LONDON -- On a number of levels we are approaching decision time for Ukraine -- at least in terms of the course of reform, the relationship with the IMF and perhaps also the political setting.

An IMF technical mission visited Kyiv last week. But this seems to have been a little more than your plain vanilla technical mission. DC-based desk head, Ron Van Rooden, also visited Kyiv, I sense to figure out the lay of the land with respect to some key IMF reform requirements.

It is fair to say that there is considerable frustration now with Ukraine among the international financial institutions. The current IMF program has been stalled since the completion of the last review (3rd) back in April 2017. Promises of reform from President Poroshenko appear to be falling on deaf ears. It is more a case now of “seeing is believing”.

Even back then numerous structural benchmarks were missed. But Ukraine got a pass, as it was recognized that the nationalization of Privatbank had been a hugely difficult but important reform milestone. And there also were promises made on energy pricing, land reform, and the appointment of a new NBU governor. These have subsequently not been delivered on.

A good review of the state of play with the IMF is detailed in the following Unian report.

https://economics.unian.info/10015307-ukraine-and-imf-critical-point.html

It is always difficult to set the pitch right as to where Ukraine is on its reform path. But it is fair to say that some very substantial, even remarkable, reforms have been undertaken in the period since the Euromaidan revolution – including:Privatbank nationalization, bank reform, NBU reform, introduction of inflation targeting, a flexible exchange rate, fiscal reform/adjustment, debt restructuring, gas sector reform (reduction of Naftogaz deficit), healthcare and education reform, ProZorro, et al.

But it is also fair now to say that reform has slowed over the past year or so, as we approach 2019 elections and the Poroshenko administration looks at its own stalling poll ratings.

Christina Lagarde, IMF Managing Director, and President Poroshenko last met on Jan. 24, at the World Economic Forum, in Davos. (UNIAN/Mikhail Palinchak)

Ukraine Got only Half the IMF Money

Indeed, only three reviews of the IMF EFF have been completed, and only four credit tranches of a scheduled 12 released, so just $8.7 billion of $17.5 billion from the program disbursed. We have seen reform back-tracking, with the failure of Ukraine’s government to deliver on its commitment as per the 3rd review to hike gas prices last summer. In addition, almost one year after the resignation of the former governor of the NBU, Valeria Gontareva, Ukraine still has no permanent central bank governor. Instead, the very capable Yakiv Smoliy only serves in an acting capacity.

Meanwhile, we seem to see rear-guard actions from Ukraine’s vested oligarchic and political elites to stall efforts by the Ministry of Finance to clean up the state fiscal service, to remove reformist Finance Minister Oleksandr Danylyuk, and to stall improving governance around SOEs. And then there is the mega battle being fought over the creation ofthe Anti-Corruption Court, or ACC.

For the IMF/IFIs, there are now three/four major issues/focal points for reform:

First, the creation of an “independent” ACC. For the uninitiated, corruption is the number one issue in Ukraine, as reflected in all surveys of business and popular opinion. I would argue the reason that real GDP growth performance has been so lackluster over the past year (still sub-2% despite the low base) is that we have not yet seen a material improvement in the business environment and specifically that related to corruption.

Ukraine is still a challenging place to do business. Various reforms have been undertaken to reduce scope for corruption – ProZorro, VAT refund reform, gas price reform (albeit creeping back), cleaning up the banking system (better regulation and supervision). But not all behavior is changing, or is changing too slowly. It is not only about taking away the opportunity to act/benefit from corrupt actions, but also including some sanction for wrong-doing. While various new institutions have been created to identify graft -- e-declarations and NABU -- and to begin the process of bringing people to account, the court and judicial system is so corrupt and broken that few, if anyone has been sanctioned for wrong doing.

The international community have concluded that to clear this particular bottleneck special anti-corruption courts need to be created that are fully independent, the latter assured by international oversight on hiring/firing of judges. The Poroshenko administration submitted proposals to the Venice Commission, agreeing to abide by its conclusions – therein a condition of the IMF program.

But when the Venice Commission returned its verdict and made recommendations these appeared to be lacking in the draft bill on ACCs tabled by President Poroshenko to the Rada. The message from Poroshenko is that it is now the responsibility of the Rada to make changes to his bill to make the legislation compliant with the Venice Commission and hence the IMF/IFIs.

Unfortunately, the Rada operates with the pro-presidential bloc only benefitting from situational majorities. Unless a bill gets clear support/direction from the presidency/government, it is very unlikely to secure Rada support. We already saw that with passage of the pension reform bill last year – which still seems to fall somewhat short of prior IMF requirements.

One is left with a sense that there is a fundamental unwillingness from many within the ruling establishment, and Rada, to deliver on truly independent ACCs, which by definition could well risk hard actions against many in Ukraine’s elites.

The sense is that the presidency and Rada are just going through the motions, trying to buy time, and wear down the IFIs, perhaps just trying to kick the can. The problem with this is that it does not change the core problem -- high perceived levels of corruption which weigh on business, investment and growth and development of Ukraine’s economy.

Failure to address this issue is one reason why so many young Ukrainians have opted to leave the country – with 1.2 million Ukrainians working in Poland for example. Remarkably, this now creates labor shortages in Ukraine – keeping wage price pressure high, forcing the NBU to keep policy rates high, which feeds back into weak growth/development, and perhaps back into corruption and a vicious cycle.

Second: following through with gas price liberalization and the un-bundling of Naftogaz. These are keys for efficient energy use, and further removing opportunities for graft.

Third: land reform – seemingly more important for other IFIs, namely the World Bank which has been leading the initiative.

We could probably add nomination of a new NBU governor, but I don’t particularly see this as a deal breaker from the IMF, especially given that acting governor Smoliy seems to be doing a good job. It could be a problem, if a new, less orthodox/competent name emerges in the running, and pressure to make political appointments to the NBU management and the NBU board mounts. There seems to be politicking in this respect in the background.

Gas Prices Can Rise to Market Levels Once Heating is Off

In the end, with the heating season ending, it is possible to see the Poroshenko administration conceding to gas price adjustment, content in the knowledge that this will only hit the consumer next October – and the impact would be moderated by extension of targeted subsidies. On land reform I think there is enough understanding from the IFIs that this is a tricky issue. Given willingness to act from the administration, a compromise solution can be reached around a roadmap for reform.

As a result, all roads lead to the ACC as the most likely key sticking point.

On this I am not hopeful.

For Ukraine’s elites this is an existential threat. The IFIS understand the critical and game changing importance of this issue to the broader development of the economy and the country. Simply put, it could and should be game changing.

The Poroshenko administration assumes that passing somewhat revamped bill, still short of Venice Commission recommendations, but a first iteration towards that, will be enough to buy a bit more time and perhaps push the issue beyond the next elections.

I do not though think that is enough for the IMF.

This does provide the potential for a break in the relationship – as it is so important to both sides.

Ukraine Without IMF?

But can the Poroshenko administration survive without IMF financing to the next elections?

Well, total debt financing needs to year end are $7-8 billion. Of this, over $5 billion is in FX, split roughly 50:50, IMF/IFI and market financing.

The Unian report suggests that in the absence of IMF financing, it would be difficult for Ukraine to return to international capital markets.

I am not so sure.

Remember that the “highly successful” 2017 Eurobond issue, combined with a liability exercise issue, was placed only “on a promise” of IMF monies in the pipeline. The Ministry of Finance pitch was: “in June/July” “or the autumn at the latest.”

The market believed that. Institutional investors are still inclined to buy on a promise – unless difficulties with the IMF and IFIs are more clearly spelled out. Obviously much ultimately also depends on the global market backdrop and pricing. But given current market pricing, a deal priced in the 7-8% range likely would still find plenty of takers, albeit not sure if that is with the IMF.

Clearly the danger for the IMF/IFIs is: the government strings the market along, promises reforms, comes to market, fills the coffers and then fails to deliver reform. This would be terrible for the long term Ukraine story and surely another opportunity lost.

But, reflective of the 10-month lag since the last IMF review, this seems the most likely scenario -- unless the IMF signals that the program is actually at risk.

June Copenhagen Conference: Reform Deadline?

I don’t think we are that far away from the latter scenario, given frustrations from the IFIs are building. Perhaps the deadline could be the Ukraine reform conference planned for Copenhagen on June 27:

http://um.dk/en/news/NewsDisplayPage/?newsID=1B62519D-877E-4F8D-A0F8-36CE22633AB9

The Danish government leads the way here, taking the baton from the UK which hosted a similar conference last July. It is possible to imagine by that date, that the IFIs might bundle together credits, all linked to key reforms such as the ACC, in order to entice the Poroshenko administration over the line.

Petro and Yulia Hold Hands?

A potential complication in all this is local talk of early elections – with Concorde Capital this week linking a meeting between President Poroshenko and his arch political rival Yulia Tymoshenko earlier in the month to a potential deal to push for early elections.

Obviously early elections would put the entire reform agenda on hold, to buy time (kick the can) over the ACC. Early elections would also stymie calls from some for political reform in Ukraine before parliamentary elections scheduled for November 2019. Reformists want to move away from the current split constituency/PR system which benefits business interests and ensures anti-reform vested interests dominate the Rada.

Given the past bad blood between Poroshenko and Tymoshenko, it is hard to imagine a deal between the two politicians. However, Ukraine’s oligarch politicians have all worked with/against each other on numerous times in the past.

Opportunities and interests might just be aligning at this point in time, perhaps noting potential threats from new political forces/characters, including pop star politician, Svyatoslav Vakarchuk. Surely early elections would dull his chances in the presidential poll, while also heading off the chances for electoral reform – in essence playing to established political forces and names.

Timothy Ash is senior sovereign strategist for emerging markets at BlueBay Asset Management in London and a member of the UBJ Editorial Board.

Posted Feb. 22, 2018