ukraine secured disbursement of the latest credit would certainly be used as evidence by those plying the IMF-soft hands approach to Ukraine. Notwithstanding the debate over the IMF's broader strategy towards Ukraine, it is difficult to see the Fund being in a position to disburse the next tranche due by November.

By that time Ukraine will be in election mode, and we doubt that the government will be able to deliver sufficiently on the IMF agenda by then to enable the fund to lend into the elections. The Fund will also probably want to defend itself from accusations of potentially bank-rolling the government in the run-up to elections.

BUDGET/DEBT FINANCING 

The significant widening in the budget deficit, and the fact that international capital markets are effectively closed to Ukraine (5Y CDS is still north of 1,500bps) has left the country dependent on official financing. The general budget deficit to June is estimated at around UAH17bn.

Annual debt redemptions due in 2009 are estimated at UAH29bn, which obviously creates a huge budget financing gap, assuming little scope for budget tightening in H2 2009 in the midst of an election campaign. The Treasury has managed to re-launch domestic debt auctions, issuing UAH11bn in the year to date albeit at the price of yields on government paper in the 15-25% range.

Privatisation receipts had been targeted at UAH8bn for the year, but are unlikely to reach even UAH1bn partly due to legislative blocks to sales and to the global crisis. The gap in budget financing is thus expected to be covered by draw down of World Bank Funding (US$1.9bn) and also IMF funding; around half of IMF disbursements are in fact earmarked for budget support. With the disbursement of the next IMF tranche in late July/early August the government will perhaps have secured around US$5bn in budget financing from multilateral sources this year.

Essentially this should enable the government to close the budget gap to October/November. Importantly for foreign investors this will also get Ukraine through the August/September period when gas imports/external debt redemptions peak (around US$1.5bn in sovereign/quasi sovereign debt potentially matures in August/September, including the US$500m Naftogaz 09's). Ukraine's sovereign external debt schedule is then light until 2011. The threat of a sovereign default will thus have been put back until after the presidential elections (at least).

From the IMF's perspective they will have bought Ukraine time, until the new administration emerges after the election. The government in the run up to the 2010 presidential elections will also face a budget financing constraint of lacking the funds to go on a pre-election spending spree (we doubt the NBU, which is in Yushchenko's sphere of influence will bank-roll pork barrelling by the government controlled by his arch rival Tymoshenko), albeit it will be interesting to see what spending promises are made in the run up to the election, and how these will be reigned in, with the help of the IMF anchor after the elections.

Over the slightly longer term, reform of Naftogaz is central to broader fiscal reform and this has been clearly stated by the IMF in recent communiqués. The Fund recognises the critical importance of the company to the economy, and we do not expect the Fund to object to the government supporting the company in meeting its external liabilities in the year ahead, especially when the company has broader regional significance in terms of regional energy security.

Reform of Naftogaz though essentially means reform of domestic gas pricing, an acutely difficult political issue. Herein gas prices to industrial users have been raised to market prices, and the government is committed to raising household gas prices; the issue is not as politically sensitive as this mostly relates to the supply of gas for cooking and to rural users and hence typically comprises a smaller share of household budgets.

The key battleground though is gas pricing at the municipal level. The problem is that the government does not have the power to set/enforce gas price hikes on municipal heating companies.

These are controlled by municipalities. They currently charge UAH878 per 1,000 per tcm, versus cost prices of over UAH2,025. Municipal heating companies not only fail to charge consumers prices to cover costs, but their collection rates are only around 50%, creating huge arrears to Naftogaz. This subsequently undermines Naftogaz's cash flow position and its own ability to pay for imported gas.

The government is hence forced to step in by providing subsidies to Naftogaz, a situation which is clearly destabilising for Naftogaz, and creates uncertainty over the companies' ability to hold to its gas supply agreement with Gazprom which requires payment for gas supplied over the previous month by the 7th day of the following month.

Resolution of the problem above obviously rests on hiking domestic gas prices, which is universally acknowledged by the political establishment, albeit, obviously given the political cost, has been slow to deliver on. The government says it is committed to hiking gas prices by 20% this year, and gradually raising them to cost prices, and then targeting subsidies at the poor.

In terms of the problem of municipal gas pricing the plan is to move the right to price gas to the national agency for energy price regulation, albeit this is proving to be a judicial nightmare. Legally at present it takes at least 3 months to enforce gas price hikes, albeit the hope is that the process can be streamlined; but this may need to await the conclusion of elections, especially as parliament is currently on its summer recess.

BALANCE OF PAYMENTS AND EXCHANGE RATE 

The good news is that gas consumption has reduced considerably which does reduce the draw on the balance of payments from energy imports; assuming that Russia does not enforce its right to keep hold Ukraine to the agreement to import 42 bcm of gas annually. Industrial consumption of gas has fallen by around one half to 20 bcm, household consumption is down more modestly at 18 bcm, with municipal heating companies consuming 10 bcm, and transmission costs of 4-5 bcm, this suggests use of only 55 bcm, down from around 72 bcm in recent years.

Even given the hike in gas import prices in 2009 to an expected average of US$228 per 1,000 cu metres, from US$179.5 one year earlier, this still suggests a saving in gas import costs of around US$1-1.5bn annually. As the economy recovers in 2010 gas consumption by industry is expected to recover somewhat, but is now never expected to return to pre-crisis levels; largely due to extensive energy conservation/efforts at diversification away from gas (e.g. to coal).

As elsewhere in the region the combination of deflation in domestic demand, and a currency adjustment, has brought a marked narrowing in the current account deficit from around 7% of GDP in 2008, to an expected out-turn of close to balance in 2009. Concerns over high debt roll-overs have eased thru a combination of high roll-overs by foreign-owned banks (~ 90%), plus some debt restructuring by domestic borrowers. The provision of IMF/WB financing has also helped to stabilise the exchange rate.

The IMF appears generally happy with the NBU's management of exchange rate policy, reducing interventions more generally. IMF government efforts to resolve problems in the banking sector through a recapitalisation process has also helped reduce/stem capital flight. Whether the exchange rate will remain stable in the run up to the presidential elections is debatable though; typically the UAH weakens in the run up to elections as dollarization increases on the back of concern over political risk.

Add to this the likely stalling in IMF disbursements, and the continued need to fund gas imports, and the UAH will likely have an easing bias to year-end; albeit this is likely to be contained in the UAH8-9 per US$1 range.

From a balance of payments perspective the UAH does not appear over-valued at present, but political risk could still fuel yet more capital flight/concern over banking sector stability; arguably though those that wanted to remove deposits from banks/convert to FX have already done this.

There are also suggestions that Ukrainian FX holdings (under the mattress) may already be around US$90bn; this does not seem unreasonable given the size of the country and its recent track record of crisis.

BANKING SECTOR REFORM 

In general, and has been the case in Russia and Kazakhstan, NPLs have risen rapidly, and are likely in the range of 25-35% of loan books. The shear extent of NPLs reflects the depth of the recession.

Official forecasts suggests a real GDP decline of 10-12% in 2009, and even this may appear optimistic given data for the first few months of the year; the NBU has suggested that real GDP may have declined by 25-30%. And as has proven the case in developed market economies (e.g. the Madoff case) recession has revealed numerous fraudulent borrowing practices.

Difficulties in attaching collateral through the courts also appears to have made banks relatively pro-active in pushing debtors to renegotiate terms; quickly seeking to capitalise overdue debt service payments, often and predictably at a very high premium. A culture of restructuring has ensued.

The high level of NPLs and doubts over the quality of existing bank capital, alongside a deletion of 35-40% of banks' deposit bases through the crisis thus far, left many banks on the brink/in need of recapitalisation.

Banking sector restructuring was a key plank of the IMF programme and herein progress does seem to have been made. The diagnostic test on banks, as per the programme, has been completed. Banks needs for recapitalisation have been assessed, and the bank recapitalisation process is under way.

Foreign banks which assume a 40-50% market share by assets, have generally already been recapitalised by their parents - thus the burden of recapitalisation has been shared. Seven domestically owned banks have been identified as in need of government support as existing owners proved unable to provide the required level of additional capital.

Three of these banks have already received UAH10bn in capital injections with government bonds being placed on their balance sheets in exchange for the state taking equity stakes and leading roles in their corporate governance structures. A further four banks are being prepared for recapitalisation, with the cost of this latter operation put at UAH16bn.

Thus the cost of bank recapitalisation to be borne by the state coming in around UAH26bn, which is below the UAH44bn planned in the original IMF programme, and does not appear to jeopardise the sovereign's debt sustainability position; we estimate that the public sector debt/GDP ratio will rise from less than 20% in 2008 to still only around 40-45% of GDP as of the end of 2009, still low by regional standards.

There appears still to be concern over state control/oversight of banks to which it has been forced to recapitalise; herein existing owners still appear not to have got the message that the state is now the majority owner and they need to take a backseat.

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