By Luke Baker and Justyna Pawlak
BRUSSELS (Reuters) - The European Union is in advanced discussions with the International Monetary Fund on providing standby financing to Ukraine should the country come under economic pressure from Russia later this year, senior EU officials have told Reuters.
Ukraine is expected to sign a free trade and association agreement with the European Union at a summit in Lithuania on November 28-29, as long as it meets remaining conditions, including releasing former prime minister Yulia Tymoshenko from prison.
Ex-Soviet Ukraine's shift closer to the EU and away from Russia's sphere of influence has irritated Moscow, which has threatened to interrupt gas supplies to its neighbor and has demanded Kiev repay outstanding loans.
The standoff is shaping up to be one of the most sensitive geopolitical moments between East and West since the end of the Cold War. For Moscow it cuts to the heart of a sense of diminished power in its backyard, with Ukraine seen by many in Russia as culturally and historically Russian.
If the EU-Ukraine pact is signed, and the Kremlin does retaliate in the ways many expect, the EU has plans in place to supply Ukraine with natural gas, as well as arrangements with the IMF for emergency financing - even if some analysts doubt the IMF and Ukraine can bridge long-standing differences.
"The IMF plays a very important role and there are ongoing discussions with them about standby arrangements," said a senior EU official, speaking on condition of anonymity.
A second EU official directly involved in talks on Ukraine added: "There are ongoing discussions to support the IMF and find a way for standby arrangements to be concluded soon."
The head of the IMF's mission in Ukraine said there was no link between Ukraine signing the EU deal and receiving help.
"There is no connection between the possible signing of an association agreement between Ukraine and the EU and the discussions on a possible Fund-supported program," Nikolay Gueorguiev said in a statement emailed to Reuters.
Ukrainian officials declined to comment on the EU role, noting that Ukraine was already in talks with the IMF directly.
It is not clear exactly how much money Ukraine would need, but bankers and asset managers familiar with the distressed financial situation of the nation of 45 million suggest a standby facility between $10 and $15 billion may be necessary.
That would come with strict conditions which have already proved a stumbling block in a series of loan arrangements between the Fund and Ukraine. The last, $15-billion, agreement was suspended in early 2011 because Ukraine refused to remove subsidies on household gas supplies.
However, the EU officials indicated that the IMF could introduce more flexibility into the program to take into account Ukraine's circumstances. The EU has worked intensively with the IMF on loans to troubled euro zone states over the past three years where similar flexibility has been necessary.
"The discussions are not in any way telling the IMF what they should do, or even telling them to lower the bar," said the second European Union official, referring to conditions the IMF sets borrowers to protect its prospects of being repaid.
"It's not a case of telling them not to push on conditionality," the official said, adding that the Washington-based global lender was looking at ways that could help Ukraine meet the conditions. "The IMF is actually thinking about maybe looking at the calendar of implementation and a certain road map, rather than demanding that everything is done tomorrow, whatever the political and social implications of that may be."
The IMF mission in Ukraine on Thursday again called on the government to raise natural gas prices for domestic consumers and introduce a flexible exchange rate for the national currency - two long-standing demands it has made in continuing negotiations on an assistance package.
As well as standby financing - critical for a country where foreign reserves to fund imports stand at barely $20 billion and upcoming debt repayments total more than $60 billion - the EU has contingency plans in place to supply Ukraine with gas.
The country currently imports nearly all its gas from Russia and is also the major transit route for Russian gas to the EU. The EU depends on Russia for about a quarter of all its gas, around 60 percent of which passes through Ukraine.
Russia and Ukraine have waged two "gas wars" in the past - in the winters of 2006 and 2009 - with Moscow halting deliveries to both Ukraine and by extension the rest of Europe.
EU officials say they will find ways of supplying Ukraine with gas via other routes, potentially through the Nord Stream pipeline that flows from Russia to Germany, bypassing Ukraine.
That gas could be diverted to Ukraine via Slovakia using a reverse flow in the pipeline. That is politically sensitive in Slovakia, which worries about the impact on its own supplies and pricing. But officials say it is feasible and would be the most likely method used should Russia isolate Ukraine.
However, such a "back-fill" means of supplying gas to Ukraine could only be used for a limited number of weeks, energy analysts say, and it would probably diminish supply in other areas, pushing European gas prices sharply higher.
"There are discussions with the Ukrainians and EU states to create favorable conditions for Ukraine to be able to import gas from sources other than Russia, or from the same source, but via a different route," the second source said. "Together with the IMF discussions, it is an extremely important issue."
As well as the potential IMF standby facility, the EU has set aside 610 million euros ($840 million) that it could lend to Ukraine. It has so far linked the disbursement to Ukraine meeting conditions for help from the IMF.
While the contingency planning by the EU and IMF may go some way to calming international concerns about the fragility of Ukraine's economy, some investors are not convinced a standby IMF loan deal will be feasible.
"Even if the IMF is not that strict with Ukraine in terms of conditionality, their positions are still miles apart," said Viktor Szabo, a portfolio manager at Aberdeen Asset Management.
Szabo indicated that Ukraine's unwillingness to let the hryvnia currency depreciate in a free float, and its reluctance ahead of elections in 2015 to end subsidies for household gas, ruled out a meeting of minds with the IMF.
Still, if an arrangement were made - with the EU working closely with the IMF to make it happen - foreign investment could quickly flow into Ukraine to take advantage of the deal.
"There's probably quite a lot of money sitting on the sidelines," said Szabo. "In some circles, there is the expectation that if the EU and IMF do come in, then significant investments could flow, although it will take some time." ($1 = 0.7262 euros)
(Additional reporting by Barbara Lewis, Adrian Croft and Jan Strupczewski in Brussels, Pavel Polityuk in Kiev and Henning Gloystein in London; Writing by Luke Baker; Editing by Alastair Macdonald)