(Bloomberg) -- Ukraine risks losing support from IMF member countries for a proposed $17.5 billion bailout if the conflict in the former Soviet republic continues to escalate, according to two people familiar with the matter.
The new four-year loan program is awaiting approval by the International Monetary Fund’s executive board, which represents the lender’s 188 member nations. Getting the panel’s consent will become more challenging if pro-Russia rebels continue their advance and seize territory such as the strategic port city of Mariupol, one of the people said.
A second person said that while a worsening conflict would complicate approval, IMF country representatives are likely to maintain their support unless an open conflict with Russia breaks out affecting the majority of Ukraine. Both people asked not to be identified because the matter is confidential.
Any doubts over the IMF funds would increase pressure on Ukrainian allies including the U.S. and European Union to step up their own funding to prevent the country from becoming more vulnerable to Russian economic pressure and wider incursion by pro-Russia rebels. A worsening conflict would make it tougher for Ukraine to maintain economic commitments to the IMF and repay the money while deepening the fund’s involvement in the worst standoff in Europe since the end of the Cold War.
Plugging Ukraine’s financing needs and stabilizing its economy amid an armed conflict will be an “enormous challenge,” said William Taylor, the U.S. ambassador to Ukraine from 2006 to 2009 who is now acting executive vice president at the U.S. Institute of Peace. “If they’re going to exist as a nation, they’re going to have to be able to defend themselves.”

Board Support

Last year’s $17 billion, two-year bailout for Ukraine by the IMF had broad support from the fund’s board, overcoming concerns at the time about the security risks in the country, one of the people said.
There have been many violations of the cease-fire agreed on in the Belarusian capital of Minsk on Feb. 12, U.S. Secretary of State John Kerry said Wednesday. Ukraine and its allies in the EU and the U.S. accuse Russia of backing the militants in the conflict that has killed more than 5,600 people, according to United Nations estimates. Russia denies military involvement.
Ukraine’s decision this week to tighten capital controls may also complicate the IMF plans. IMF staff members are revising their economic projections in light of the restrictions, according to one of the people familiar with the situation.

Exchange Rate

The Washington-based IMF said in announcing the program Feb. 12 that Ukraine agreed to maintain or implement certain policies, including a flexible exchange rate. The lender said in a statement earlier this week that while capital controls may be necessary, the fund expects them to be eventually lifted.
Ukrainian officials will have to explain to the IMF why the central bank tightened capital controls, as well as how the government plans to revive the economy in general, one of the people familiar with the matter said.
The IMF’s executive board will consider the aid package on March 11 and the loans will be front-loaded to help stabilize the economy quickly, the fund said in an e-mailed statement Wednesday without elaborating on how the conflict will influence the board’s decision. The fund hasn’t given any indication that members will reject the program.
The IMF also said it’s ready to assist Ukraine in designing measures to address imbalances in the foreign-exchange market.

No Condition

Gerry Rice, an IMF spokesman, said last week that the proposed aid for Ukraine isn’t conditioned on an end to the fighting. “The conflict is something that we are concerned about and monitor, but the new program makes very conservative assumptions in its baseline scenario for 2015 to buffer a further impact of the ongoing conflict in the east,” he told reporters.
The intensifying conflict has shattered the fund’s economic projections. In April, the IMF forecast the Ukrainian economy would grow 2 percent this year after shrinking 5 percent in 2014. By September, the fund had cut its growth forecast to 1 percent this year, while assuming the conflict would subside “in the coming months.”
The Ukrainian economy ended up shrinking as much as 7.5 percent in 2014 as the conflict took a “significant toll on the industrial base and exports,” undermining confidence and putting pressure on the financial system, the IMF said this month. The economy will probably contract 5.5 percent this year, Finance Minister Natalie Jaresko said Feb. 16.

Reserves Plunge

Ukraine’s gold and foreign-currency reserves plunged to $6.4 billion in January, the lowest since 2004, from $17.8 billion a year earlier, according to central bank figures.
“The situation is really serious and if there is any foreign donor help, it should be coming in a matter of weeks, not months,” said Ondrej Schneider, senior economist at the Institute of International Finance in Washington and a former adviser to the Czech government. “It’s a matter of weeks before they run out of reserves.”
Jaresko said Wednesday that the government is trying to get the parliament to approve laws to fulfill IMF requirements ahead of the fund’s March 11 decision. The first part of the IMF loan will be disbursed within several days after approval, Jaresko said at a briefing in Kiev.
IMF Managing Director Christine Lagarde said earlier this month that the aid program is subject to “high risks,” with the main one being “geopolitical developments that may affect market and investor confidence.”
The IMF-led program totals $40 billion when including bilateral deals with nations as well as about $15 billion in savings expected from negotiations the country is pursuing with bond investors. Achieving that level of savings from a bond restructuring is probably too optimistic, Schneider said.
The IMF has stalled payouts under the existing funding plan as the nation held presidential elections in October, lawmakers delayed the passage of this year’s budget and the parties negotiated the revised bailout.
To contact the reporter on this story: Andrew Mayeda in Washington atamayeda@bloomberg.net
To contact the editors responsible for this story: Chris Wellisz at cwellisz@bloomberg.netScott Lanman, Brendan Murray